Social Comparisons and Optimal Taxation in a Small Open Economy

• Published date: 01 October 2019
• Date: 01 October 2019
• Author: Tomas Sjögren,Thomas Aronsson,Olof Johansson‐Stenman
• DOI: http://doi.org/10.1111/sjoe.12308

Scand. J. of Economics 121(4), 1500–1532, 2019

DOI: 10.1111/sjoe.12308

Social Comparisons and Optimal Taxation

in a Small Open Economy*

Thomas Aronsson

Ume˚a University, SE-901 87 Ume˚a, Sweden

thomas.aronsson@umu.se

Olof Johansson-Stenman

University of Gothenburg, SE-405 30 Gothenburg, Sweden

olof.johansson@economics.gu.se

Tomas Sj¨ogren

Ume˚a University, SE-901 87 Ume˚a, Sweden

tomas.sjogren@umu.se

Abstract

In this paper, we analyzehow international capital mobility affects the optimal labor and capital

income tax policy in a smallopen economy when consumers care about relative consumption. The

main results crucially depend on whether the governmentcan tax returns on savings abroad. If the

government can use flexible residence-based capital income taxes, then the optimal policyr ules

from a closed economy largely carry overto the case of a small open economy.If it cannot, then

capital income taxes become completely ineffective.The labor income taxes must then indirectly

also reflect the corrective purpose that the absent capital income tax would have had.

Keywords: Capital mobility; optimal taxation; positional goods; relative consumption; small

open economy

JEL classification:D03; D60; D62; F21; H21; H23

I. Introduction

People care about their relative consumption (i.e., how much they consume

relative to what other people consume).1While this insight has a long

history, and was noted by the founding fathers of economics, including

*The authors are grateful for helpful comments from two anonymous referees and participants

at the Regional Science Association conference in Graz 2016. Research grants from the Bank of

Sweden Tercentenary Foundation, the Swedish Council for Working Life and Social Research,

and the Swedish Tax Agency (RS10-1319:1) are also gratefully acknowledged.

1For empirical evidence from research on happiness and from questionnaire-based experimental

research,s ee, forexample, Easterlin (1995, 2001), Johansson-Stenman et al. (2002), Blanchflower

and Oswald (2004), Ferrer-i-Carbonell (2005), Solnick and Hemenway (2005), Carlsson et al.

(2007), and Clark and Senik (2010).

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T.Aronsson, O. Johansson-Stenman, and T. Sj ¨ogren 1501

Adam Smith and John Stuart Mill, the literature dealing with the optimal tax

policy implications of relative consumption comparisons is more recent. Our

paper contributes to this body of literature by considering an intertemporal

model of a small open economy with a mobile capital stock, where the

government redistributes and corrects for externalities by using nonlinear

labor income and capital income taxes. We show that the optimal tax policy

responses to relative concerns crucially depend on whether the government

can observe and tax the returns on savings abroad through a flexible

residence-based capital income tax. Under quite realistic assumptions, the

optimal tax policy response can differ considerably from the tax policies

prescribed by closed-economy models in earlier studies.

Most earlier studies dealing with the tax policy implications of social

comparisons are based on static models of closed economies, and they

do not address the potential role of capital income taxation. A major

finding in this literature is that relative consumption comparisons typically

imply much higher optimal marginal labor income tax rates than in

standard economic models (without any social comparisons), because

relative consumption concerns give rise to large negative externalities. The

literature also explains how this corrective tax element will be modified

when information asymmetries prevent redistribution through lump-sum

taxes.2To our knowledge, Aronsson and Johansson-Stenman (2010) were

the first to analyze the role of capital income taxation in an economy where

people care about relative consumption, and where the government can

simultaneously use an optimal nonlinear labor income tax for purposes

of redistribution and externality correction.3They found that consumer

preferences for relative consumption have important implications for capital

income taxation even when the labor income tax is optimal, because the

positional externalities that consumers impose on one another can vary

both over the individual life cycle and over time in general. The more

(less) positional people become over time, the stronger will typically be

the argument for taxing (subsidizing) savings at the margin.4

2The earlier literature in this area includes Boskin and Sheshinski (1978), Oswald (1983),

Tuomala (1990), Ljunqvist and Uhlig (2000), Dupor and Liu (2003), Aronsson and Johansson-

Stenman (2008), and Eckerstorfer and Wendner(2013).

3See also Aronsson and Johansson-Stenman (2014a) for a generalization, in particular with

respect to the nature of the social comparisons. See Abel (2005) for a study of first-best optimal

capital income taxation in a representative-agent economy(without any labor income tax), where

the representative consumer has preferences for relative consumption.

4For instance, if people become more positional when their income increases, as suggested by

empirical evidence in Clark et al. (2008), there is an incentive to tax capital income at the margin

in a growing economy where people become more positional overtime. Similarly, if the young

are more positional than the old, which is consistent with some empirical evidence (Pingle and

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1502 Optimal taxation in a small open economy

However, the studies on optimal taxation refer red to above, and indeed

almost all previous studies in the policy-oriented literature on relative

consumption, are based on closed-model economies.5This is problematic

when dealing with capital taxation as most (if not all) developed countries

are open to capital mobility. Our main contribution in this paper is that

we generalize the setting of Aronsson and Johansson-Stenman (2010) to

a small open economy with capital mobility where individuals can invest

their savings either domestically or abroad. This generalization is clearly

important because capital mobility can seriously restrict the use of capital

income taxation as a means of correction and redistribution.

The point of departure is the optimal income tax model with overlapping

generations (OLG) developed by Aronsson and Johansson-Stenman (2010),

where (realistic) information asymmetries prevent the government from

using type-specific lump-sum taxes for purposes of redistribution. Here,

this model is augmented with an international capital market, and it is

embedded into the framework of a small open economy.6A small open

economy is here meant to imply that the country is small enough for its

government to treat the world market interest rate as exogenous – a realistic

assumption for many (if not most) countries. Nevertheless, at the end of

Section III, we comment on how the results would change if the economy

were large in the sense that the government is able to (strategically) affect

the world market interest rate.

The scope for capital income taxation will, of course, depend on

whether all capital income is observable to the government. Following the

terminology in the literature on capital income taxation in open economies,

we refer to “source-based” capital income taxation when the capital income

is taxed at the source (i.e., imposed by the country where this income is

generated, irrespective of whether the income earner is a domestic or foreign

resident). In contrast, “residence-based” capital income taxation means

that the tax is levied on the citizens of a particular country, irrespective of

whether they earn their income domestically or abroad. An individual who

Mitchell, 2002; Johansson-Stenman and Martinsson, 2006), it is, for this reason, desirable to

subsidize capital income at the margin.

5To our knowledge,the only exceptions are Aronsson and Johansson-Stenman (2014b), with an

examination of the optimal provision of public goods, and Aronsson and Johansson-Stenman

(2015), dealing with optimal income taxation in two-country economies with social comparisons

within as well as between countries.

6Many earlier studies have examined the implications of international capital mobility for

revenue collection and provisionof public goods at the national level in contexts without relative

consumption comparisons; see, for example, Zodrow and Mieszkowski (1986), Wilson (1986),

Bucovetsky and Wilson (1991), and Huber (1999). See also Aronsson and Sj ¨ogren (2014),

who analyze the tax policy implications of quasi-hyperbolic discounting in an economy with

international capital mobility.

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