Optimal Capital Income Taxes and Capital Controls in Small Open Economies

This paper studies the optimal taxation of capital income in a simple model of a small open economy where domestic residents can evade taxes on their foreign investment income. The national government can only tax domestic capital income and can impose capital controls, which however absorb real resources. The design of optimal policy in this model depends on the revenue needs of the government. For relatively low levels of government expenditures, it turns out that the country does not levy capital income taxes but may restrict capital exports. Otherwise, the country taxes domestic capital income and sets capital controls such that capital exports are driven to zero, at an optimum. In contrast to other models with capital controls it turns out that this policy can lead to underinvestment in domestic capital.