Optimal Taxation of Foreign Source Investment Income With Heterogeneous Households

Abstract

Using a two-country static general equilibrium model with two goods (tradables and nontradables) and heterogeneous households (laborers and capital owners), this article analyzes how real exchange rate and income redistribution affect the optimal taxation of foreign source investment income. It shows that if the home tradable good sector is capital intensive relative to the nontradable good sector and if the weight of capital owners in the social welfare function is sufficiently high, then the optimal tax rate on foreign source investment income is lower than the tax rate on domestic investment income. Numerical simulations suggest that a higher weight of capital owners in the social welfare function and a higher fraction of the multinational's capital exported from the home country are among the factors that lead to a greater (negative) differential between the taxes on foreign source and domestic investment income.