A Model of Tradeable Capital Tax Permits

Standard models of horizontal strategic capital tax competition predict that, in a Nash equilibrium, tax rates are inefficiently low due to externalities - capital infl ow to one state corresponds to capital out ow for another state. Researchers often suggest that the federal government impose Pigouvian taxes to correct for these effects and achieve efficiency. We propose an alternative incentive-based regulation: tradeable capital tax permits. Under this system, the federal government would require a state to hold a permit if it wanted to reduce its capital income tax rate from some pre-determined benchmark. These permits would be tradeable across states. We show that, if the federal government sets the correct number of total permits, then social efficiency is achieved. We discuss the advantages of this system relative to the canonical suggestion of Pigouvian taxes.