On the optimal tax policy mix when consumers and firms are imperfectly mobile

An optimal taxation approach is employed to discuss the interaction between factor and commodity taxes for a small open economy when both profit-earning firms and domestic consumers are imperfectly mobile internationally. In this framework, we demonstrate two main results: first, a destination-based commodity tax dominates an origin-based VAT from an efficiency perspective since the first is an independent instrument in the presence of non-wage income, whereas the latter can be duplicated by an appropriate combination of wage and (cash-flow) profit taxation. Second, with mobility costs for firms the optimal profit tax is positive even if the location of firms imposes no social costs on the small country. Simulation results show how the optimal mix of wage, profit and consumption taxes depends on key model parameters.