Why Governments Should Tax Mobile Capital in the Presence of Unemployment

This paper shows that a small open economy should levy positive source-based taxes on capital income to fight involuntary unemployment and increase welfare. A revenue-neutral tax reform which increases the capital tax rate and reduces the labour tax rate will induce firms to substitute labour for capital. Such a tax will lower marginal cost of production, increase output, and reduce unemployment as long as labour tax rate exceeds the capital tax rate. The result holds even though trade unions might succeed in subsequently increasing the net-of-tax wage rate if the elasticity of substitution between capital and labour is above a critical value which is itself below one. Independent of the elasticity of substitution, the government can promote wage moderation by increasing the personal tax credit instead of reducing the labour tax rate