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Bauer, Christian; Davies, Ronald B. and Haufler, Andreas (August 2011): Economic integration and the optimal corporate tax structure with heterogeneous firms. Discussion Papers in Economics 2011-14 [PDF, 274kB]

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We study the optimal combination of corporate tax rate and tax base in a model of a small open economy with heterogeneous firms. We show that it is optimal for the small country's government to e®ectively subsidize capital inputs by granting a tax allowance in excess of the true costs of capital. Economic integration reduces the optimal capital subsidy and drives low-productivity firms from the small country's home market, replacing them with high-productivity exporters from abroad. This endogenous policy response creates a selection effect that increases the average productivity of home firms when trade barriers fall, in addition to the well-known direct effects.

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