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This paper shows that a small open economy that suffers from involuntary unemployment should levy a positive source-based tax on capital income. A revenue-neutral tax reform that increases the capital tax rate and reduces the labour tax rate will induce firms to substitute labour for capital. Such a tax reform will lower the marginal cost of production, increase output, reduce unemployment, and increase domestic welfare as long as the 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). Finally, and importantly, independent of the size of the elasticity of substitution, the government can promote wage moderation and reduce unemployment by increasing the personal tax credit of employed workers instead of reducing the labour tax rate.

Why Governments Should Tax Mobile Capital in the Presence of Unemployment