J Popul Econ (2014) 27:257–273

DOI 10.1007/s00148-013-0480-x

ORIGINAL PAPER

Effects of capital taxation on economies with different

demographic changes: short term versus long term

Akira Yakita

Received: 18 September 2012 / Accepted: 24 June 2013 /

Published online: 17 July 2013
© Springer-Verlag Berlin Heidelberg 2013

Abstract We examine the effect of source-based capital taxation on capital accumu-

lation in countries with endogenous fertility and free international capital mobility.
When fertility is constant, a tax cut accelerates domestic capital accumulation
through international arbitrage and exerts negative influences on the welfare of a for-
eign country. In contrast, with endogenous fertility, a tax cut by an economy with
a higher tax rate and exporting capital may deter capital accumulation and hence
lower the welfare in not only domestic but also foreign economies in the long term,
although the tax cut may accelerate domestic capital accumulation in the short term.

Keywords International capital mobility · Source-based capital taxation ·

Endogenous fertility · Demographic change

JEL Classifications F21 · H25 · J14

1 Introduction

In an open economy with free international capital mobility, since the arbitrage condi-
tion holds internationally, source-based capital taxation prevents capital from flowing
into the economy and rather induces capital outflows abroad. When the mobile costs

Responsible editor: Alessandro Cigno

Electronic supplementary material The online version of this article
(doi:10.1007/s00148-013-0480-x) contains supplementary material, which is available
to authorized users.
A. Yakita ()
Graduate School of Economics, Nagoya City University, 1 Yamanohata, Mizuho-cho, Mizuho-ku,
Nagoya 467-8501, Japan
e-mail: yakita@econ.nagoya-cu.ac.jp
258 A. Yakita

of other production factors such as labor are high, it may be undesirable to tax
such capital based on the source rule in order to secure enough domestic produc-
tion and employment (e.g., Gordon 1986; Devereux et al. 2002). Since capital moves
toward economies with lower taxes, tax cuts will be rather endorsed politically.1 As
Fig. 1 shows, the corporate tax rate has been recently reduced in many OECD coun-
tries, while some countries have not changed substantially.2 These changes in the
differences among the tax rates would affect the international capital movements
immediately as well as in the long term.
While the theoretical analysis of the effects of capital taxation on interna-
tional capital movement has mostly assumed a two-country model, it is mostly
assumed that, except for taxes, economic environments, such as demography, are
similar in those economies. However, it is now well recognized that even among
developed countries, the population ages and grows at different speeds, and the sav-
ings/investment patterns vary between countries and over time. The purpose of the
present paper is to investigate the short-term and long-term effects of source-based
capital taxation and its changes on both capital accumulation in each economy and
international capital movements between two economies with endogenous fertility.
In the literature on patterns of international capital movements and/or trade among
economies with different demographic changes, (Higgins 1998; Helliwell 2004;
Lührmann 2003) among others have shown empirically that economies with a large
working population will tend to be net capital exporters in a global market because
of high domestic savings, that relatively young economies tend to import capital due
to their high investment demand and low national savings, and that a country with a
large retired population will tend to be net capital importing. Using theoretical mod-
els, Ito and Tabata (2010) and Yakita (2012) analyzed capital movements between
economies with a different speed of population aging.3 However, capital taxation is
not explicitly considered in these studies.
On the other hand, in the literature on international capital taxation, two rules
have been conventionally distinguished, the residence rule and the source rule. One
may call them taxation on savings and investment, respectively. Sibert (1988, 1990)
and Ihori (1991) among others analyzed the international influences of changes in

1 Thus, the possibility of tax cut competition has been pointed out. For arguments on tax competition in the
framework of a noncooperative game, see, for example, Hamada (1966), Wildasin (1988), and Huizinga
and Nielsen (1997), while for tax harmonization, see, for example, Razin and Sadka (1991a) and Razin and
Yuen (1996). From the viewpoint of securing tax revenues from capital taxation, however, international
cooperation in the form of international exchange of savings information can be considered. See Huizinga
and Nielsen (2008). Mendoza and Tesar (1998) among others more recently examined the international
transmission of tax reforms in a dynamic model and showed that normative and positive implications of
tax reforms are significantly different in open economies from those in closed economies. However, none
of the literature cited above considered endogenous fertility.
2 The tax cuts in OECD countries may be attributed to the fact that they moved from boom to recession

during the period. On the other hand, Devereux et al. (2002) also showed that the average statutory corpo-
rate income tax rates in the European Union and the USA have fallen dramatically from 48 % in 1982 to
35 % in 2001.
3 Momota and Futagami (2005) examined the effects of demographic structure on international lending

and borrowing in a two-country model of Blanchard–Weil overlapping generations.

Short-term and long-term effects of capital taxation on economies 259

45
-0.04
40 8.72 0.2

0.01 0.97 5
9 3.38 10 9 9
35 5.5 5 3 13
1.81
0 5 3 5.5 2
30 8 0 1.7
1
5 4 Reductions
25 2.93
in 2004-
-4 2009
20 0 0
-0.5 3
tax rate in
15
0 2009
10

-5

-10

Fig. 1 Effective corporate income tax rates in 2009 and changes in 2004–2009

the capital taxation using overlapping generations settings. They showed that while
residence-based capital taxation affects capital accumulation in the same direction
both at home and abroad, a cut in source-based capital taxation accelerates domes-
tic capital accumulation through international arbitrage, thereby exerting negative
effects on the welfare of other countries. Although countries actually employ both
types of capital taxation and, at the same time, tax credits or deductions to avoid dou-
ble taxation, source-based taxation is more important from the political viewpoint in
the sense that the differences in tax rates directly cause international capital move-
ments. Therefore, the present study focuses on source-based capital taxation. We
consider the situation in which the tax rates are different and a country with a higher
tax rate has an incentive to reduce the rate in order to attract capital inflows from the
rest of the world. In order to focus on the short-term and long-term effects of the tax
policy, we consider a once-and-for-all change of the tax rate.
The main results of the present study are as follows: If the tax revenue from capital
taxation increases the income of the working and child-rearing generation, the cap-
ital tax induces workers to have greater life-cycle savings for their retirement and a
greater number of children. Assuming that the initial steady-state population growth
rates of both economies are the same, per-worker savings is higher in the home
economy with higher capital taxation. Then, if the tax rate is reduced in the home
economy, the home workers decrease the number of their children due to the reduced
income brought about by lower government expenditures. Although the tax cut tends
to internationally attract capital to the home country and accelerate domestic cap-
ital accumulation through capital inflows in the short term, the capital labor ratios
in both economies decline in the long term since the world economy approximately
approaches the autarkic economy of greater population with a still smaller life-cycle
260 A. Yakita

savings. Thereby, the long-term economic welfare will also be lower not only in the
other economy but also at home. This result is in contrast to that in conventional
models with fixed and common fertility.
The model is basically the same as those of two countries populated by two-
period-lived overlapping generations in Sibert (1988, 1990) and Ihori (1991), incor-
porating endogenous fertility decisions of agents. The next section introduces a
model, in which the government spends the tax revenue to increase workers’ income.
Section 3 examines the short-term and long-term effects of a tax cut. Section 4 exam-
ines the welfare effect of the tax cut on domestic and foreign economies. The effects
of a tax increase and an introduction of transfers to the retired generation will be
discussed in Section 5. The case of transfers to both generations and a numerical cal-
culation of the policy change effects are shown in the Appendices of the Electronic
Supplementary Material (ESM). The final section concludes the paper.

2 Model

We assume an open two-country model with perfectly free capital mobility, while
labor is a country-fixed factor. Agents in each country live for two periods, working
and rearing children in the first (young) period and retiring in the second (old). The
lengths of the two periods are certain and normalized to one. Capital stock depreciates
completely after one-period use.

2.1 Households in country i

The lifetime utility of an agent in country i who works in period t (hereafter called
generation t) is assumed as uit = log cti + ε log nit + ρ i log dti+1 , where cti is the
agent’s consumption in the first period, nit is the number of his children, and dti+1 is
his consumption in the second period.4 ε is the utility weight on having children and
ρ i is the discount factor, where 0 < ε, ρ i . The budget constraints of the agent when
young and old, respectively, are
 
wti 1 − znit + Tti = cti + sti (1)

Rti+1 sti = dti+1 (2)

where sti is the life-cycle savings, Tti is the transfers from the government, wti is the
wage rate in country i in period t, Rti+1 is the gross rate of return on savings, and z
is the child-rearing (time) cost per child.5 The agent chooses consumption in the two
periods and the number of children so as to maximize the lifetime utility subject to

4 The utility function is common in the literature. See, for example, Zhang et al. (2001) and van Groezen
et al. (2003).
5 The gross rate of return stands for one plus the rate of return.
Short-term and long-term effects of capital taxation on economies 261

the budget constraints (1) and (2).6 The optimal savings plan and number of children
are as follows:7
ρi  
sti = wti + Tti (3)
1+ε+ρ i
 
1 ε Tti
nt =
i
1+ i . (4)
z 1 + ε + ρi wt

2.2 Production sector in country i

The production technology of country i is assumed to be presented by the following

constant-returns-to-scale production function of capital and labor:
   
Yti = F i Kti , Lit = Lit f i kti (5)

where Yti denotes the aggregate output of country i and Kti and Lit are aggregate cap-
ital stock and labor of country i, respectively, in period t and kti = Kti /Lit . Assuming
that factor markets are competitive, domestically for labor and internationally for
capital, the following conditions hold:
 
rti = fki kti (6)
   
wti = f i kti − kti fki kti (7)
where rti is the before-tax rate of return on capital in country i in period t, and the
subscripts of the function denote the partial derivatives with respect to the variables,
e.g., fki = ∂f i /∂k i .
For analytical convenience, we assume that the production technologies in the two
countries are the same.

2.3 Government in country i

For our purpose, government levies capital taxes based on the source rule and rebates
the tax revenue to the domestic working generation in a lump-sum manner in each
period. This is only a simplifying assumption. Actually, the tax revenue, possibly
together with those from other taxes, is appropriated for various expenditures such
as those which may raise the productivity in the private production sector and/or
improve social security services. In particular, government may rely on the Keynesian

6 For example, Fanti and Gori (2009) explicitly take into account material costs of child rearing. With
material costs, the number of children tends to depend positively on wage income, which is in turn posi-
tively related to the capital labor ratio, the state variable. However, the positive relation between fertility
and income does not necessarily seem to be supported empirically. Thus, we assume only forgone income
costs of child rearing in the present study. An increase in the after-tax wage rate raises the opportunity
(time) cost of child rearing, decreasing the number of children.
7 We may incorporate human capital accumulation during childhood into the model without altering our

results essentially.
262 A. Yakita

expenditure policy which serves to reduce unemployment and/or increase employ-

ment. Since this study assumes full employment as well as the balanced government
budget, such a policy may be interpreted as one that increases income and/or the
productivity of the working generation as a whole. Focusing on the effect of the
expenditure enhancing the income of the working generation, we assume here that
the expenditure is solely lump-sum transfers to the working generation.8
The budget constraint of the government in country i is then given as

τ i rti Kti = Tti Nti (8)

where τ i stands for the source-based capital income tax rate in country i and Nti is
the population size of the working generation of country i in period t.

2.4 Domestic labor market equilibrium

Since labor is assumed to be a country-fixed factor, the following equilibrium

condition in the domestic labor market must hold:
 
Lit = 1 − znit Nti . (9)

Making use of (9), the government budget constraint (8) can be rewritten as
   
τ i 1 − znit kti fki kti = Tti . (10)

Then, by inserting (7) and (10) into (4), it follows that

    
1 ε τ i 1 − znit kti fki kti
nt =
i
1+     .
z 1 + ε + ρi f i kti − kti fki kti

Therefore, by solving for nit , we obtain the number of children per worker as
     
ε f i kti − 1 − τ i kti fki kti
nt = 
i

     . (11)
z 1 + ε + ρ i f i kti − kti fki kti + τ i εkti fki kti

2.5 Equilibrium in the international capital market

Assuming perfect capital mobility between countries, we have the equilibrium

condition in the international capital market as

st1 Nt1 + st2 Nt2 = Kt1+1 + Kt2+1 (12)

8 See Section 5.2 and Appendix B of the ESM for the plausibility of the assumption.
Short-term and long-term effects of capital taxation on economies 263

or, in terms of per worker in country 2,

   
lt st1 + st2 = lt 1 − zn1t +1 n1t kt1+1 + 1 − zn2t +1 n2t kt2+1 , (13)

where lt = Nt1 /Nt2 , Nti+1 = nit Nti (i = 1, 2), and (9) are used. The arbitrage
condition in the world capital market is given as9
       
1 − τ 1 fk1 kt1 = 1 − τ 2 fk2 kt2 = RtW (14)
   
where RtW = Rti (i = 1, 2) holds. Recalling that sti = s i kti ; τ i and nit = ni kti ; τ i
(i = 1, 2), (13) and (14) give the dynamic system of this two-country world in terms
of kt1 and kt2 .
At this point, for expositional purpose, we assume that the production function is
of Cobb–Douglas type, i.e.,10
   α
f i kti = A kti (0 < α < 1; A > 0) , (15)

and that the source-based capital tax rate in country 2 is set at zero, i.e., τ 2 = 0.
Under these assumptions, we can show from (11) that
ε 1 − (1 − τ 1 )α 1 ε
n1t = ≡ n1 and n2t = ≡ n2 . (16)
z (1 + ε + ρ 1 )(1 − α) + τ 1 εα z 1 + ε + ρ2
From (16), we have that dnit /dkti = 0 (i = 1, 2) and that

> < τ 1α
n1 = n2 as ρ 1 = ρ 2 + (1 + ρ 2 ). (17)
< > 1−α
If ρ 1 = ρ 2 , we have n1 > n2 , and recalling that the populations in countries 1 and 2
grow at rates n1 and n2 , respectively, we can readily show that 1/lt → 0 as t → ∞.
In order to have constant relative population sizes for the two countries at the initial
long-term equilibrium, we assume here that n1 = n2 initially, i.e., from (17)
τ 1α
ρ1 = ρ2 + (1 + ρ 2 ) (> ρ 2 ), (18)
1−α
and also, for expositional simplicity, that the initial population sizes in both countries
are the same, i.e., lt = 1.

9 Even under the tax credit schemes by which capital exporting countries allow taxes paid to foreign gov-
ernments by firms investing abroad to be credited against domestic tax liabilities, double taxation may not
be avoided if the source-based capital tax rates in other economies are high. Bond and Samuelson (1989)
showed that strategic behavior by the two countries involved leads to the elimination of trade in capital if
the source country can restrict capital flows. See also Giovannini (1989), Frenkel et al. (1991), Razin and
Sadka (1991b), and Gordon and Hines (2002).
10 We may assume instead a constant-elasticity-of-substitution production function. In that case, the results

will be complicated, although the qualitative properties of the results are expected to hold basically by
choosing parameters properly.
264 A. Yakita

2.6 Existence and stability of the long-term world equilibrium

Now, we investigate the existence and stability of the long-term equilibrium. Using
(13) and (14), we obtain
dst1 1 dst2 2
dkt + 2 dkt = (1 − zn1 )n1 dkt1+1 + (1 − zn2 )n2 dkt2+1 (19)
dkt1 dkt
(1 − τ 1 )fkk
1
dkj1 = fkk2
dkj2 (j = t, t + 1) (20)
where making use of (3), (7) and (10), and taking (16) into account, we have
dst1 ρ1 
= −[1 − τ 1
(1 − zn 1
)]k 1 1
f
t kk + τ 1
(1 − zn1 1
)f k >0 (21)
dkt1 1 + ε + ρ1
dst2 ρ2  
= −k 2 2
t f > 0. (22)
dkt2 1 + ε + ρ2 kk

Inserting dkj2 of (20) into (19), we obtain

1
dst1 dst2 fkk
dkt1+1 + (1 − τ 1)
dkt1 dkt2 2
fkk
= . (23)
dkt1 (1 − zn1 )n1 + (1 − zn2 )n2 (1 − τ 1 )
1
fkk
2
fkk

Thus, since both the denominator and numerator are positive, the stability condition
of the dynamic system, (13) and (14), is
dkt1+1
0< < 1. (24)
dkt1
We assume that the stability condition (24) is satisfied.
Under the Cobb–Douglas production function, we can readily show that
 
kfkk → 0 and fk → 0 i.e., dsti /dkti → 0 as k → ∞ and (25a)
 
kfkk → −∞ and fk → ∞ i.e., dsti /dkti → ∞ as k → 0. (25b)
Therefore, there is a steady state, = (i = 1, 2). Denoting the steady-state
kti kti+1
capital stocks by k∞ and k∞ , we find that they satisfy the following equations:11
1 2

s 1 (k∞
1
) + s 2 (k∞
2
) = (1 − zn1 )n1 k∞
1
+ (1 − zn2 )n2 k∞
2
(26)
      
1 − τ 1 fk1 k∞ 1
= fk2 k∞ 2
= R∞W
. (27)
The long-term equilibrium can be depicted as in Fig. 2. From (27), we have < 1
k∞
2 . On the other hand, we will have s 1 (k ) = s 2 (k ) when τ 1 = 0, while we can
k∞ t t
show that an increase in the tax rate raises savings for a given capital labor ratio, i.e.,

11 So
 far,
 we have assumed
 that n1 = n2 . If n1 > n2 , i.e., if ρ 1 > ρ 2 + [τ 1 α/(1 − α)](1 + ρ 2 ), we have
s 1 ka1 = 1 − zn1 n1 ka1 as an asymptotic long-term equilibrium since 1/lt → 0 as t → ∞, while if
   
ρ 1 < ρ 2 + [τ 1 α/(1 − α)](1 + ρ 2 ) and n1 < n2 , we will have s 2 ka2 = 1 − zn2 n2 ka2 since lt → 0 as t
→ 8.
Short-term and long-term effects of capital taxation on economies 265

(1 zn) nk
s 1 (1 zn1 )n1 k 1
s1 ( k 1 )

s 2 (k 2 )

(1 zn 2 )n 2 k 2 s2

0 k
k a2 k 1 k 2 k a1

Fig. 2 World steady state (n1 = n2 , l = 1) and autarkic steady states

∂st1 /∂τ 1 > 0, from (3), (7), (10), and (16).12 Therefore, savings curve s 1 is above
curve s 2 , as illustrated in Fig. 2. This implies that
   
s 1 (k∞
1
) − (1 − zn1 )n1 k∞1
= − s 2 k∞ 2
− (1 − zn2 )n2 k∞
2
> 0. (28)

At the initial long-term equilibrium, country 1 exports capital to country 2 or, in other
words, capital escapes from the country with a higher source-based capital tax to the
country levying no such taxes. It should be noted that, denoting the autarkic long-
term capital labor ratios when both countries are closed by ka1 and ka2 , respectively,
we have
ka2 < k∞
1 2
< k∞ < ka1 . (29)

The savings–investment differences of the two economies in the world steady state
are also illustrated in Fig. 2. With the same rate of population growth, the economy
with a (higher) source-based capital tax will export capital because of higher life-
cycle savings due to a higher discount factor, i.e., due to longer retirement periods.

3 Effects of a cut in source-based capital taxation on capital accumulation

In this section, assuming that the world economy is initially in the long-term equilib-
rium defined in the previous section, we analyze the effect of a tax cut in country 1,
associated with changes in the wage-income enhancing expenditure policy.13

12 SeeSection 3 for the derivation.

13 Startingalternatively with a symmetric situation in which τ 1 = τ 2 and ρ 1 = ρ 2 , the capital labor ratio
in country 2 is affected by capital outflows to country 1 in the short term, although there would be no long-
term effect on country 2 since the population weight of country 2 approaches one. However, as mentioned
in Section 1, we are concerned with a more realistic case of τ 1 = τ 2 .
266 A. Yakita

3.1 Long-term effect

From (16), we have

dn1 εα (1 − α)(1 + ρ 1 )
=
 > 0. (30)
dτ 1 z (1 + ε + ρ 1 )(1 − α) + τ 1 εα 2

That is, the tax cut decreases the fertility rate in country 1. The result can readily be
shown as follows: The tax cut reduces the income of the working generation, inducing
workers to reduce the number of their children. Thus, the relative population size of
the home country with higher life-cycle savings approaches zero in the long term,
i.e., lt → 0 as t → ∞. The long-term equilibrium in the world capital market is thus
given as
   
s 2 k̃∞
2
= 1 − zn2 n2 k̃∞ 2
, (31)
 
W = k̃ 2 = k 2 , and the long-
that is, the worldwide capital labor ratio is given by k̃∞ ∞ a
term capital labor ratio in country 1 is given by the condition
     
1 − τ̃ 1 fk1 k̃∞
1
= fk2 k̃∞
2
= R̃∞
W
, (32)

where τ̃ 1 (< τ 1 ) denotes the new tax rate and x̃ denotes the value of variable x after
the tax cut. Therefore, we have the following proposition:

Proposition 1 Suppose that country 1 has a higher (source-based) capital income

tax than country 2, exporting capital to country 2, and that the fertility rates in both
countries are the same in the initial (worldwide) steady state. When the capital tax
rate in country 1 is reduced, its fertility rate declines, and its relative population
size approaches zero in the long term. The capital labor ratios in both countries will
decrease in the long term.

Thus, the tax cut policy does not necessarily succeed in raising the capital labor
ratio in the home country in the long term. The important assumption is that the econ-
omy with higher capital taxation initially exports capital abroad, which does not seem
implausible. It should be noted that if country 1 is closed, the change in the steady-
state capital labor ratio does not necessarily decline, depending on the two opposite
effects; the positive one of the tax cuts on capital accumulation and the negative one
on the number of workers induced by the reduced tax revenue–income transfers. If
the former is relatively great, the new autarkic long-term capital labor ratio is higher
and vice versa. In contrast, with free international capital mobility, the capital labor
ratio in the economy with greater life-cycle savings does not increase in the long term
because of the higher growth of the working population in the other economy. The
greater working population in country 2 demands more capital, importing from the
home country. However, although per-worker life-cycle savings in the home coun-
try is higher, its total life-cycle savings becomes smaller and smaller as time elapses,
since it has a lower population growth than country 2.
Short-term and long-term effects of capital taxation on economies 267

3.2 Short-term effect

Next, in order to show the short-term effect of the tax cut, we assume that it occurs
only once in period t. The tax change causes reallocation of capital between countries
in the period of the policy change (i.e., in period t), and then, the transitional pro-
cess follows. For expositional simplicity, we normalize the population sizes of both
economies in period t to one without loss of generality, i.e., Nt1 = Nt2 = 1.
Since the total capital is determined by the world savings in the previous period,
the reallocated capital must satisfy the constraint
Kt1 + Kt2 = K t ≡ st1−1 Nt1−1 + st2−1 Nt2−1 (33)
and the arbitrage condition
 
   Kt1

K t − Kt1
1 − τ̃ fk1
1
= fk2 . (34)
1 − zn1 1 − zn2

Differentiating (34) with respect to τ 1 , we obtain

k1 z 1
dKt1 fk1 − (1 − τ̃ 1 )fkk1 t dn
1−zn1 dτ 1
= < 0. (35)
dτ 1 (1 − τ̃ 1 )fkk
1 1
1−zn1
+ fkk2 1
1−zn2
Thus, a tax cut induces capital inflows into country 1 from country 2 in the period of
the policy change. Therefore, from the definition, we have
dkt1 1 dKt1 kt1 z dn1
= + . (36)
dτ 1 1 − zn1 dτ 1 1 − zn1 dτ 1
Inserting (35) into (36) and rearranging terms, we obtain
    1
dkt1 kt1 z dn1 2 1 − zn
= f 1
k + f 2
kk / 1 − τ̃ 1
f 1
kk + f kk . (37)
dτ 1 1 − zn2 dτ 1 1 − zn2
Since dn1 /dτ 1 > 0, the sign of (37) is not determined a priori. That is, the capital
labor ratio does not necessarily rise in spite of capital inflows. The capital labor ratio
in the period of the tax cut will be lower if the negative effect from the reduced num-
ber of children (i.e., the second term in the numerator parentheses), or equivalently
the increase in the labor supply, is greater than the positive effect of capital inflows
(i.e., the first term) and vice versa. On the other hand, since Kt2 = K t − Kt1 , we have
dkt2 1 dKt1
= − > 0. (38)
dτ 1 1 − zn2 dτ 1
The capital labor ratio in country 2 decreases with tax cuts in country 1 because of
capital outflows abroad.
Given the reallocation of capital in the period of the policy change, the capital
labor ratio in period t + 1 is determined by the system (13)  and (14), in which the
tax rate and the fertility rate in country 1 are τ̃ 1 and n1 τ̃ 1 , respectively. Savings in
both countries in period t is determined for the reallocated capital stocks as given, but
the tax change also affects the capital labor ratios in period t + 1 through changes in
268 A. Yakita

savings and the fertility rate.14 In order to take these effects into account, we examine
the transition from period t to t + 1, assuming that the capital labor ratios in period t
remain constant. From (13) and (14), we obtain
     1    
1 − zn1 n1 1 − zn2 n2 dkt +1 /dτ 1 kt Sτ
   = (39)
1 − τ̃ 1 f 1 kk −f 2 kk dk 2 /dτ 1 kt
t +1
0
where
dst1    1
1 dn
Sτ = kt − 1 − 2zn1
k t +1 (40)
 dτ 1 dτ 1

and subscript kt denotes the change with maintaining constant the capital labor ratios
in period t. From (39), we obtain
dkt1+1 
k = D −1 (−f 2 Sτ ) (41a)
kk
dτ 1 t
dkt2+1     
k = D −1 − 1 − τ̃ 1 f 1 Sτ , (41b)
t kk
dτ 1
    
where D = − 1 − τ̃ 1 1 − zn2 n2 fkk 1 − 1 − zn1 n1 f 2 > 0. Since dn1 /dτ 1 > 0
  
kk 
and dst1 /dτ 1 kt = ρ 1 [1 − zn1 − τ̃ 1 z(dn1 /dτ 1 )]kt1 fk1 / 1 + ε + ρ 1 > 0,
we cannot determine  the  sign of S 
τ . However, we can easily show that
sgn dkt1+1 /dτ 1 kt = sgn dkt2+1 /dτ 1 kt . When the effect of tax change on the
fertility rate (i.e., dn1 /dτ 1 > 0) is sufficiently
 great (small), we will have Sτ < (> )0.
If Sτ < ( > )0, we have dkt1+1 /dτ 1 kt < (>)0 and dkt2+1 /dτ 1 kt < (>)0. When
the fertility effect of tax cut is sufficiently great, the capital labor ratios of both
economies in period t + 1 will be higher with a lower capital tax rate in country 1,
given capital labor ratios in period t, kti (i = 1, 2). Thedynamics of the system after
period t + 2 is given by (13) and (14) for τ̃ 1 and n1 τ̃ 1 .15

3.3 Transition

Now, we may sum up the results as follows: On the one hand, in the short term,
the tax cut may increase, though not necessarily, the capital labor ratio in country 1,
thereby decreasing capital outflows to country 2. On the other hand, the decreased
tax revenue reduces the income of the working generation and hence induces them
to have fewer children in the home country. The effects of capital reallocation are
instantaneous impacts, while the effect on fertility remains permanently. Therefore,
in the long term, the negative effect of the decreased number of workers in country 1
will dominate the short-term effects and hence reduce the capital labor ratios in both
countries.
The transition of the world capital market equilibrium can be also shown in terms
of the gross interest rate in the market. When country 1 cuts the tax rate, the world
gross rate of return on capital, RtW , will move in the opposite direction of kt2 . It will

  
14 Theeffect on savings is given by ∂st1 /∂kt1 dkt1 /dτ 1 + ∂st1 /∂τ 1 , with its ambiguous sign from (37).
15 However, owing to the capital taxation–expenditure policy, the capital labor ratios after period t + 2

might increase through increased savings.

Short-term and long-term effects of capital taxation on economies 269

W = f 2 k2
 
immediately rise from R∞ k ∞ in period t, since the tax cut brings about an
additional demand for capital in country 1 and hence induces capital inflows to coun-
try 1 from country 2, i.e., international reallocation of capital. Then, for a short term,
as the world total savings may increase, the rate of return may decline. However, as
the relative population size of country 1 shrinks, the aggregate savings per worker
in the world decreases and, therefore, the rate of return gradually increases. When
the relative population size of country 1 approaches zero, the world asymptotically
approximates an isolated single country, i.e., country 2. In that situation,
the rate
  of
W = f 2 k2 ,
return on capital is equal to the autarkic rate of return of country 2, R̃∞ k a
where R∞ W < R̃ W from (29).16
∞
At this stage, we should relate our contribution within the context of the literature
on tax incidence. In the literature on tax incidence in open economies, the estab-
lished view is that if the taxing economy is large, the share of the benefit of the tax
cut received by capital is roughly equal to its share of the world capital stock. How-
ever, as shown, for example, by Harberger (2008) and Zodrow (2010), labor receives
more than 100 % of the benefit of the tax cut in the form of wage rises when labor is
mobile across domestic production sectors, i.e., between good production and child
production (or child rearing) in the present setting. The risen wage rate increases
the forgone cost of child rearing, reducing the number of children. Thus, the con-
ventional argument also holds in our model, but our analysis shows that it is only
in the short term. The endowment of the country-fixed factor may change over time
as a result of the policy change in the present setting. The decline in the number of
workers with greater life-cycle savings per worker in the home country reduces the
worldwide capital supply as time elapses. Thereby, the capital labor ratios not only
in the home country but also in country 2 fall through arbitrage in the long term.
Thus, with endogenous fertility and differences in per-worker life-cycle savings, the
conventional incidence may not hold and in general should be modified: Labor, an
immobile factor, may bear the burden (but not receive the benefit) of the tax cut in the
form of lower wage rates in the long term.17 Contrastingly, tax increases may benefit
the country-fixed factor, as will be shown in Section 5.

4 Welfare effects of a tax cut

In this section, we examine the instantaneous and long-term welfare effects of a tax
cut.
In country 1, responding to the decrease in government transfers, the working gen-
eration reduces the number of children, consumption, and life-cycle savings in the
period of the policy change (i.e., in period t). While the decreased life-cycle savings
will lower the capital labor ratio in the next period, the tax cut induces capital inflows
from country 2 in period t, raising the world interest rate. Therefore, the wage rate
in period t tends to be higher than otherwise, although the labor supply increases

16 See Fig. A3 in Appendix A of the ESM.

17 For the conventional results on tax incidence, see, for example, Kotlikoff and Summers (1987).
270 A. Yakita

(or child-rearing time decreases). If the capital inflows are sufficiently great, the
increased wage income may increase lifetime utility of working generation t in coun-
try 1. Otherwise, if the reduction in total income due to the tax reduction is relatively
great, the welfare of generation t may be lowered relative to the previous steady-state
lifetime utility. On the other hand, the retired generation of country 1 in period t ben-
efits from both the tax reduction and the raised interest rate, and their ex post lifetime
utility will be higher.
In country 2, the working generation will suffer from the lower capital labor ratio
due to the decreased capital inflows from (or increased capital outflows to) country
1, and the retired generation will benefit from the rise in the world interest rate.
Next, in the long term, the lifetime utilities of generations of both countries in the
following periods depend on the evolution of the capital labor ratios. Inserting the
optimal plans of individuals into the lifetime utility in country 1, we have
uit = log cti + ε log nit + ρ i log dti+1
 −(1+ε+ρ i )  ρ i 
= log 1 + ε + ρ i · (ε/z)ε · ρ i
 
+(1 + ε + ρ i ) log wti + Tti − ε log wti + ρ i log Rti+1 (42)

where, in the Cobb–Douglas production function case,

 α
Tti = τ i (1 − zni )αA kti (43a)

   α−1
Rti+1 = 1 − τ i αA kti+1 (43b)

wti = (1 − α)A(kti )α (43c)

ε 1 − (1 − τ i )α
nit = . (43d)
z (1 + ε + ρ i )(1 − α) + τ i εα
Differentiating (42) and (43a–43d) with respect to kti and inserting the terms into
duit /dkti , we obtain

duit 1 dkti+1 kti
= i α(1 + ρ ) − ρ (1 − α) ·
i i
· i . (44)
dkti kt dkti kt +1

Taking (24) into account, we will have duit /dkti > 0 near the new steady state where
kti = kti+1 .18 Since, as shown in the previous section, the capital labor ratios in both
countries eventually decline to the new steady state in its neighborhood, the lifetime

18 We assume here that condition α > ρ i /(1 + 2ρ i ) is satisfied. This is true for plausible parameters.
Short-term and long-term effects of capital taxation on economies 271

welfare of an individual in both countries decreases near the new steady state. Thus,
we have the following result:19

Proposition 2 Suppose that country 1 cuts the capital tax rate. Then, although the
lifetime utility of the working generation in country 1 may increase due to capital
inflows in the short term, the lifetime utility of individuals in the new steady state will
be lower than that in the initial steady state since the capital labor ratio becomes
lower. On the other hand, the welfare of individuals in country 2 will be lower not
only in the short term due to capital outflows but also in the long term due to the
worldwide fall in the capital labor ratios.

5 Discussion

5.1 Tax increase

The result in the previous section seems to provide a conjecture that a tax increase
may be desirable for both countries in the long term. In this subsection, we consider
the effects of a tax increase.
From (30), a tax increase raises the fertility rate and life-cycle savings in country
1.20 Since the fertility rate in country 1 becomes higher than that in country 2, the
long-term world equilibrium of the world economy approaches the domestic equi-
librium in country 1 with the increased tax rate, in contrast to the case of a tax cut.
Therefore, in the long term, the steady state may be characterized by two conditions:
   
s 1 k̆∞
1
= 1 − zn̆1 n̆1 k̆∞1
(45)
   
(1 − τ̆ 1 )fk1 k̆∞
1
= fk2 k̆∞
2 W
= R̆∞ (46)
W = k̆ 1  = k . The
 1

where the new steady-state worldwide capital labor ratio is k̆∞ ∞ a
changes in the fertility rate and life-cycle savings per worker in country 1 tend
to raise the long-term worldwide capital labor ratio, although the autarkic equilib-
rium of country 1 also changes since the tax rate is altered. Therefore, the ratio in
country 2 will be raised through arbitrage in the international capital market. The
increased capital labor ratios improve the lifetime welfare of the future generations
in both economies. The short-term effects of a tax increase on the capital labor ratios
are opposite to those in the previous case of a tax cut, and hence, the effects are
ambiguous.
It should be noted that with a tax increase, there might be intergenerational income
redistribution policies such as those asserted in Kemp and Wong (1995), which would
achieve Pareto improvements, whereas this will not be true in the case of a tax cut.

19 See Fig. A4 in Appendix A of the ESM.

20 The first- and second-period consumption and children are assumed to be superior goods in the present
study.
272 A. Yakita

5.2 Income transfers to the old generation

So far, we have assumed that the tax revenue is transferred only to the working and
child-rearing generation. Alternatively, we may also consider the transfers to the old
generation or an expenditure policy-enhancing income of the retired. However, when
the fertility decision of agents comes to depend on the capital labor ratio in the next
period, and the capital labor ratio in turn depends on the fertility decisions of the
next generation, it becomes difficult to solve the equilibrium analytically. Intuitively,
transfer income during retirement tends to reduce lifetime savings and increase the
number of children as consumption goods. These factors together tend to lower the
capital labor ratios worldwide, reducing the wage rates. The lower wage income will
decrease life-cycle savings and so on. The net effect of transfers to the old generation
is thus difficult to grasp. Nevertheless, as long as the tax-expenditure policy greatly
affects the income of the working generation relative to that of the retired, our result
will qualitatively hold.21

6 Concluding remarks

We have analyzed the effects of tax cuts in the country with a higher source-based
capital tax rate on capital accumulation and the economic welfare in the home and
the other country. In the short term, a tax cut may increase the capital labor ratio in
the home country because of decreases in capital outflows. However, in contrast to
those in models of countries with a common and fixed demographic structure, the
tax cut policy may reduce the capital labor ratios and thereby deteriorate the welfare
of individuals in the countries in the long term if fertility decisions of individuals are
endogenous.
Conversely, it is also shown that tax hikes may accelerate capital accumulation
in both countries in the distant future. In this case, intergenerational transfers (from
future generations to current generations) might improve the welfare of all genera-
tions. Although we are concerned with the positive analysis in the present paper, the
dynamic normative considerations require us to analyze the optimality of tax-transfer
policy. This is a subject for future research.

Acknowledgments The author is indebted to two anonymous referees for their constructive sugges-
tions and comments. He also thanks Toshihiro Ihori, Jun-ichi Itaya, Ryuta Kato, Hisahiro Naito, Yasuyuki
Osumi, Tadashi Yagi, and the seminar participants at the 27th Annual Congress of the European Economic
Association (University of Málaga, Spain), Doshisha University, Hokkaido University, the University of
Hyogo, the Institute of Statistical Research (Tokyo), and the Nagoya Macroeconomics Workshop, for the
helpful comments and suggestions on earlier versions.

21 See Appendix B of the ESM.

Short-term and long-term effects of capital taxation on economies 273

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