Investment abroad is often a means of evading taxes on wealth or on the income from capital: inter national capital flows to evade taxes are likely to be particularly widespread in developing countries. Exchange rate controls and restrictions in capital movements are frequently introduced in order to prevent such tax evasion and so increase government revenues, but these controls distort the economy's allocation of resources. Are capital controls a desirable `second-best' policy, given the existence of distortionary domestic taxation?
In Discussion Paper No. 231, Research Fellow Alberto Giovannini attempts to provide a general equilibrium framework within which the desirability of capital controls and their impact on domestic welfare can be assessed. Giovannini considers a one-good, two-period model of an open economy. Domestic residents consume in both periods and can transfer wealth between periods by investing in domestic capital or by purchasing (or selling) foreign bonds. The government taxes income from domestic investments, and these taxes are known by domestic residents at the time investment decisions are made. Domestic residents can borrow from the rest of the world at a given rate of interest, equal to the world lending rate. Giovannini also assumes that the world interest rate is given: in most countries, he argues, the size of international capital flows is too small to affect the world rate of interest.
Giovannini considers first the case where the country can only raise revenue by taxing income from dom estic investment. An increase in the tax rate lowers the net return on domestic investment projects. If capital can move abroad, the lower rate of return prompts investors to substitute foreign for domestic assets in their portfolios. Domestic investment falls and foreign investment rises, to the point where the after-tax rate of return on domestic investments is equal to the tax-free return on foreign assets (which is assumed to be equal to the world rate of interest). Thus capital flight for the purpose of tax evasion causes a fall in domestic investment and output. The freedom to substitute foreign for domestic assets does, however, allow the country's private sector to trade present and future consumption at an undistorted (world) rate of interest, since capital movements ensure that the after-tax return on domestic investment is equal to the world interest rate.
The effects of capital controls can then be evaluated by comparing this case with a situation in which residents cannot evade domestic taxes by purchasing foreign securities: income from all assets, domestic and foreign, is taxed at the same rate. In this case domestic investment is unaffected by changes in tax rates, since both domestic and foreign assets are taxed at the same rate. The terms of trade between present and future consumption are distorted, however, because neither foreign nor domestic assets yield an after-tax return equal to the world rate of interest.
A comparison of these two cases allows Giovannini to assess whether tax evasion through international capital mobility lowers national welfare. He notes that the problem resembles that studied in the optimal taxation literature: this literature suggests that in general one should tax those goods with a smaller demand elasticity: this ensures that the after-tax allocation of resources is closest to the pre-tax, undistorted optimum. Giovannini shows that the welfare consequences of tax evasion through international capital mobility depend on the relative magnitude of two effects: the interest-elasticity of savings and the interest-elasticity of domestic investment. In Giovannini's model the elasticity of returns to scale of the domestic investment technology determines the interest elasticity of domestic investment: the closer the production technology to constant returns to scale the larger the fall in the domestic capital stock after an increase in taxes. The welfare losses from international tax evasion are larger when domestic and foreign investment are close substitutes and intertemporal substitution in consumption is small.
The relative importance of portfolio substitution and intertemporal substitution thus provides a simple criterion to evaluate the welfare effects of international tax evasion from an individual country's perspective. Giovannini speculates that this general criterion would not be overturned in more complicated models that incorporate uncertainty, many assets and a variety of taxes. He concludes that the application of the `public finance' approach adopted in this Discussion Paper to normative questions, such as the optimal design of controls or the taxation of international capital flows, might also prove fruitful.

Discussion Paper No. 231, April 1988 (IM)