Personal Taxation and Investment Incentives in a Small Open Economy

A simple portfolio model is used to investigate the effects of personal taxes on real investment incentives in a small open economy with large and small firms. When shares in large firms can be traded internationally and their rate of return is exogenously determined on international equity markets, a tax on the return on riskless bonds will induce a portfolio shift from bonds to shares in large firms. This shift reduces the impact of the bond tax on the required rate of return on shares in domestically owned small firms, provided that returns on shares in small and large firms are positively correlated. The total impact of the bond tax may even change from a negative to a counter-intuitive positive one if the “beta” between the returns on small and large firms is above unity. A personal tax on equity returns does in general have an ambiguous impact on the pre-tax rate of return requirement of domestically owned firms. An exogenous rate of return on large company shares is shown to enhance the possibility for the equity tax to reduce the required pre-tax rate of return in small domestic firms. A sufficient condition for a negative relationship is again that the “beta” between the returns in small and large firms is above unity. This revised version was published online in July 2006 with corrections to the Cover Date.