Tax Holidays and the International Capital Market

The paper shows how a tax holiday may signal to a skepticalcapital market that the future level of taxation will be moderate.After the signal has informed investors that the host countrygovernment is a low-spender, the tax profile flattens out, correspondingto a tax reform stage. Contrary to the recent literature on taxholidays, this model assumes that: the capital market is perfectlycompetitive; sunk costs are captured by a convex cost function,instead of fixed costs; taxation is distortionary, not lump-sum;and the government maximizes a welfare function rather than taxrevenue.