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Oxford Economic Papers Advance Access originally published online on August 30, 2005
Oxford Economic Papers 2005 57(4):717-731; doi:10.1093/oep/gpi039
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© Oxford University Press 2005; All rights reserved

Optimal capital taxation in economies with unionized and competitive labour markets

Erkki Koskela* and Ronnie Schöb{dagger}

*Department of Economics, P.O. Box 17 (Arkadiankatu 7), FIN-00014 University of Helsinki, Finland; e-mail: erkki.koskela{at}helsinki.fi {dagger}Department of Economics and Management, Otto-von-Guericke-University Magdeburg, P.O. Box 41 20, D-39016 Magdeburg, Germany; e-mail: ronnie.schoeb{at}ww.uni-magdeburg.de

According to the existing literature, capital taxes should not be imposed in the presence of optimal profit taxation in either unionized or competitive labour markets. We show that this conclusion does not hold for economies with dual labour markets where the competitive wage rate provides the outside option for unionized workers. Even with non-distortionary profit taxation, it is optimal for such economies to tax capital if the revenue share of capital in the unionized sector is lower than in the competitive sector. This is because taxing capital income reduces employment and lowers the outside option of workers in the unionized sector, with the latter employment effect being stronger. A capital subsidy should be granted if the opposite relationship of the revenue shares of capital holds.

Key Words: JEL classification: H21 • J51 • C70


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