Privatization, Public Investment, and Capital Income Taxation

18 Pages Posted: 20 Apr 2016

See all articles by Harry Huizinga

Harry Huizinga

Tilburg University - Center for Economic Research (CentER); Centre for Economic Policy Research (CEPR)

Soren Bo Nielsen

Copenhagen Business School - Department of Economics; Centre for Economic Policy Research (CEPR); CESifo (Center for Economic Studies and Ifo Institute)

Date Written: January 1997

Abstract

An investigation of the optimal boundary between public and private production.

Huizinga and Nielsen investigate the optimal boundary between the public and private production sectors. They use a model in which government and private production coexist - in which a range of production activities can be carried out by either the government or the private sector. In effect, the government determines which activities to maintain within the public sector and which to privatize. In choosing the sectoral boundary, the government trades off the relative inefficiency of marginal government production against the private investment distortion created by tax policy.

In an open economy, the private investment decision is distorted by a source-based income tax. In a closed economy, the private investment decision is distorted by either a private investment tax or a savings tax. Either tax produces a wedge between the gross return on investment and the net-of-tax return received by savers. Because of this tax wedge, the private cost of capital exceeds the shadow cost of public capital.

Optimally, the government sector is shown to be too large in the sense that the government carries out some activities in which it has an efficiency disadvantage and the private sector has an efficiency advantage. And it invests more in those activities than the private sector would. Generally the size of the government sector is related positively to the investment tax wedge.

The level of investment taxes - and thus the size of the state production sector - may be affected by tax competition in the international economy. As international capital becomes more mobile, there seems to be more scope for international (investment) tax competition. As a result of tax competition, perhaps, corporate income tax rates have been on a downward trend in European countries. In Europe, the general lowering of corporate income tax rates has coincided with a trend toward privatizing government activities.

Huizinga and Nielsen focus on the relationship between capital income taxes and the size of the government production sector. Analogously, one could consider the relationship between labor income taxes and the size of the state sector. In that instance, the model predicts that a formerly state-owned enterprise, after privatization, reduces its payroll. Privatization also seems to lead to reduced employment levels.

These results hold in both open economy and closed economy versions of the model.

This paper - a product of the Finance and Private Sector Development Division, Policy Research Department - is part of a larger effort in the department to understand private sector development.

Suggested Citation

Huizinga, Harry and Nielsen, Soren Bo, Privatization, Public Investment, and Capital Income Taxation (January 1997). World Bank Policy Research Working Paper No. 1741. Available at SSRN: https://ssrn.com/abstract=604981

Harry Huizinga (Contact Author)

Tilburg University - Center for Economic Research (CentER) ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands
+31 13 466 2623 (Phone)
+31 13 466 3042 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Soren Bo Nielsen

Copenhagen Business School - Department of Economics ( email )

Porcelænshaven 16 A, 1
Frederiksberg C, DK-2000
Denmark

Centre for Economic Policy Research (CEPR)

London
United Kingdom

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

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