GCOE Discussion Paper Series
Global COE Program

Human Behavior and Socioeconomic Dynamics
Discussion Paper No. 254

Capital mobility — a resource curse or blessing? How,
when, for whom?

Hikaru Ogawa, Jun Oshiro and Yasuhiro Sato

March 2012GCOE Secretariat
Graduate School of Economics

OSAKA UNIVERSITY

1-7 Machikaneyama, Toyonaka, Osaka, 560-0043, Japan

Capital mobility — a resource curse or blessing? How,
when, for whom?∗
Hikaru Ogawa†

Jun Oshiro‡

Yasuhiro Sato§

March 25, 2012

Abstract
This paper investigates which of the two countries —resource-rich or resourcepoor— gains from capital market integration and capital tax competition. We develop a framework involving vertical linkages via resource-based inputs as well asinternational fiscal linkages between resource-rich and resource-poor countries. Our
analysis shows that capital market integration causes capital flows from resourcepoor countries to resource-rich countries and thus improves production eﬃciency
and global welfare. However, such gains accrue only to resource-poor countries,
and capital mobility might even hurt resource-rich countries. In response to capital
flows, the governments of both resource-rich and resource-poor countries have an
incentive to tax capital. Such taxations would enable resource-rich countries to exploit their eﬃciency gains through capital market integration and become winners
in the tax game.

Keywords: capital market integration, natural resource, resource curse, tax competition
JEL Classification: F21; H20; H77∗

We thank Yoshitsugu Kanemoto, Mutsumi Matsumoto, Harris Selod, Takatoshi Tabuchi, and theparticipants of various seminars and conferences for their very useful comments and discussions. We
acknowledge the financial support from RIETI, the Japan Society for the Promotion of Science, througha Grant-in-Aid for Scientific Research (S, A, B, C) and a Grant-in-Aid for Young Scientists (B).
†
Graduate School of Economics, Nagoya University (Japan), email: ogawa@soec.nagoya-u.ac.jp‡
Graduate School of Economics, Osaka University (Japan), email: junoshiro5@gmail.com.
§
Graduate School of Economics, Osaka University (Japan), email: ysato@econ.osaka-u.ac.jp.

1

Introduction

In the past few decades, we have observed drastic increases in capital flows among countries. Such capital movements have provoked intensive discussions on where the capitalis moving to and how the governments react to capital flows.
With respect to the first question, the availability of natural resources is regarded
as one of the main factors that attract capital. Dunning [12] summarized the literature
on foreign direct investment (FDI) and identified three very common investment motivations: resource-seeking, market-seeking, and eﬃciency-seeking. He suggested that capitalis attracted to countries and regions that have large endowments of natural resources,
large markets, and good economic and political environments, including infrastructure
and institutions, to minimize production and transaction costs. Several studies support
this view; for example, OECD [25] with regard to FDI to China and Asiedu [2] and Morisset [23] with regard to FDI to Africa. Morisset [23] (page 2) explains as follows: “notsurprisingly, the African countries that have been able to attract most FDI have beenthose with the largest tangible assets such as natural and mineral resources as well aslarge domestic markets”; “the role of market size can be further evidenced by the almost
perfect positive correlation between FDI inflows and GDP for a group of 29 African countries during 1996 and 1997 (the correlation coeﬃcient equals 0.99)”; and “traditionally,
about 60 per cent of FDI in Africa is allocated to oil and natural resources (UNCTAD,
1999). This is corroborated by the coeﬃcient correlation between FDI inflows and thetotal value of natural resources in each country, which appears close to unity (i.e. 0.94)
for the group of 29 African countries during 1996-1997.” Also, Kudina and Jakubiak [21](page 3) states, “historically, the most important host country determinant of FDI has
been the availability of natural resources, e.g. minerals, raw materials and agricultural
products.”
Regarding the second question, the literature on tax competition theory, which dates
back to at least Zodrow and Mieszkowski [46] and Wilson [41], has achieved certain results.
The literature investigated the role of governments in attracting capital to their jurisdictions.1 For example, Bucovetsky [5], Kanbur and Keen [20], Ottaviano and van Ypersele[28], Sato and Thisse [36], and Wilson [42] analyzed the eﬀects of market size on capital1

Wilson [43], Wilson and Wildasin [44], and Fuest, Huber, and Mintz [15] provide surveys of theliterature on tax competition.

1

flows and the governments’ reactions to them. Studies such as Bayindir-Upmann [3], Fuest[17], Matsumoto [22], Noiset [24], and Wrede [45] examined the role of infrastructure andinstitutions provided by the local governments to benefit production possibilities.2 However, another highly important factor to attract capital, the existence of natural resource
wealth, has been overlooked in this literature.34
The purpose of this paper is to explore how the existence of natural resources aﬀects
the distribution of capital across countries, how governments react to capital flows, andhow the welfare of a region is aﬀected by capital flows and tax competition. For this,we develop a tax competition model involving two countries, one of which is endowedwith natural resources. There are two sectors in these countries: the numéraire good
sector and the resource-based intermediate good sector. The former is characterized byperfect competition, and its production requires capital, labor, land, and the intermediate
good. The latter sector is characterized by oligopoly à la Cournot, and its production
requires capital as a variable input and the numéraire good as a fixed input. We focus on
the circumstances in which the intermediate good can be produced only in places where
the natural resources exist, because it is prohibitively costly to transport the resource
itself across countries. Using this framework, we first examine the impact of capital
market integration in a laissez-faire economy (without government intervention). We
show that once the capital markets are integrated, resource-rich countries can import
capital from resource-poor countries. Although such capital movements help improveglobal production eﬃciency and increase global welfare, the gains of these accrue only
to resource-poor countries, with resource-rich countries, in contrast, even suﬀering from
capital movements. We refer to this as the resource-curse associated with capital market
integration. We next investigate the implications of a tax game in our environment. In
a tax game, governments can levy a tax/subsidize capital. In equilibrium, both countries
2
3

More recent examples include Cai and Treisman [7] and Bucovetsky [6].
To the best of the authors’ knowledge, Raveh [33] is the only exception, studying the role of natural

resources in tax competition. He incorporated a competitive resource sector into a standard capital tax
competition model. However, his focus is on the diﬀerences in tax instruments available between countries
and not on the resources of a particular country.
4
There are studies on the role of other types of asymmetries: the eﬀects of initial inequality of capitalendowments are investigated by DePater and Myers [9], Peralta and van Ypersele [30], and Itaya et al.
[19]; the diﬀerence in labor market institutions are introduced by Haufler and Mittermaier [18], Egger
and Seidel [13], and Ogawa et al. [26].

2levy a tax on capital, the rate being higher in the resource-rich country than in the
resource-poor country. This is consistent with Slemrod [37], who empirically showed thata country enjoying higher per capita income from natural resources (oil) is likely to levy
tax on corporate income at a higher rate.5 In addition, this paper shows that resource-richcountries gain from tax competition, while resource-poor countries lose from it: there isa resource-blessing associated with tax competition. Since the latter loss dominates theformer gain, the tax game reduces global welfare compared to the laissez-faire economy.
Beginning with a seminal article by Sachs and Warner [35], voluminous scholars havewidely discussed the impacts of natural resource wealth on economic growth. This literature suggests that large natural resource endowments can aﬀect economic performanceboth positively and negatively via Dutch disease, institutional quality, armed conflict,volatility of commodity prices, financial imperfection, or investment of human capital.6
However, none of those studies focused on the transmission mechanism for natural resources to the economy through fiscal externalities arising from factor mobility. The
study most closely related to this paper is Bretschger and Valente [4]. Extending thetwo-country endogenous growth model, they analyzed the strategic resource taxation
policies between resource-rich and resource-poor economies involved in an asymmetrictrade structure induced by uneven endowments of natural resources.7 They showed thata resource-poor country has an incentive to levy tax on the use of domestic resources at
an excessively high rate to reduce resource dependency. In a similar vein, this paper analyzes an economy in which the geographical necessity and availability of natural resources
induce an asymmetric industrial structure and then inter-industry trade linkages.
The rest of the paper is organized as follows. The basic environment is presented
in Section 2. In Section 3, we study the eﬀects of capital market integration without
government intervention. Section 4 examines the eﬀects of tax competition, and Section
5 concludes the paper.
5

There is a controversy over the robustness of this empirical finding. Dharmapala and Hines [11]concluded that higher corporate tax rates are not observed in the data of resource-abundant countries.
6
The literature on the so-called “natural resource curse” is comprehensively reviewed by Frankel [16]and van der Ploeg [39]. For an overview on the recent empirical literature, see Torvik [38] and Rosser[34].
7
Wildasin [40] also constructs a tax competition model with inter-industry trade linkages. In contrast
to Wildasin [40], we characterize the equilibrium arising from tax competition and examine the welfare
properties of such equilibrium.

3

2

The basic settings

Consider two countries (1 and 2) in each of which there is a representative individualof measure one possessing three factors of production, land, labor (L), and capital (K).
Each factor endowment in each country is fixed at unity. We assume that individuals areimmobile between countries and supply their labor in their own country of residence. In
contrast, we consider two scenarios in which capital is either immobile or mobile. In thefirst case, all factor markets are local. In the second case, individuals can freely choose
where to supply their capital, so that both labor markets are local but the capital market
is global. We first compare these two cases without taxation, and then introduce the tax
game to the case in which capital is mobile.
In this economy, two goods are produced, a numéraire good (X) and a resource-based
intermediate good (M) (petroleum, steel, minor metals, etc.). The numéraire good (Xgood) is produced using capital, labor, land, and the intermediate good (M-good) as
inputs under perfect competition. The production of M-good requires capital as variable
input and the numéraire X-good as fixed input. We assume that the production of Mgood does not need labor because such resource-based sectors are considered highly capitalintensive and account for only a small part of employment.8 Natural resources exist onlyin country 1, and it is prohibitively costly to transport them to country 2. We call country
1 the resource-rich country and country 2 the resource-poor country. In country 1, firms
start production after paying for the fixed input as entry costs; they exploit the natural
resources (raw crude oil, iron ore, other mineral ore, etc.) and transform them into Mgood, using capital. M-good is tradable without incurring additional costs. The mining
industry is an example of the M-good sector. Imagine the production of rare earths.
Exploration companies export purified and lighter rare earth elements after separating
and refining them near the mine sites. This is because ores mined are so heavy that it
would be highly costly to transport them, but purified rare earth elements are light enoughto be exported. The concentration of resource-based intermediate production implies that
X-good is produced in both countries whereas M-good is produced only in country 1, and8

For instance, among all the EU countries, Romania had the highest employment share of the mining

and quarrying industry in 2009 (Eurostat, http://epp.eurostat.ec.europa.eu). Still, its employment shareof the mining and quarrying industry is only 3.3 percent. The share in most EU countries is less than 2
percent.

4

that both the produced goods are traded freely without costs. Hence, country 2 imports
M-good from country 1 while exporting X-good.9 Figure 1 describes the environment of
the model.

Figure 1: Schematic diagram of model
The mass of firms in X-sector is one in each country. Each firm operates a single plant.
The firms are owned by individuals who reside where firms locate. We assume that the
production of X-good requires labor as a variable input and land as a fixed input; fixed
cost is associated with installing a new production line prior to entry. Without loss ofgenerality, we normalize the land requirement to one. After renting one unit of land, afirm (an X-firm) produces X-good and earns profit in country i, given by
Πi = Xi − (ri + ti )Ki − wi Li − pM Mi − ψi ,where wi , ψi , ri , and ti are the labor wage rate, land rent, capital price, and capital9

Of course, this is an extreme case. In the other extreme case, the production of M-good is equallypossible in country 2 as well. Such a case yields the same allocation as the one observed in the mobile
capital case without government interventions in this paper. The reality lies between the two: one country
has some advantage in producing M-good over the other. Our analysis then works to pin down the upper
limit of the possible eﬀects of this type of asymmetry.

5tax rate in country i, respectively; pM represents the price of M-good, equalized acrosscountries. The production function for producing X-good in country i is assumed to bequadratic:10
Xi = α(Ki + Li + Mi ) −β 2
γ(Ki + L2i + Mi2 ) − (Ki + Li + Mi )2 ,22

where α, β, and γ are constants satisfying α, β > 0 and β +3γ > 0.11 α represents the levelof total factor productivity, and a positive β ensures that the firms use all kinds of inputs.
γ captures the substitutability/complementarity between the inputs in production: apositive (negative) γ represents that any pair of factors are Pareto-substitutes (Paretocomplements). The inequality β + 3γ > 0 is necessary for the equilibrium factor of
employment and equilibrium number of firms to be a positive real number.
Note that each firm in the X-sector uses a fixed amount of land, regardless of the
production. Land rent is determined through a bidding process by which the firms incountry i compete to use the land. As a result, in an equilibrium where the land market
clears, land rent is determined in such a manner that the profit of each firm is driven to
zero.
From a firm’s profit maximization, we obtain the linear factor demand functions asfollows:αγ
1− (ri + ti ) +(ri + ti + wi + pM ),β + 3γ ββ(β + 3γ)

(1)

Li =

α
γ
1
− wi +(ri + ti + wi + pM ),β + 3γ ββ(β + 3γ)

(2)

Mi =

α
γ
1
− pM +(ri + ti + wi + pM ).
β + 3γ ββ(β + 3γ)

(3)

Ki =

The total demand for M-good is given by M ≡ M1 + M2 , yielding the inverse demand
function for the good:P
2αβ − β(β + 3γ)M + γ 2i=1 (wi + ri + ti ).
pM =2(β + 2γ)
10(4)This functional form is already used by Ottaviano et al. [27] for utility functions and Peng et al. [29]for production functions. A production function is often specified as a quadratic form in the literature
on tax competition. For example, see Bucovetsky [5], Elitzur and Mintz [14], Peralta and van Ypersele[31], and Devereux, Lockwood and Redoano [10].
11α is assumed to be suﬃciently large to ensure that the production function is concave, and bothfactor prices and factor employment are positive in equilibrium.

6

We assume that the M-good sector is characterized by oligopoly, where n identicalfirms (M-firms) producing M-good engage in Cournot competition. Each firm in country
1, after paying for a fixed amount, F (> 0), of the numéraire good as the entry cost,
determines the quantity of supply of M-good. Each firm needs one unit of capital toproduce one unit of M-good. A firm’s profit is given by
π = [pM − (r1 + t1 )]m − F,where m gives the firm’s supply of M-good, and r1 and t1 are the endogenous capital priceand (temporarily exogenous) capital tax rate, respectively. For given factor prices, theCournot equilibrium is characterized by the level of output m, the price of M-good pM ,P
and the number of firms in the M-good sector n. Using M = n m, the level of outputs

in the Cournot equilibrium is12P
2αβ − 2(β + 2γ)(r1 + t1 ) + γ 2i=1 (wi + ri + ti )
M
m=
=
.
n
β(β + 3γ)(1 + n)

(5)Equations (4) and (5) give the equilibrium price of M-goods:P
2αβ + 2(β + 2γ)n(r1 + t1 ) + γ 2i=1 (wi + ri + ti ).
pM =2(β + 2γ)(1 + n)

(6)

We assume that firms enter and exit the market freely. Then, the profit of a firm is driven
to zero, determining the equilibrium number of firms as follows:13
P
2αβ − 2(β + 2γ)(r1 + t1 ) + γ 2i=1 (wi + ri + ti )
p
n=
− 1.
2β(β + 2γ)(β + 3γ)F

(7)

The factor markets are assumed to be perfectly competitive. The full employment

condition of labor market is
L1 = L2 = 1,(8)

K1 + M = 1,

(9)Capital market clearing requires

K2 = 1,

12

Amir and Lambson [1] provide the conditions under which the Cournot equilibrium exists and issymmetric. Our settings satisfy those conditions.
13
We ignore the integer constraint and consider the number of firms as a positive real number.

7

when the capital is immobile, andK1 + M + K2 = 2(10)when the capital is mobile. These market clearing conditions determine the remaining
factor prices wi and ri .

3

Eﬀects of capital mobility

Before considering the tax game, let us examine the eﬀects of capital mobility by comparing the case of immobile capital with that of mobile capital in the absence of policy
intervention (i.e., t1 = t2 = 0). This comparison will form the basis of our analysis of the
tax game (in Section 4).

3.1

Equilibrium factor prices

The factor demands Li , Ki , and Mi are determined by (1), (2), and (3). Equations (5) and(6) represent each firm’s supply of M-good, m, and the price of M-good, pM , respectively.
The free-entry condition (7) yields the number of M-firms n. Substituting (2) into (8),we obtain the wage rate wi . The capital price ri is determined by (9) combined with (1)if the capital is immobile and (10) combined with (1) if the capital is mobile. Finally, theland rent ψi is determined by X-firms’ zero profit condition, written as Πi = 0.
We start from the case where there is no capital mobility. Using equations (1) to (6)and t1 = t2 = 0, the market clearing conditions (8) and (9) are rearranged to yield thefactor prices as functions of the number of firms n:µ¶
βγn
w1 = α − (β + 2γ) 1 +,Ξ(n)(3β + 8γ)n + β + 3γ,
w2 = α − (β + γ)(β + 2γ)
Ξ(n)3 + 2n2(β + 2γ)n + 3γ
− 2γ − β 2 n,r1 = α − β
3 + 8n(3 + 8n)Ξ(n)3 + 10n6(β + 2γ)n + 2β + 5γ
− 2γ + β 2 n,r2 = α − β
3 + 8n(3 + 8n)Ξ(n)where Ξ(n) is defined as
Ξ(n) ≡ (β + 2γ)(3β + 4γ)n + (β + γ)(β + 3γ).
8(11)

Equation (11) shows how the number of firms in the M-good sector aﬀects factor prices:∂wi /∂n < 0 (i = 1, 2) and ∂r2 /∂n < 0 if and only if the production factors are Paretosubstitutes in the production of X-good (i.e., γ > 0) and ∂r1 /∂n > 0. An increase in nwould raise the demand for capital in country 1, resulting in an increase in capital prices.
This reduces the demand for both capital and labor in the X-sector and decreases thewage rate when the factors are Pareto-substitutes. This eﬀect is transmitted to country
2 through reductions in the price of M-good, pM . A larger number of firms in Cournot
competition would lower the price of M-good, thereby increasing the demand for the good
but reducing the demand for other factors. When the factors are Pareto-complements, alower pM would increase the demand for all factors and raise the prices of other production
factors.
Plugging (11) into (7), we obtain the equilibrium number of M-firms as"r#2(β + γ)Φ
β
I
n =
−1 ,
3β + 4γFΦ(12)where the superscript I indicates that the variable is related to the equilibrium without
capital mobility (i.e., the case of immobile capital) and Φ is defined asΦ≡

β + 3γ> 0.
2(β + 2γ)In the following analysis, we assume that the entry cost is suﬃciently small:
F <

β
,
Φ

Thus, the equilibrium number of M-firms is strictly positive. From (11) and (12), theclosed-form expression of the equilibrium factor price is as follows:√
3β 2 + 9βγ + 8γ 2 + γ βΦFI,
w1 = α −3β + 4γ√(β + γ)(3β + 8γ) − γ βΦFI
w2 = α −,3β + 4γ√
β 2 + 7βγ + 8γ 2 + (2β + 3γ) βΦFI
r1 = α −,3β + 4γ√(β + γ)(3β + 8γ) − γ βΦFIr2 = α −.
3β + 4γ(13)

From (13), we find that r1I > r2I . Since the intermediate good sector exists, a resource-richcountry can enjoy a higher capital price than a resource-poor country. Therefore, we willobserve the flow of capital from the resource-poor country to the resource-rich country
9once the capital becomes mobile. A higher capital price in the resource-rich country will inturn increase the demand for labor and wage rates (i.e., w1I > w2I ) if its labor and capitalare Pareto-substitutes in the production of X-good (i.e., γ > 0); the opposite holds true(i.e., w1I < w2I ) if they are Pareto-complements (i.e., γ < 0).
Next, we introduce capital mobility. If we allow for capital mobility, the capital prices
will be equalized between countries:
r1 = r2 = r.

(14)

Similar to the case of immobile capital, on the basis of (1) to (6) and t1 = t2 = 0, werearrange the market clearing conditions (8) and (10) to yield the factor prices as functionsof the number of firms n. We then derive the equilibrium number of M-firms from (7). In
this case, we obtain the number of firms and factor prices as follows:
r
βΦ
− Φ,
nM =
F

(15)

w1M = w2M = α − β − 2γ,
β + 4γ 1 p
βΦF ,−rM = α −22where the superscript M represents the equilibrium with capital mobility. Since F < β/Φ
is assumed, nM > 0 is satisfied. A simple comparison will show that r1I > rM > r2I , whichis the result of capital export from country 2 to country 1 under an integrated capital
market.

3.2

WelfareEach individual gains utility from consuming the numéraire good. We take the amount ofconsumption of a representative individual as the criterion of national welfare. It is equal
to the national income Yi , which consists of the total market value of final goods (i.e., theoutput of X-good minus the amount to be used in M-sector as fixed requirement) plus
the net factor income from abroad:
Y1 = X1 − F n + pM M2 + r1 (1 − K1 − M ),(16)

Y2 = X2 − pM M2 + r2 (1 − K2 ).

(17)

10

From (9), the net capital income of both countries is equal to zero when their capitalis immobile. Substituting the equilibrium factor prices (13) into welfare functions (16)and (17), we obtain the equilibrium national welfare in the case of immobile capital:√
Υ1 − (β + γ)(5β + 8γ)ΦF + 2(5β 2 + 13βγ + 8γ 2 ) βΦFI,(18)
Y1 = 2α −2(3β + 4γ)2√Υ2 − β(β + γ)ΦF + 2β(β + γ) βΦFI
Y2 = 2α −,2(3β + 4γ)2where Υ1 and Υ2 are defined asΥ1 ≡ 13β 3 + 71β 2 γ + 120βγ 2 + 64γ 3 ,Υ2 ≡ Υ1 + 4β(β + γ)(β + 2γ).
Welfare is unambiguously higher in country 1 than in country 2 under the assumptionthat F < β/Φ. This is confirmed by

Y1I − Y2I =´p2(β + γ)(β + 2γ) ³
βΦF
> 0.
β
+
ΦF
−
2
(3β + 4γ)2√Note that β + ΦF − 2 βΦF > 0 under the assumption that 0 < F < β/Φ, since thegeometric mean does not exceed the arithmetic mean. This shows that a resource-richcountry enjoys higher welfare than a resource-poor country, which is intuitively plausible.
From (15), (16), and (17), we see that the welfare level across all countries undercapital mobility is the same:(3β + 8γ) − ΦF + 2
Y1M = Y2M = 2α −

√

βΦF

4

.

(19)

This is a direct result of factor price equalization under free trade.
Proposition 1 If capital is immobile, welfare is higher in resource-rich countries thanin resource-poor countries (i.e., Y1I > Y2I ). If capital is mobile, welfare is the same acrosscountries (i.e., Y1M = Y2M ).

3.3

Welfare implications of capital mobility: a resource curse or
blessing?

Here, we examine the impacts of capital market integration on the welfare of each country
and on global welfare by comparing YiM with YiI . From (18) and (19), we obtain´pβ(β + 2γ) ³
Y1M − Y1I = −
βΦF
< 0.
β
+
ΦF
−
2
4(3β + 4γ)2
11

The diﬀerence is strictly concave in F . Similarly, for country 2,(7β + 8γ)(β + 2γ)
Y2M − Y2I =24(3β + 4γ)³´pβ + ΦF − 2 βΦF > 0.

Furthermore, we can also explore the impacts of such changes on global welfare. In ourenvironment, it is natural to consider global income, defined by Y1 + Y2 , as the criterionof global welfare. We can readily see that Y1 + Y2 changes as
Y1M + Y2M − Y1I − Y2I =´p(β + 2γ) ³
β + ΦF − 2 βΦF > 0.
2(3β + 4γ)

Proposition 2 Capital market integration hurts the resource-rich countries (i.e., Y1M <Y1I ) but benefits resource-poor countries (i.e., Y2M > Y2I ). It further enhances global
welfare (i.e., Y1M + Y2M > Y1I + Y2I ).
Proposition 2 implies that the national income of resource-rich countries will unambiguously decrease due to capital mobility. That is, there exists a resource-curse, in the sensethat resource-rich countries do not enjoy the benefits of globalization. When capital isimmobile, the “manna from heaven” wealth that raises the rate of returns on capital andthen increases capital income would make country 1 better oﬀ than country 2 (cf. Proposition 1). Once the capital markets are integrated, however, country 2 will be able toexploit the benefits of its natural resources bonanza through capital investment. Corresponding to its capital inflows, country 1 has to pay for the import of capital. Meanwhile,
capital inflows are used not only in the X-sector but also in the M-sector, leading to anincrease in the production of M-good. Since the negative eﬀects of the leakage of thenatural resources bonanza always exceed the positive eﬀects of the expansion in both sectors, capital mobility leads to a resource-curse. In contrast, country 2 always gains from
capital movements, not only because of the increasing capital income but also because of
the expanding M-sector.

4

Tax game

4.1

Non-cooperative tax competition

Given the eﬀects of capital market integration, we next examine the governments’ reactions to such integration, and its welfare implications. In the tax game, the government12

of each country simultaneously chooses its capital tax level in order to maximize national
welfare, anticipating market reactions and taking the tax policy of the other country as
given. The tax game consists of three stages: first, the governments determine their tax
rates; second, the distribution of capital is determined; and finally, the production of all
goods takes place and all prices are determined so that all the markets clear. We solve
the model backward to obtain the subgame-perfect Nash equilibrium.
Since the third stage is already described in Section 2, we start from the second stage.
Temporarily, we assume that the tax diﬀerences are suﬃciently small; that is, 2β > t1 −t2 .
This is necessary for M-firms to have the incentive to produce (i.e., pM −r1 −t1 is positive).
As will be shown later, this condition is satisfied in equilibrium. Just as in the case whencapital is mobile and governments are inactive, we use equations (1) to (6) and rearrange
the market clearing conditions (8) and (10) to obtain the factor prices as functions of thenumber of firms n. We then derive the equilibrium number of M-firms from (7). In thiscase, we obtain the number of M-firms and factor prices as follows:(2β − t1 + t2 ) pβΦF − Φ,2βFγ(t1 − t2 )w1T = α − β − 2γ +,2(β + 2γ)γ(t2 − t1 ),w2T = α − β − 2γ +2(β + 2γ)2β − 3t1 − t2 1 pβΦF ,rT = α − β − 2γ +−422β + t1 − t2 1 p
βΦF ,+pTM = α − β − 2γ +
4
2
nT =

(20)

where the superscript T represents the tax game case. Note that taxation by country 1
has a greater impact on capital prices than that by country 2: ∂rT /∂t1 < ∂r T /∂t2 < 0.
In the first stage, each government simultaneously chooses ti to maximize Yi , anticipating the market reactions described in (20) and taking tj (i 6= j) as given. We assume thatthe tax revenues are redistributed equally and in a lump-sum fashion to each individual.
Then, the national welfare is given by (16) and (17).
The best response functions are given by14´p−(11β + 16γ)t1 + (5β + 8γ)t2 1 ³∂Y1=+
1 − ΦF/β = 0,∂t18β(β + 2γ)2∂Y2
βt1 − (7β + 8γ)t2
=
= 0.
∂t2
8β(β + 2γ)
14

The associated second-order conditions are globally satisfied.

13

Note that we observe a strategic complement in tax decisions. Still, the global concavity of
Yi with respect to ti ensures the existence of the unique non-cooperative Nash equilibrium,in which the tax rates are given by
tT1 =
tT2 =

´
³
p
β(7β + 8γ)(β + 2γ) 1 − ΦF/β2(3β + 4γ)2³´p2
β (β + 2γ) 1 − ΦF/β2(3β + 4γ)2

,

(21)

.

A simple comparison would show that tT1 > tT2 > 0, because we have assumed thatF < β/Φ.
Proposition 3 In a subgame-perfect Nash equilibrium, both countries impose positive
capital taxes. In particular, resource-rich countries levy a higher tax rate than resourcepoor countries; that is, tT1 > tT2 > 0.
This is consistent with the empirical evidence shown in Slemrod [37]. Note that capitaltaxation in either country reduces the capital price (i.e., drT /dt1 < 0 and drT /dt2 < 0).
Since country 1 is an importer of capital, it has an incentive to raise t1 in order to exploit
the return to capital and lower capital prices. In contrast, country 2 is an exporter ofcapital, and hence has a weaker incentive to raise t2 to keep the capital prices high.
These terms-of-trade eﬀects lead to a higher tax rate in country 1 than in country 2.
When country 1 levies a positive tax rate on capital, the amount of capital exported fromcountry 2 declines if country 2 imposes no tax. In such a case, country 2 can regain therent originated from capital mobility by setting a positive tax rate as long as its tax rate
is lower than the tax rate of country 1.
Note further that capital taxation lowers the price of M-good (∂pTM /∂t1 > 0 and∂pTM /∂t2 < 0), implying that country 1 has an incentive to raise its capital tax rate in order
to increase its revenue from the export of M-good; country 2 also has an incentive to raise
its capital tax rate to reduce its payment for M-good. However, because ∂(−pM M2 )/∂t2 =∂(pM M1 )/∂t1 holds true in equilibrium, we know that such incentives are counteracted
by each other, and do not lead to tax diﬀerentials.
Here, the equilibrium tax rates satisfy the condition 2β > tT1 − tT2 assumed above:p
2β(5β + 6γ) + 2β(β + 2γ)(β + 3γ)FT
T
2β − t1 + t2 => 0.
2(3β + 4γ)
14The next question we ask is, who gains from uncoordinated tax competition? Plugging
the equilibrium conditions (1), (3), (20), and (21) into (16) and (17), we obtain theequilibrium national incomes Y1T and Y2T . We can compare these with YiM , i.e., the welfare
level under capital mobility in the absence of government interventions (i.e., t1 = t2 = 0):p(15β + 16γ)(β + 3γ)(F + β/Φ − 2
Y1T − Y1M =232(3β + 4γ)p(7β + 8γ)(β + 3γ)(F + β/Φ − 2
Y2T − Y2M = −232(3β + 4γ)

F β/Φ)F β/Φ)

,

,

p
(β
+
3γ)(F
+
β/Φ
−
2
F β/Φ)
Y1T + Y2T − Y1M − Y2M = −.
16(3β + 4γ)pNote that F + β/Φ − 2 F β/Φ > 0 holds true under the assumption of 0 < F <β/Φ because of the inequality of arithmetic and geometric means. Therefore, we haveY1T − Y1M > 0, Y2T − Y2M < 0, and Y1T + Y2T − Y1M − Y2M < 0. These results can besummarized as follows.
Proposition 4 A resource-rich country gains from tax competition (i.e., Y1T > Y1M ),whereas a resource-poor country loses from it (i.e., Y2T < Y2M ). The latter loss dominates
the former gain, and therefore, tax competition hurts global welfare (i.e., Y1T + Y2T <Y1M + Y2M ).
There is a resource-blessing in the sense that the presence of a resource-based sector
enables a resource-rich country to gain from fiscal competition. However, the tax diﬀerentials created by such competition induce losses in global welfare, resulting in welfare
losses in resource-poor countries.
The intuition underlying the resource blessing is as follows. Rearranging the national
income from the income side, we get
Y1 = (w1 + r + t1 + ψ1 ) + t1 (1 − K2 ).
The first parenthesis on the right-hand side (w1 +r +t1 +ψ1 ) represents the factor incomes
earned by the initial factor endowments in country 1. Substituting (20) into this, we havew 1 + r + t 1 + ψ1 =15

(t1 − t2 )2+ Υ3 ,
16(β + 2γ)

where Υ3 is a bundle of parameters. The sum of factor incomes increases in tax diﬀerentials: the outflows of capital induced by tax gaps increase the scarcity of initial endowments. At the same time, country 1 is still a net importer of capital, i.e., 1 − K2 > 0, eventhough country 1 aggressively levies a higher capital tax than country 2. Thus, country 1
can increase its revenue by taxing capital inflows attracted by the benefits of its natural
resources bonanza: that is, t1 (1 − K2 ) > 0. In contrast, country 2 is doubly cursed in thesense that at a subgame-perfect Nash equilibrium, its initial factor endowments lead tothe loss of factor incomes, and it loses the opportunity to levy tax on capital.

4.2

Tax coordination

The ineﬃciency (losses in global welfare) arising from tax competition makes room fortax coordination to work. Consider the case where countries coordinate their policies andjointly make a tax oﬀer to maximize global income, Y1 + Y2 . The first-order conditions
for global welfare maximization are given by15
(t2 − t1 )(3β + 4γ)∂(Y1 + Y2 )
=
= 0,
∂t1
4β(β + 2γ)(t1 − t2 )(3β + 4γ)∂(Y1 + Y2 )
=
= 0.
∂t2
4β(β + 2γ)
These conditions require that t1 = t2 as long as the solution is interior.
Proposition 5 Global welfare maximization requires that the capital tax rates in the twocountries be harmonized to reach the same level.
Note that the level of coordinated tax rates is undetermined16 . Tax rate equalization
t1 = t2 leads to factor price equalization, implying that capital distribution goes back to
the one observed in the case of mobile capital without government intervention.

5

Concluding remarks

The literature on capital market integration and tax competition has overlooked the roleof natural resources. We examined how the natural resources of a particular country
15
16

The second-order conditions are also satisfied.
This indeterminacy is based on the linearity of utility and factor demand functions; for example, see

Peralta and van Ypersele [31] and Itaya et al. [19].

16

aﬀect the flow of capital and the governments’ reactions to them, who benefits from
capital mobility and tax competition, and what are the welfare implications. In so doing,
we developed an analytically solvable framework involving vertical linkages via resourcebased inputs and international fiscal linkages between resource-rich and resource-poor
countries. Our analysis showed that capital market integration yields capital flows fromresource-poor countries to resource-rich countries, improving production eﬃciency andglobal welfare. However, such gains accrue only to resource-poor countries, and capital
mobility can even make resource-rich countries worse oﬀ. Once we introduce the possibilityof governments intervening in reaction to capital flows, both countries can levy a positive
tax rate on capital. In particular, resource-rich countries will levy a higher tax rate thanresource-poor countries. This tax wedge would make the resource-rich country a winner
and the resource-poor country a loser. As a result, tax competition hurts global welfare.
Propositions 4 and 5 imply that while a tax harmonization policy among countries
would enhance global welfare, it inevitably will invoke a resource curse if there are notransfers among them. This is because the interests of the two countries are directly in
conflict and no Pareto-improvement is possible. It is thus worth investigating a mechanism
to implement tax harmonization policies among asymmetric countries, which will be an
important topic for future research.

17

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