Consider a world economy composed of two countries, A and B. There is a fixed stock of capital,.

Consider a world economy composed of two countries, A and B. There is a fixed stock of capital, K, that allocates between the countries on the basis of the after-tax return. Let the after-tax return in country i, i = A;B, be equal to r – mKⁱ – tⁱ , where Kⁱ is the quantity of capital that locates in country i and tⁱ is the tax rate in country i.

a. Provide an interpretation of the parameter m.

b. Assuming that each country chooses its tax rate to maximize tax revenue, calculate the Nash equilibrium choice of tax rates.

c. What is the effect on the equilibrium tax rates of reducing m? Explain this result.

d. What are the ancient tax rates?

e. What are the implications of these findings for tax policy?