Knowledge Spillovers and the Optimal Taxation of Foreign Firms

Abstract

Knowledge spillovers are a typical rationale for countries to allow and even subsidize multinational firms. I examine the optimality of such policies in a growth model in which productive skills are formed on the basis of the exposure to ideas in a country. Because of knowledge dissemination, openness to foreign firms can greatly enhance the formation of domestic skills in a developing country. However, laissez-faire openness is suboptimal and could even be growth and welfare-reducing. Then, I solve for the taxation program that maximizes the welfare of the recipient country subject to the equilibrium behavior of national and foreign firms. Under the optimal taxation programs, openness always leads laggard countries to catch up with the frontier. However, a developing country should only subsidize the entry of foreign firms if it can also subsidize the domestic accumulation of know-how. The implications of suboptimal foreign tax programs, financing constraints, and expropriation incentives are also considered.