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This paper analyzes the effects of a land rent tax on capital formation and foreign investment in a life-cycle small open economy with endogenous labor-leisure choices. The consequences of land taxation critically depend on how the tax proceeds are used by the government. A land tax depresses capital formation, crowds out foreign investment and increases national wealth and consumption when the land tax revenues are distributed as lump-sum payments. If the proceeds from land taxation are used to finance unproductive government expenditure, the land tax will be neutral in its effects on the capital stock, nonhuman wealth and labor. When the tax revenues are used to reduce labor taxes, the land rent tax spurs nonhuman wealth accumulation and ambiguously affects the capital stock and labor.

In a non-altruistic OLG closed economy, where land serves as an input as well as an asset, a tax on land rent is associated with a higher capital stock and output per person in the steady state. The rationale for this result, discovered by Feldstein (1977), is that a land tax hike, by initially reducing the value of land, diverts saving away from land into real capital, therefore spurring capital accumulation and temporarily output growth. The increase in the capital stock in turn lowers the real interest rate and raises the marginal productivity of land as well as the wage rate. Steady state financial wealth, consumption and welfare rise. The positive effect of the land rent tax on capital formation, which can be denominated the “Feldstein effect”, is grounded in the portfolio choice. Since capital and land are the only assets of the economy, any “flight from land”, determined by the land rent tax, is by necessity a “flight into real capital”. The “Feldstein effect” is independent of alternative uses of land tax revenues. There have been many articles analyzing the implications of land rent taxes for the resource allocation and incidence analysis.1Calvo et al. (1979) demonstrated that the Feldstein findings depend on the non-Ricardian (in the demographic sense) structure of the economy, by showing that in a Barro–Ramsey economy, a tax on land rent is fully capitalized in the price of land and no effect on capital accumulation occurs, as originally predicted by Ricardo (1817). Fane (1984) argued that, once a fully compensated land tax is considered in a model with finite-lived disconnected generations, the unique effect of taxation is to cause a fall in the land value with no shifting; a land tax is fully compensated when the land tax shift is accompanied by the issuance of perpetual government bonds, whose sale proceeds are used to make lump-sum transfers to the landlords hit by the tax, and the land tax revenues are employed to finance the interest payments on the newly issued government bonds.2 The Ricardian results on the land tax shifting can also be obtained in a life-cycle setting with no-bequests if current consumption and future consumption are perfect substitutes in the individuals' utility function; see Kotlikoff and Summers (1987). Chamley and Wright (1987) analyzed the dynamic incidence of pure rent taxation in the Feldstein (1977) model. They found that the impact response of the land price to an increase in the land tax may be positive or negative. If positive, this response is always smaller than one-half of the tax revenues; if instead the price of land falls immediately, the loss in value is never greater than indicated by the full Ricardian capitalization of the land tax. In a finite-lived small open economy having unrestricted access to the world capital market and a fixed labor supply, saving diverted from land by a rise in land taxation is not directed towards real capital; under perfect capital mobility, in fact, the portfolio mechanism discovered by Feldstein implies that the “flight from land” necessarily determines a “flight into foreign assets”. This was shown by Eaton (1988), who discovered that a land tax leaves the capital stock, domestic output and non-land input prices unaffected.3 The land tax however reduces the price of land, crowds out foreign investment and hence raises national income as well as the consumption and welfare of nationals. There is nothing surprising in the Eaton (1988) findings, since, even though the economy he analyzed is in principle a three-asset economy (as net foreign assets enter the asset menu of savers in addition to physical capital and land), it de facto works as a two-asset economy, since the capital stock is tied down by the given world interest rate. By considering a monetary growth model, Ihori (1990) investigated the role of land taxation in an inflationary OLG economy. He found that a balanced budget rise in land taxation accompanied by an increase in government spending induces an increase in the capital stock and a reduction in factor returns, while a tax reform from lump-sum taxes to land taxes crowds out capital formation and increases the real return on land and capital. In all the cases studied by Ihori (1990), the nominal price of land is normally reduced by land taxes, while the real price may rise or fall. Hashimoto and Sakuragawa (1998) found in a “learning by doing” endogenous growth economy with finite horizons that the effects of the imposition of a land tax differ according to the tax-transfer programme adopted. If the tax revenues are wasted or transferred wholly to the younger generations, the growth rate is always increased by pure rent taxes, whereas if they are transferred wholly to the older generations, the output growth rate may be reduced. None of these articles has analyzed the implications of endogenous labor–leisure decisions for the macroeconomic consequences of land taxation. As originally recognized by Feldstein (1977),4 the labor supply responses may strongly affect the incidence of a pure rent tax because of the income effects that can arise according to the compensatory financing adopted by the government. The purpose of this paper is to investigate the effects of a land tax on capital formation and foreign investment in a life-cycle small open economy with perfect capital mobility, where the supply of labor is endogenous. We find that the consequences of land rent taxation differ substantially from those predicted by Feldstein (1977), Eaton (1988), and the others, and critically depend on how the tax proceeds are used by the government. Land taxation does not spur capital accumulation as in a closed economy, but instead depresses capital formation and economic growth when the tax revenues are lump-sum transferred to consumers. Labor supply and domestic output are reduced by the shock, while nonhuman wealth and national income are increased. If, instead, the proceeds from land taxation were used to finance unproductive government expenditure, the tax on pure rent would be neutral in its effects on the capital stock and aggregate wealth. In this case, the reduction in the land price stemming from higher taxation only implies a compensating decrease in foreign investment. When the tax proceeds are used to cut labor income taxes, land taxation ambiguously affects the labor supply and the capital stock, while it raises domestic wealth and aggregate consumption. The paper is organized as follows. Section 2 outlines the analytical framework. Section 3 investigates the steady state consequences of land taxation under different compensatory financing schemes. Section 4 concludes.

This paper has investigated the consequences of land taxes in a small open economy of wealth formation, where the rate of return on capital is exogenously determined on the world capital market, consumers have finite horizons, and the supply of labor is endogenous. This latter feature differentiates our analysis from the previous articles on land taxation, which have instead assumed inelastic labor choices. A variable labor supply alters the conventional conclusions regarding the long-run incidence of land taxes. The final effects of land taxation on the resource allocation, wealth formation and economic growth depend upon the government uses of the tax proceeds; in our analysis the land tax revenues are alternatively employed to increase lump-sum transfers, the government expenditure, or to cut wage taxes. Land taxation increases consumption and stimulates wealth formation, but reduces the capital stock and manhours, when the tax revenues are distributed as lump-sum payments. The exporting of the tax burden to non-residents (who do not receive government transfers) and the intergenerational wealth transfer (due to the fact that changes in lump-sum payments, by altering the distribution of resources across heterogeneous generations, modify aggregate saving and nonhuman wealth) are the basic mechanisms that underpin these effects. A rise in the land tax, whose proceeds are used to finance an increase in the government spending, produces no consequences on consumption, wealth, labor hours, and capital formation, since the intergenerational redistribution of resources seen in the case of lump-sum compensatory finance does not occur and the tax exporting does not matter, as the government spending leaves consumption and the labor supply choices unaffected. Finally, a revenue-neutral tax reform that reduces labor income taxes in favor of land taxes raises consumption and national wealth, but exerts ambiguous effects on labor and the capital stock as the international and intergenerational redistributive mechanisms conflict with a substitution effect due to the increase in the after-tax wage rate.