We reconsider the conventional wisdom that, in the presence of public goods, Nash tax rates are inefficiently low and decrease with the size of population. We use a general equilibrium dynamic model of a world economy, in which a worldwide environmental quality has features of public goods. We show that the type of policy externality from one country to another (and hence whether we undertax, or overtax, in a Nash equilibrium relative to a cooperative one) can be reversed, when we introduce dynamics. Specifically, the policy externality changes from positive (which is the static, standard case) to negative, once the same model allows for long-term endogenous growth. This happens because in a growing economy, long-run capital tax bases are elastic so that a higher tax rate leads to lower economic growth, smaller tax bases, lower tax revenues, lower clean-up policy in each country, and this eventually generates a negative external effect upon other countries. Then, negative policy externalities imply that Nash tax rates are inefficiently high and increase with the size of population. © 2002 Elsevier Science (USA). All rights reserved.
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