Recent theoretical work has argued that a small open economy should use residence-based but not source-based taxes on capital income. Given the ease with which residents can evade domestic taxes on foreign earnings from capital, however, a residence-based tax may not be administratively feasible, leaving no taxes on capital income.

Optimal-tax theory forecasts that small open economies should not tax capital income. Yet, countries do tax capital income. Why the inconsistency? This paper shows that use of the double-taxation convention, whereby governments credit taxes paid abroad against domestic taxes, helps explain this inconsistency. In particular, capital income will be taxed if a dominant capital exporter acts as a Stackelberg leader when setting its tax policy. Due to the convention, other countries will then tax capital imports, making it attractive for the dominant capital exporter to tax capital income. Without a dominant capital exporter, however, the model still forecasts no capital-income taxes.

Optimal‐tax theory forecasts that small open economies should not tax capital income. Yet, countries do tax capital income. Why the inconsistency? This paper shows that use of the double‐taxation convention, whereby governments credit taxes paid abroad against domestic taxes, helps explain this inconsistency. In particular, capital income will be taxed if a dominant capital exporter acts as a Stackelberg leader when setting its tax policy. Due to the convention, other countries will then tax capital imports, making it attractive for the dominant capital exporter to tax capital income. Without a dominant capital exporter, however, the model still forecasts no capital‐income taxes.