A Tale of Tax Policies in Open Economies

Recent financial crises in Europe as well as the periodic battles in the U.S. over the debt ceiling point to the importance of fiscal discipline among developed countries. This paper develops an open economy model, calibrated to the U.S. and a subset of the EMU, to evaluate the impact of various permanent tax changes. The first set of experiments considers a targeted one percentage point reduction in the government deficit-to-GDP ratio through raising one of: the consumption tax, the labor income tax, or the capital income tax. In terms of welfare, the consumption tax is found to be the least costly of the tax increases. A second set of experiments looks at deficitneutral tax changes: partially replacing the capital income tax with either a higher labor income tax or higher consumption tax; and partially replacing the labor income tax with an increased consumption tax. Reducing reliance on capital income taxation is welfare-enhancing, although it leads to short term losses. Reducing labor income taxation improves international competitiveness and is welfare-improving.