result in a “free lunch” in our analysis. This is in stark contrast with the results of some of the closed-economy, endogenous growth models reviewed in the introduction (such as Ireland (1994) and Novales and Ruis (2002)) in which significant dynamic Laffer effects emerge for parameterizations of the initial tax rates similar to ours. As we have already stressed in the introduction, this is not surprising in the endogenous growth literature, in which the growth effects of tax cuts are likely to be strong.
A more relevant comparison of our results is with RBC models in which the rate of growth is exogenous. Trabandt and Uhlig (2006) look at the impact of reductions in income taxes financed by cuts in government spending transfers for a parameterizaiton similar to ours. Their results are quantitatively similar to ours, since in the new steady state revenue collection falls by about 2 percent, compared to about 3 percent in our case.11 How can quite different models generate such close results? One explanation is that that while the introduction of market imperfections—compared to the RBC framework—entails that our initial steady-state is suboptimal and larger efficiency gains can be derived from reducing the tax burden, those gains are offset by the open-economy dimension, which implies that part of the growth benefits of the domestic tax reduction accrue to the foreign country. The importance of the open economy dimension in preventing the emergence of dynamic Laffer effects in our framework is even more evident if our results are compared with the RBC model and Leeper and Yang (2008), in which a 1 percent reduction in income taxes—starting from an initial tax rate of 25 percent—implies a revenue loss much smaller than ours (about 0.3 percent compared to 3 percent in our case). The possibility of analysing the interaction of market imperfections and open economy channels is an advantage of using a NOEM framework, on which we will focus more explicitly in section IV B.
The Degree of Self Financing: if not a “Free” Lunch, at Least a “Cheap” Lunch?
As we have discussed above, “free lunches” deriving from tax cuts are generally ruled out both in our NOEM model and in previous RBC models. Recent research (Mankiw and Weinzierl 2006; Trabandt and Uhlig 2006) however, has shifted the focus in the RBC literature from “free lunches” to “cheap lunches”, in the sense of investigating whether tax cuts which do not generate dynamic Laffer effects can be at least largely self-financing.
The degree of self financing has been defined as12
11 See Trabandt and Uhlig (2006), Table 7. The fall in revenue collection is smaller if the initial tax rate is higher (see Trabandt and Uhlig (2006), Table 8).
See Mankiw and Weinzierl (2006) and Trabandt and Uhlig (2006).