New steady state 0.5
Table 2. Income Tax Rate Cut: Degree of Self Financing 1/
Nominal tax revenues
Real tax revenues
1/ See equations (25) and (26) for the definition.
New steady state 17.3
Table 2 reports the degree of self-financing at various horizons following an income tax cut. One result emerging from Table 2 is that in our model it matters whether we consider the degree of self-financing in terms of nominal or real tax revenues, since the results are significantly different. More importantly, Table 2 shows that the degree of self-financing in real terms stabilizes at about 17 percent in the new steady state. 13 This value is of the same order of magnitude of those calculated by Mankiw and Weinzierl (2006) and Trabandt and Uhlig (2006) for a labor income tax cut in the US. As discussed above, however, the same authors have shown that the degree of self-financing can be significantly larger in the case of capital income tax cuts or when the parameterization is based on higher initial tax rates (such as those used by Trabandt and Uhlig (2006) in their parameterization of the EU-15). Furthermore, Leeper and Yang (2008) find a much larger degree of self-financing. Given that in our exercise the degree of self-financing is at the bottom of the range derived in the existing literature, we can conclude that in our model not only a cut in the income tax rate does not produce a “free lunch”, but also that the “lunch” is not that “cheap”. We are now ready to move to the analysis of global implications of tax reforms.
B. The International Effects
As we have already stressed above, one advantage of using the NOEM framework is the possibility to analyze how market imperfections interact with the open economy dimension in determining the results. One important open-economy channel obviously works through exchange rate movements. Figure 1 (c) shows that the reduction in domestic income taxes implies an appreciation of the domestic nominal exchange rate (a fall in the price of foreign currency in terms of domestic currency). This appreciation is due to a “money demand” effect stemming from the increase in domestic consumption caused by the domestic tax cut. Since money demand is a positive function of consumption including taxes (see equations (10) and (11)), the increase in domestic consumption (both in absolute terms and relative to foreign consumption) increases domestic money demand compared to foreign. This implies that the domestic currency appreciation displayed in Figure 1(c) is required to reestablish equilibrium in the money market.
13 The result of a negative degree of self-financing at t=1 is due to the dynamics of the nominal wage, which in the short run undershoots its new long-run steady-state level, thus implying that the “general equilibrium” revenue loss is temporarily higher than the “partial equilibrium” one in equations (26) and (27).