Figure 1(a) also shows a temporary increase of foreign output following the domestic tax cut. This is partly due to the increase in world demand deriving from higher domestic consumption. Since household preferences do not display home bias the increase in domestic consumption falls on foreign as well as on domestic goods (an “expenditure boosting” effect). Figure 1(a) also shows that the short run increase in foreign output is faster than the one in domestic output. This suggests that, in addition to the global expenditure boosting effect discussed above, an “expenditure switching” effect is also at work: part of the increase in foreign output is due to the fact that foreign goods become cheaper as a consequence of the appreciation of the domestic currency. The expenditure switching effect of a nominal exchange rate change alters the relative price of goods only as long as prices are sticky. Since under our parameterization half of the firms adjust their prices in every period, the expenditure switching effect peters out fast. This explains why the increase in foreign output is temporary.
Even though the impact of the expenditure switching effect is temporary, the fact that part of the benefits—in terms of output stimulation—of the domestic tax reduction accrue to foreigners explains why dynamic Laffer effects do not emerge in our model and the degree of self-financing is lower than the ones calculated in RBC models for similar parameterizations.
The short-run increase in foreign output is matched by a short-run reduction in foreign consumption. In the long run, foreign consumption slightly increases compared to its initial steady-state level. This dynamics of foreign consumption is driven by changes in the terms of trade and by foreign households’ desire to use their temporary income gains to smooth consumption over time. Since in the short run, due to the appreciation of the domestic currency, the foreign terms of trade worsen (an increase in Figure 1(d)), foreign households reduce their short-run consumption. In this way they save part of their extra short-run income (Figure 1(a)), thus running a current account surplus (Figure 1(i)). In the medium and long run, however, the foreign terms of trade improve (a fall in Figure 1(d)) due to a relative increase in the supply of domestic goods which implies a fall in the relative price of domestic goods. This terms of trade effect, together with external wealth accumulation due to the current account surplus, allow foreign households to increase their long-run consumption even though their long-run income returns to almost initial steady-state levels. Figure 1(h) also shows that the domestic tax reform has a temporary positive impact on foreign tax collection, due to the fact that foreign households increase their labor supply at an unchanged income tax rate level.
The responses of macroeconomic variables to tax cuts presented in this section are broadly consistent with findings of the empirical literature. The result that domestic activity is stimulated in response to a tax reduction is a standard one in studies of the US economy (see for example Blanchard and Perotti (2002)). Although empirical studies of the international transmission of fiscal policy are scarce, our result of a positive international output spillover is consistent with foreign output multipliers calculated by Giuliodori, Beetsma, and Klassen (2006) for several European countries.