Table 5. Consumption Tax Rate Cut: Degree of Self Financing 1/
Nominal tax revenues
Real tax revenues
1/ See equations (25) and (26) for the definition.
One important difference between income and consumption tax reductions is that they have opposite effects on the nominal exchange rate. While in the case of an income tax cut the domestic exchange rate appreciates (Figure1(c)), a consumption tax cut results in a domestic depreciation (Figure 2(c)). The intuition for this result is the money demand effect already discussed in section IV. Since money demand is a positive function of consumption including taxes, the reduction in the consumption tax rate has a negative effect on domestic money demand, which for our parameterization is stronger than the effect of the increase in real consumption excluding taxes. The negative impact on money demand implies a transmission mechanism symmetric to the one described in section IV, resulting here in a domestic depreciation (rather than in an appreciation as in section IV).
A result that can be clearly seen in Figure 2 and Table 4 is that, even in the case of consumption tax cuts, no dynamic Laffer effects emerge in our model. Domestic labor income tax collection increases in this case, because domestic households increase their labor supply at an unchanged income tax rate. The increase in labor income tax collection, however, is not large enough to compensate for the reduction in consumption tax collection. As a result, total revenue collection in real terms drops by 3.4 percent in the steady-state, an order of magnitude comparable to the one derived in the case of income tax reductions (compare Tables 1 and 4). Furthermore, the degree of self-financing in real terms in the new steady state is 11.5 percent (Table 5), which is lower than the 17.3 percent derived for the case of income tax reductions (Table 2). Table 5 also shows that the degree of self-financing is larger in the short-run (27.8 percent) than in the long-run. This result is due to the fact that the expenditure switching effect, which shifts demand towards domestic goods thus increasing domestic income tax collection due to higher labor, is stronger in the short run.
In summary, consumption tax cuts do not generate a “free lunch” for the budget. In fact, the “lunch” they deliver is, in our model, less “cheap” than the one delivered by labor income tax cuts. While previous literature did not delve into the study of the self-financing features of consumption tax cuts, our results are broadly consistent with the findings of the endogenous growth model of Novales and Ruiz (2002), in which no dynamic Laffer effects emerge for consumption tax reductions, as well as with those of Trabandt and Uhlig (2006), who find mixed results (depending on the specific utility functional form) on the existence of steady- state Laffer curves for consumption taxes.
One advantage of introducing both income and consumption taxes in the framework we use is that we can compare alternative options for fiscal stimulus packages. Comparing Figures 2(a) and 1(a) we can see that a fiscal expansion policy based on a one percentage point reduction in consumption taxes has a stronger and faster impact on short-run domestic output compared to a fiscal package based on a one percentage point reduction in income taxes. The