Figure 3. Comparison of Alternative Tax Policy Options to Achieve a Given Reduction in Transfers
Figure 3(a) shows that, once the domestic government has decided to reduce transfers and total tax collection by a certain amount (in our example to 2.9 percent less than in the initial steady state) implementing this plan by reducing the consumption tax rate implies a larger short-run impact on domestic output compared to an income-tax based strategy. In the medium and long run, however, the income-tax based strategy stimulates the domestic economy more than the consumption-tax based one.
VI. A REVENUE NEUTRAL TAX REFORM
In all the exercises considered so far, tax rates were exogenously reduced and revenue collection adjusted endogenously. In this section, we consider a policy in which the income tax rate is reduced as in section V and the consumption tax rate is increased by the amount needed to compensate the long-run revenue loss stemming from lower income taxes.
Following an income tax rate reduction from 20 to 19 percent (the same as in section V), the consumption tax rate needs to be increased from to 8 to 8.85 percent in order to keep total revenue collection constant in the new steady state. The macroeconomic impact on the domestic and foreign country of such revenue-neutral tax reform is presented in Figure 4.