Figure 4. Impact of a Revenue Neutral Tax Reform
Starting with the domestic economy, it was already clear from sections IV and V that the impact of the revenue neutral tax reform would be equal to the sum of the expansionary impact of an income tax reduction (as in Figure 1(a)) and the contractionary impact of a consumption tax increase (as suggested by Figure 2(a), in which a consumption tax cut stimulates the economy). Figure 4(a) and 4(b) shows that the contractionary impact of the increase in the consumption tax rate dominates quantitatively in the short run, so that the final effect of the revenue neutral policy on the domestic economy is a reduction in output, which is only partially reversed in the medium and long run.
Figure 4(b) shows that domestic consumption excluding slightly increases. Such an increase and the consumption tax rate hike implies that domestic money demand—which is a positive function of consumption including taxes—increases. The consequent appreciation of the domestic exchange is quantitatively stronger than the one observed in the non revenue- neutral policy of section IV (compare Figures 4(c) and 1(c)). This appreciation obviously contributes to shift demand towards foreign goods, thus resulting in a temporary increase of foreign output compared to the initial steady state. Foreign agents, however, use their higher income to accumulate external assets (Figure 4(i)) rather than to increase consumption. While in this exercise domestic revenue collection is constant in the steady-state due to the policy followed by the domestic government, the impact on foreign revenue. is positive and especially pronounced in the short run (Figure 4(f,h), due to higher foreign labor supply at an unchanged foreign tax rate. The impact on foreign tax collection is quantitatively stronger than in the case of a non-revenue neutral reduction in domestic income taxes (compare Figures 1(f,h) and 4(f,h)) due to the fact that foreign output increases