Table 9. Consumption tax rate cut: degree of self-financing for different values of the labor disutility parameter Degree of self-financing
Nominal overall tax revenues
Real overall tax revenues
New steady state 15.6 11.5 8.6
This paper focuses on the impact of tax reforms in a two-country model with imperfect competition and nominal rigidities. In particular, we investigate and compare the effects of unilateral reductions in domestic income and consumption tax rates.
Our analysis shows that, for a standard parameterization, dynamic Laffer effects do not emerge following reductions in income or consumption tax rates, since total revenue collection permanently falls in both cases. This implies that in our model such tax reforms are not self-financing and therefore do not deliver a “free lunch” for the budget. We also study the degree of self-financing in the sense of Mankiw and Weinzierl (2006). Since the degree of self-financing that we derive is at the bottom of the range provided by previous literature, we conclude that not only “free lunches” do not emerge in our model, but also that the “lunches” delivered by tax cuts are not that cheap.
In addition to the budgetary impact, the tax reforms that we study also have important implications for domestic and foreign macroeconomic variables. A reduction in the domestic labor income tax rate generates a domestic boom, in which both output and consumption increase. The foreign economy is affected both in the short and in the long run through various transmission channels (an expenditure switching effect, a terms of trade effect, and a trade surplus/deficit effect).
A comparison of consumption-tax based versus income-tax based fiscal stimulus packages shows that, if a given reduction in public spending and total revenue collection is achieved by a consumption (rather than income) tax rate reduction, the impact on domestic output is larger in the very short run but smaller in the medium and long run. In a revenue-neutral tax reform, in which consumption taxes are increased to compensate the income tax reduction, the contractionary effect of higher consumption taxes dominate in the short run but is partially reversed in the long run.
The model presented in this paper could be extended in several directions. For example, rather than being restricted to balance its budget in every period, the government could be allowed to run a deficit which would result in debt accumulation. The analysis of how such a