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© 2008 International Monetary Fund

WP/08/227

IMF Working Paper

IMF Institute

Tax Reforms, “Free Lunches”, and “Cheap Lunches” in Open Economies

Prepared by Giovanni Ganelli and Juha Tervala1

Authorized for distribution by Enrica Detragiache

September 2008

Abstract

This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.

This paper focuses on the macroeconomic and budgetary impact of tax reforms in a New Keynesian two-country model. Our results show that both income and consumption unilateral tax rate reductions do not constitute a “free lunch”, in the sense that they have negative budgetary consequences for the country which implements them. In addition, the degree of self-financing implied by our model is in the 8½-24 percent range. Since the degree of self-financing estimated in previous literature was larger, we conclude that in our model not only the “lunch” is not “free”, but is also not that “cheap”. A comparison of alternative (income-tax versus consumption-tax based) fiscal stimulus packages shows that consumption tax cuts imply a larger short-run impact on domestic output but the income tax cuts stimulate the domestic economy more in the long run. We also look at the implications of a revenue-neutral tax reform in which consumption taxes are increased to compensate for lower income tax collection.

JEL Classification Numbers:E62, F41, H2

Keywords:Tax Cuts; Dynamic Laffer Effects; Self-financing.

Authors E-Mail Address:gganelli@imf.org, juha.tervala@helsinki.fi

1 Mr. Ganelli is with European Division of the IMF Institute and Mr. Tervala is with the Department of Economics, University of Helsinki, Finland. We are grateful for comments to Enrica Detragiache, Lennart Erickson, Pertti Haaparanta, Juha Kilponen, Erkki Koskela, Tapio Palokangas, Panu Poutvaara, Antti Ripatti and seminar participants at the IMF Institute and at the University of Helsinki. Juha Tervala would like to thank the Yrjö Jahnsson Foundation for financial support.

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