effects on policy interdependence between countries, a proper analysis of the implications of tax reforms should be carried out within a global open-economy framework. This statement, which was without doubt already true when the Lecture was delivered, is all the more valid in relation to today’s highly globalized world economy, in which tax competition and highly mobile factors of production need to be factored in by national authorities in their tax policy decisions.
In this paper we aim at jointly analyzing the two important dimensions of tax reforms discussed above, by focusing on the domestic and international budgetary impact of unilateral income and consumption tax cuts. In doing so, we use a New Keynesian two- country model with imperfect competition and nominal rigiditities. Our model falls in to the so-called New Open Economy Macroeconomics strand of the literature.5
Our results show that, for a standard parameterization, dynamic Laffer effects do not emerge in our model. Both income and consumption unilateral tax rates reductions have negative budgetary consequences for the country which implements them. In addition to studying whether tax cuts can pay for themselves and be a “free lunch” for the budget, we also study whether they can be largely self-financing—in the sense of Mankiw and Weinzierl (2006)— and therefore result at least in a “cheap lunch”. We find that the degree of self-financing of income tax cuts in real terms is about 17 percent in our benchmark parameterezation and is in the 13-24 percent range in the sensitivity analysis that we carry out. The degree of self- financing of consumption tax cuts in real terms is 11.5 percent in our benchmark and in the 8.6-15.6 range in our sensitivity analysis. Since the magnitudes that we derive for self- financing are at the bottom of the range calculated in previous literature, we conclude that in our framework tax cuts not only do not deliver a “free lunch”, but that the lunch is also 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).
Another contribution of our paper is a comparison between alternative (income-tax based versus consumption-tax based) fiscal stimulus packages. We wiev this as an important issue, since the policy makers of several industrial countries have shown, in recent years, a renewed interest in fiscal policy as a counter-cyclical tool. For example, tax cuts have been used to
5 Following the seminal paper by Obstfeld and Rogoff (1995, 1996), important contributions to this literature include, but are not limited to, Betts and Devereux (2000, 2001), Corsetti and Pesenti (2001), and Obstfeld and Rogoff (2000, 2002). Surveys of this literature are provided by Lane (2001), Sarno (2001), Coutinho (2005), and Corsetti (2007).