stimulate the economy in the US more than once in the last decade, while Japan also tried to boost growth in the 1990s through an expansionary fiscal policy. In Europe, the Stability and Growth Pact has been recently re-interpreted in a way that facilitates the countercyclical use of fiscal policy. The importance of fiscal policy as a tool to stimulate the economy in a downturn was also recently stressed by the IMF’s Managing Director, who stated “But in a sense, medium-tem fiscal policy is all about saving for a rainy day. It is now raining” (Strauss-Kahn 2008). Our results show 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.
The importance of the issues on which we focus has obviously not escaped previous contributions. Most of the papers in the tax reform literature use closed-economy endogenous growth or neoclassical models to ascertain the existence of dynamic Laffer effects. Ireland (1994) finds that in an endogenous growth model an income tax reduction from an original rate of 20 percent generates a dynamic Laffer effect as long as the new rate is greater than 7.6 percent. Pecorino (1995) criticizes Ireland (1994) for not taking into account that returns from human capital accumulation are less highly taxed compared to other income sources, and shows that if this is taken into account dynamic Laffer effects only emerge for initial levels of tax rates of the order of 60 percent. Novales and Ruiz (2002) extend Ireland (1994) and Pecorino (1995) by explicitly taking into account transitional dynamics between balanced growth paths. They show that dynamic Laffer effects can arise for reductions of income tax rates of up to 5 percentage points starting from an initial rate of 23 percent. Bruce and Turnovsky (1999) stress that Ireland’s result rely on an implausibly high (greater than unity) intertemporal elasticity of substitution and that dynamic Laffer effects can be ruled out under more realistic parameterizations.
Dynamic Laffer effects are likely to emerge in literature discussed above because, under the assumption of endogenous growth, the growth impact of tax cuts are large. This is not necessarily the case in neoclassical Real Business Cycle (RBC) models, in which the issue is rather how much of the tax cut pays for itself. Accordingly, Mankiw and Weinzierl (2006) have recently shifted the research focus, in a neoclassical setting, from dynamic Laffer effects to the degree of self-financing, in the sense of how much of the “partial equilibrium” revenue loss is paid for by growth (see section IV.A below for the formal definition). Using this methodology, they calibrate a neoclassical growth model to the US, finding that 17 percent of a labor income tax cut is self-financing for standard parameter values, a magnitude close to the one (19 percent) calculated by Trabandt and Uhlig (2006) in a similar exercise.
Compared to the above mentioned closed-economy papers, one innovation of our contribution is that of jointly analyzying the macroeconomic and budgetary implications of tax reforms in an open economy framework. This allows us, in the spirit of Frankel and Razin (1989), to study the domestic and international impact of unilateral tax reforms in a