globalized economy. A paper which takes a similar open economy view of tax reforms is Mendoza and Tesar (1998). Using a dynamic neoclassical two-country model, they study the domestic and international implications of a US tax reform. One difference of our contribution compared to theirs is that they do not explicitly focus on dynamic Laffer effects and on the degree of self-financing, since the tax reforms they analyze are such that any revenue loss caused by reductions in income tax rates is perfectly offset by an increase in consumption taxes.6 Our choice of using a New Keynesian model is another important difference compared to all the paper reviewed above, which allows us to take into account how tax reforms interact with market imperfections such as the degree of nominal rigidity in the economy.
The paper is organized as follows. Sections II and III respectively introduce the model and our benchmark parameterization. Section IV and V present and compare the results of income tax and consumption tax rates reductions. Section VI focuses on a revenue-neutral tax reform. Section VII presents some sensitivity analysis. Section VIII concludes.
II. THE MODEL
We use a standard NOEM model, similar to the one developed by Betts and Devereux (2000). Compared to the latter, there are two main differences. The first is the introduction of income and consumption taxes instead of lump-sum ones. The second is that nominal rigidities take the form of staggered price setting as in Calvo (1983), rather than one-period fixed prices. Betts and Devereux (2000) assume that a fraction of firms fix prices in the currency of the consumer. Their model therefore allows for both Local Currency Pricing (LCP)—which implies deviations from Purchasing Power Parity (PPP)—and Producer Currency Pricing (PCP). In this paper we focus our attention on the PCP case, abstracting from deviations from PPP. The model contains two countries. Firms and households are indexed by z ∈[0,1] . A fraction n of households and firms are located in the domestic
country, while 1− n are located in the foreign country. In the presentation of the model below we will introduce domestic equations. Unless equations for the foreign country are explicitly discussed, they can be assumed to be symmetric to the equations for the domestic country.
Households gain utility from private consumption and real balances, and experience disutility from supplying labor. Their utility function is therefore given by
6 Although we mostly focus on policy experiments in which governments adjust transfers to compensate changes in tax collection, in Section VI we also look at the implications of a revenue neutral exercise similar in spirit to the one carried out by Mendoza and Tesar (1998).