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Tax Reforms, 'Free Lunches', and 'Cheap Lunches' in Open Economies

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Author Info

  • Juha Tervala
  • Giovanni Ganelli

Abstract

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 8-24 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.

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Bibliographic Info

Paper provided by International Monetary Fund in its series IMF Working Papers with number 08/227.

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Length: 57
Date of creation: 01 Sep 2008
Date of revision:
Handle: RePEc:imf:imfwpa:08/227

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Related research

Keywords: Tax reforms; Income taxes; Consumption taxes; Tax rates; Budgetary policy; Economic models;

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References

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Cited by:
  1. Lehmus, Markku, 2011. "Labor or consumption taxes? An application with a dynamic general equilibrium model with heterogeneous agents," Economic Modelling, Elsevier, vol. 28(4), pages 1984-1992, July.

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