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

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  • 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 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.

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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: 30
Date of creation: 01 Sep 2008
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Handle: RePEc:imf:imfwpa:08/227

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Keywords: Tax reforms; Income taxes; Consumption taxes; Tax rates; Budgetary policy; Economic models; revenue collection; consumption tax; tax collection; tax revenues; tax cuts; tax reform; tax reduction; tax cut; tax reductions; fiscal policy; income tax cuts; tax rate reduction; fiscal stimulus; domestic tax; real tax revenues; income tax rates; budgetary impact; flat tax; public spending; reduction in transfers; government spending; tax changes; budgetary implications; total tax collection; fiscal package; foreign tax; government budget; taxation; budget constraint; fiscal stimulus package; tax rate changes; capital accumulation; reduction in tax; effective tax rates; flat taxes; tax rate reductions; tax policy; tax ? reforms; increase in consumption; reduction in public spending; fiscal expansion; fiscal policy coordination; tax legislation; domestic tax reform; expansionary fiscal policy; government budget constraint; higher income; flat tax ? reforms; tax revenue; fiscal stance; expansionary fiscal; foreign tax rate; cuts in government spending; fiscal strategies; higher tax revenues; budget balance; tax burden; tax increase; tax competition;

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