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Economic Shocks, Progressiveness of Taxation, and Indexation of Taxes and Public Expenditure in EMU

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  • Kotilainen, Markku
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    Abstract

    We study the effects of demand, tax and supply shocks in one- and two-country macroeconomic models with fixed exchange rates, with our main emphasis on the stabilisation properties of progressive taxation. The models try to depict outcomes for the EMU countries. In the one-country model we obtain a priori results. In the case of the two-country model, we calculate the solution by using realistic estimates for the parameters. In the one-country model progressive taxation tends to stabilise output in the cases of demand and tax shocks. In the case of a supply shock, tax progressiveness tends to stabilise output if taxes are fully indexed. If they are not, the outcome depends especially on the size of the demand effect of taxes. Progressive taxation stabilises prices definitely only in the case of a tax shock. In the cases of demand and supply shocks, the outcome depends in opposite ways on the relative strengths of the demand and supply effects of taxes. In the two-country model progressive taxation tends to increase output stability in both countries in the face of a demand shock. Progressiveness stabilises prices if wages and prices react only modestly to changes in taxes, but destabilises them when these reactions are strong. In the case of a tax shock, progressive taxation tends to stabilise the output and prices of both countries. In the case of a supply shock, output and prices are not very sensitive to progressiveness. When tax indexation is low, progressiveness can, however, destabilise the output of the country where the shock originates. All in all, progressive taxation tends to stabilise output or has a neutral effect in most cases. The effects on price stabilisation are, however, more controversial.

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    Bibliographic Info

    Paper provided by The Research Institute of the Finnish Economy in its series Discussion Papers with number 1011.

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    Length: 29 pages
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    Handle: RePEc:rif:dpaper:1011

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    Keywords: Economic and monetary union; EMU; taxation; public expenditure; progressiveness of taxation; indexation;

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    References

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    1. Darrel Cohen & Glenn Follette, 2000. "The automatic fiscal stabilizers: quietly doing their thing," Economic Policy Review, Federal Reserve Bank of New York, issue Apr, pages 35-67.
    2. Agell, J. & Dillen, M., 1991. "Macroeconomic Externalities: are Pigovian Taxes the Answer?," Papers 487, Stockholm - International Economic Studies.
    3. Lassila, Jukka, 1995. "Income Tax Indexation in an Open Economy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(2), pages 389-403, May.
    4. Claus Thustrup Hansen & Henrik Jacobsen Kleven, 2000. "The Role of Taxes as Automatic Destabilizers in New Keynesian Economics," CESifo Working Paper Series 399, CESifo Group Munich.
    5. Li Wenli & Pierre -Daniel Sarte, 2004. "Progressive Taxation and Long-Run Growth," American Economic Review, American Economic Association, vol. 94(5), pages 1705-1716, December.
    6. Kotilainen, Markku, 1992. "Exchange Rate Unions: A Comparison to Currency Basket and Floating Rate Regimes - A Three-Country Model," Discussion Papers 399, The Research Institute of the Finnish Economy.
    7. Marco Buti & Carlos Martinez-Mongay & Khalid Sekkat & Paul van den Noord, 2002. "Automatic Stabilisers and Market Flexibility in EMU: Is There A Trade-Off?," OECD Economics Department Working Papers 335, OECD Publishing.
    8. Bruce, Neil, 1981. "Some macroeconomic effects of income tax indexation," Journal of Monetary Economics, Elsevier, vol. 8(2), pages 271-275.
    9. Gray, Jo Anna, 1976. "Wage indexation: A macroeconomic approach," Journal of Monetary Economics, Elsevier, vol. 2(2), pages 221-235, April.
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    Cited by:
    1. Alho, Kari E.O., 2006. "Structural Reforms in the EU and Political Myopia in Economic Policies," Discussion Papers 1050, The Research Institute of the Finnish Economy.

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