Taxation Rates and Stabilization in the Framework of Supply-side Distortions

We use a simple macroeconomic modeling of a monetary union made of two structurally heterogeneous countries, with distortions in the supply function. We find that higher taxes are always output stabilizing in the event of demand shocks, but that stronger automatic stabilizers are often inflation destabilizing in the framework of large supply-side distortions. These inflationary risks are only limited if the transmission mechanisms of economic policies are more efficient, if countries are weakly open, and if economic authorities care more about price stability than instrument smoothing. Furthermore, our model also shows that in the event of supply shocks, higher taxation rates would be inflation as well as output destabilizing, and all the more as distortions are accentuated in the supply function. Therefore, reducing taxes may often improve economic stabilization. Indeed, there would be a 'critical level of supply-side distortions' above which some of the stabilization properties of automatic stabilizers become perverse even in case of demand shocks. Furthermore, the necessity to reduce the tax burden would be much more acute in the smallest and most open European countries.