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Baltic Tax Reform

The paper presents an endogenous growth economy with a representation of the tax rate system in the Baltic countries. Assuming that government spending is a given fraction of output, the paper shows how a flat tax system balanced between labor and corporate tax rates can be second best optimal. It then computes how actual Baltic tax reforms from 2000 to 2007 affect the growth rate and welfare, including transition dynamics. Comparing the actual reform effects to hypothetical tax experiments, it results that equal flat tax rates on personal and corporate income would have increased welfare in all three Baltic countries by 24% more on average than the actual reforms. This shows how equal, balanced, flat rate taxes can be optimal in both theory and practice. Further, movement towards a more equal balance between labor and capital tax rates, through changing just one tax rate, achieved almost as high or higher utility gains as in actual law for all three countries under both open and closed economy cases. This shows benefits of moving towards the optimum.

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Paper provided by Cardiff University, Cardiff Business School, Economics Section in its series Cardiff Economics Working Papers with number E2008/6.

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Length: 52 pages
Date of creation: Feb 2008
Date of revision: Oct 2008
Publication status: Forthcoming in Journal of Macroeconomics
Handle: RePEc:cdf:wpaper:2008/6
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  1. Michael B. Devereux & David R. F. Love, 1994. "The Effects of Factor Taxation in a Two-Sector Model of Endogenous Growth," Canadian Journal of Economics, Canadian Economics Association, vol. 27(3), pages 509-36, August.
  2. repec:oup:restud:v:72:y:2005:i:3:p:767-796 is not listed on IDEAS
  3. Kim, Se-Jik, 1998. "Growth effect of taxes in an endogenous growth model: to what extent do taxes affect economic growth?," Journal of Economic Dynamics and Control, Elsevier, vol. 23(1), pages 125-158, September.
  4. Ellen R. McGrattan & Edward C. Prescott, 2000. "Is the stock market overvalued?," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages 20-40.
  5. Ellen R. McGrattan & Edward C. Prescott, 2005. "Taxes, regulations, and the value of U.S. and U.K. corporations," Staff Report 309, Federal Reserve Bank of Minneapolis.
  6. Funke, Michael & Strulik, Holger, 2003. "Taxation, growth and welfare: Dynamic effects of Estonia’s 2000 income tax act," BOFIT Discussion Papers 10/2003, Bank of Finland, Institute for Economies in Transition.
  7. Stokey, Nancy L & Rebelo, Sergio, 1995. "Growth Effects of Flat-Rate Taxes," Journal of Political Economy, University of Chicago Press, vol. 103(3), pages 519-50, June.
  8. Turnovsky, Stephen J., 2000. "Fiscal policy, elastic labor supply, and endogenous growth," Journal of Monetary Economics, Elsevier, vol. 45(1), pages 185-210, February.
  9. Enrique G. Mendoza & Assaf Razin & Linda L. Tesar, 1994. "Effective Tax Rates in Macroeconomics: Cross-Country Estimates of Tax Rates on Factor Incomes and Consumption," NBER Working Papers 4864, National Bureau of Economic Research, Inc.
  10. Robert J. Barro, 1988. "Government Spending in a Simple Model of Endogenous Growth," NBER Working Papers 2588, National Bureau of Economic Research, Inc.
  11. Judd, Kenneth L., 1992. "Projection methods for solving aggregate growth models," Journal of Economic Theory, Elsevier, vol. 58(2), pages 410-452, December.
  12. Lucas, Robert Jr., 1988. "On the mechanics of economic development," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 3-42, July.
  13. Lucas, Robert E, Jr, 1990. "Supply-Side Economics: An Analytical Review," Oxford Economic Papers, Oxford University Press, vol. 42(2), pages 293-316, April.
  14. Larry E. Jones & Rodolfo E. Manuelli & Henry E. Siu, 2005. "Fluctuations in Convex Models of Endogenous Growth II: Business Cycle Properties," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 8(4), pages 805-828, October.
  15. International Monetary Fund, 2001. "Republic of Lithuania: Statistical Appendix and Tax Summary," IMF Staff Country Reports 01/40, International Monetary Fund.
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