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Product Market Integration and Income Taxation: Distortions and Gains from Trade

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  • Torben Andersen
  • Allan Sørensen

Abstract

It is widely perceived that globalization is a threat to tax financed public sector activities. The argument is that public activities (public consumption and transfers) financed by income taxes may distort labour markets and cause higher wages and thus a loss of competitiveness. If the importance of the latter effect is reinforced by globalization, it is inferred that the marginal costs of public funds increase and a retrenchment of the public sector follows. We consider this issue in a Ricardian trade model in which production and specialization structures are endogenous. Even though income taxation unambiguously worsens wage competitiveness, it does not follow that tax distortions or marginal costs of public funds increase with product market integration. The reason is that gains from trade tend to reduce both. Moreover, non-cooperative fiscal policies do not have a bias towards retrenchment due to a positive terms of trade effect from taxation.

Suggested Citation

  • Torben Andersen & Allan Sørensen, 2007. "Product Market Integration and Income Taxation: Distortions and Gains from Trade," CESifo Working Paper Series 2170, CESifo.
  • Handle: RePEc:ces:ceswps:_2170
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    References listed on IDEAS

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    7. Torben M. Andersen, 2007. "Fiscal Policy Coordination and International Trade," Economica, London School of Economics and Political Science, vol. 74(294), pages 235-257, May.
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