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On the international dimension of fiscal policy

  • Gianluca Benigno
  • Bianca De Paoli

This paper analyses the international dimension of fiscal policy using a small open economy framework in which the government finances its spending by levying distortionary taxation and issuing non-state-contingent debt. The main finding of the paper is that, once the open economy aspect of the policy problem is considered, it is not optimal to smooth taxes following idiosyncratic shocks. Even when prices are flexible and inflation can costlessly act as a shock absorber to restore fiscal equilibrium, the presence of a terms of trade externality lead to movements in the tax rate. Also in contrast with the closed economy, the introduction of sticky prices can reduce the optimal volatility of taxes.

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File URL: http://eprints.lse.ac.uk/28515/
File Function: Open access version.
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Paper provided by London School of Economics and Political Science, LSE Library in its series LSE Research Online Documents on Economics with number 28515.

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Length: 39 pages
Date of creation: Jan 2009
Date of revision:
Handle: RePEc:ehl:lserod:28515
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