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Saving Europe?: The Unpleasant Arithmetic of Fiscal Austerity in Integrated Economies

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  • Enrique G. Mendoza
  • Linda L. Tesar
  • Jing Zhang

Abstract

What are the macroeconomic effects of tax adjustments in response to large public debt shocks in highly integrated economies? The answer from standard closed-economy models is deceptive, because they underestimate the elasticity of capital tax revenues and ignore cross-country spillovers of tax changes. Instead, we examine this issue using a two-country model that matches the observed elasticity of the capital tax base by introducing endogenous capacity utilization and a partial depreciation allowance. Tax hikes have adverse effects on macro aggregates and welfare, and trigger strong cross-country externalities. Quantitative analysis calibrated to European data shows that unilateral capital tax increases cannot restore fiscal solvency, because the dynamic Laffer curve peaks below the required revenue increase. Unilateral labor tax hikes can do it, but have negative output and welfare effects at home and raise welfare and output abroad. Large spillovers also imply that unilateral capital tax hikes are much less costly under autarky than under free trade. Allowing for one-shot Nash tax competition, the model predicts a ?race to the bottom? in capital taxes and higher labor taxes. The cooperative equilibrium is preferable, but capital (labor) taxes are still lower (higher) than initially. Moreover, autarky can produce higher welfare than both Nash and Cooperative equilibria.

Suggested Citation

  • Enrique G. Mendoza & Linda L. Tesar & Jing Zhang, 2014. "Saving Europe?: The Unpleasant Arithmetic of Fiscal Austerity in Integrated Economies," Working Paper Series WP-2014-13, Federal Reserve Bank of Chicago.
  • Handle: RePEc:fip:fedhwp:wp-2014-13
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    References listed on IDEAS

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    19. Bohn, Henning, 2007. "Are stationarity and cointegration restrictions really necessary for the intertemporal budget constraint?," Journal of Monetary Economics, Elsevier, vol. 54(7), pages 1837-1847, October.
    20. Christopher L. House & Matthew D. Shapiro, 2008. "Temporary Investment Tax Incentives: Theory with Evidence from Bonus Depreciation," American Economic Review, American Economic Association, vol. 98(3), pages 737-768, June.
    21. Stéphane Auray & Aurélien Eyquem & Paul Gomme, 2016. "A Tale Of Tax Policies In Open Economies," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 57, pages 1299-1333, November.
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    As found by EconAcademics.org, the blog aggregator for Economics research:
    1. Saving Europe?: The Unpleasant Arithmetic of Fiscal Austerity in Integrated Economies
      by Christian Zimmermann in NEP-DGE blog on 2015-01-17 01:59:01

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    Cited by:

    1. Auray, Stéphane & Eyquem, Aurélien & Gomme, Paul, 2019. "Debt hangover in the aftermath of the Great Recession," Journal of Economic Dynamics and Control, Elsevier, vol. 105(C), pages 107-133.
    2. D’Erasmo, P. & Mendoza, E.G. & Zhang, J., 2016. "What is a Sustainable Public Debt?," Handbook of Macroeconomics, in: J. B. Taylor & Harald Uhlig (ed.),Handbook of Macroeconomics, edition 1, volume 2, chapter 0, pages 2493-2597, Elsevier.
    3. Janeba, Eckhard & Todtenhaupt, Maximilian, 2018. "Fiscal competition and public debt," Journal of Public Economics, Elsevier, vol. 168(C), pages 47-61.
    4. Alexandra Ferreira‐Lopes & Luís Filipe Martins & Ruben Espanhol, 2020. "The relationship between tax rates and tax revenues in eurozone member countries ‐ exploring the Laffer curve," Bulletin of Economic Research, Wiley Blackwell, vol. 72(2), pages 121-145, April.
    5. Curatola, Giuliano & Donadelli, Michael & Gioffré, Alessandro & Grüning, Patrick, 2015. "Austerity, fiscal uncertainty, and economic growth: Insights from fiscally weak EU countries," SAFE Working Paper Series 56, Leibniz Institute for Financial Research SAFE.
    6. Eijffinger, S.C.W. & Kobielarz, M.L. & Uras, R.B., 2015. "Sovereign Debt, Bail-Outs and Contagion in a Monetary Union," Discussion Paper 2015-018, Tilburg University, Center for Economic Research.
    7. Xiaoshan Chen & Campbell Leith & Mattia Ricci, 2018. "Debt Sustainability and Welfare along an Optimal Laffer Curve," Working Papers 2018_02, Durham University Business School.
    8. Filippo Balestrieri & Suman S Basu, 2018. "An Imperfect Financial Union With Heterogeneous Regions," IMF Working Papers 18/205, International Monetary Fund.
    9. Christos Shiamptanis, 2019. "Tax Austerity: Does it avert solvency crises?," LCERPA Working Papers ec0119, Laurier Centre for Economic Research and Policy Analysis, revised 1970.
    10. Enrique Mendoza, 2015. "EconomicDynamics Interviews Enrique Mendoza on Sovereign Debt," EconomicDynamics Newsletter, Review of Economic Dynamics, vol. 16(1), April.
    11. Kevin x.d. Huang & Qinglai Meng & Jianpo Xue, 2019. "Capital Income Taxation and Aggregate Instability," Vanderbilt University Department of Economics Working Papers 19-00007, Vanderbilt University Department of Economics.
    12. Auray, Stéphane & Eyquem, Aurélien & Gomme, Paul, 2019. "Debt hangover in the aftermath of the Great Recession," Journal of Economic Dynamics and Control, Elsevier, vol. 105(C), pages 107-133.
    13. Xiaoshan Chen & Campbell Leith & Mattia Ricci, 2018. "Debt Sustainability and Welfare along an Optimal Laffer Curve," Working Papers 2018_02, Durham University Business School.
    14. Kevin X.D. Huang & Qinglai Meng & Jianpo Xue, 2019. "Capital Income Taxation and Aggregate Instability," Vanderbilt University Department of Economics Working Papers 19-00007, Vanderbilt University Department of Economics.
    15. Auray, Stéphane & Eyquem, Aurélien & Gomme, Paul, 2019. "Debt hangover in the aftermath of the Great Recession," Journal of Economic Dynamics and Control, Elsevier, vol. 105(C), pages 107-133.
    16. Auray, Stéphane & Eyquem, Aurélien & Gomme, Paul, 2019. "Debt hangover in the aftermath of the Great Recession," Journal of Economic Dynamics and Control, Elsevier, vol. 105(C), pages 107-133.
    17. Jocelyn Boussard & Benoît Campagne, 2017. "Fiscal policy coordination in a monetary union at the zero lower bound," Economie et Statistique / Economics and Statistics, Institut National de la Statistique et des Études Économiques (INSEE), issue 494-495-4, pages 65-90.
    18. Christopher L. House & Linda L. Tesar, 2015. "Greek Budget Realities: No Easy Options," NBER Working Papers 21688, National Bureau of Economic Research, Inc.
    19. Auray, Stéphane & Eyquem, Aurélien & Gomme, Paul, 2019. "Debt hangover in the aftermath of the Great Recession," Journal of Economic Dynamics and Control, Elsevier, vol. 105(C), pages 107-133.
    20. repec:prs:ecstat:estat_0336-1454_2017_num_494_1_10782 is not listed on IDEAS
    21. Kabukçuoğlu, Ayşe, 2017. "The winners and losers of tax reform: An assessment under financial integration," Journal of Economic Dynamics and Control, Elsevier, vol. 85(C), pages 90-122.
    22. Janeba, Eckhard & Todtenhaupt, Maximilian, 2018. "Fiscal competition and public debt," Journal of Public Economics, Elsevier, vol. 168(C), pages 47-61.

    More about this item

    Keywords

    European debt crisis; tax competition; capacity utilization; fiscal austerity;

    JEL classification:

    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
    • E66 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - General Outlook and Conditions
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F42 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Policy Coordination and Transmission
    • F62 - International Economics - - Economic Impacts of Globalization - - - Macroeconomic Impacts

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