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Tax Cuts in Open Economies

  • Alejandro Cuñat
  • Szabolcs Deák
  • Marco Maffezzoli

A reduction in income tax rates generates substantial dynamic responses within the framework of the standard neoclassical growth model. The short-run revenue loss after an income tax cut is partly -- or, depending on parameter values, even completely -- offset by growth in the long-run, due to the resulting incentives to further accumulate capital. We study how the dynamic response of government revenue to a tax cut changes if we allow a Ramsey economy to engage in international trade: the open economy's ability to reallocate resources between labor-intensive and capital-intensive industries reduces the negative effect of factor accumulation on factor returns, thus encouraging the economy to accumulate more than it would do under autarky. We explore the quantitative implications of this intuition for the US in terms of two issues recently treated in the literature: dynamic scoring and the Laffer curve. Our results demonstrate that international trade enhances the response of government revenue to tax cuts by a relevant amount. In our benchmark calibration, a reduction in the capital-income tax rate has virtually no effect on government revenue in steady state.

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Paper provided by IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University in its series Working Papers with number 332.

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Date of creation: 2008
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Handle: RePEc:igi:igierp:332
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  1. Leeper, Eric M. & Yang, Shu-Chun Susan, 2008. "Dynamic scoring: Alternative financing schemes," Journal of Public Economics, Elsevier, vol. 92(1-2), pages 159-182, February.
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  12. Pecorino, Paul, 1995. "Tax rates and tax revenues in a model of growth through human capital accumulation," Journal of Monetary Economics, Elsevier, vol. 36(3), pages 527-539, December.
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