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Tax Reforms, "Free Lunches", and "Cheap Lunches" in Open Economies

  • Juha Tervala
  • Giovanni Ganelli

This paper focuses on the macroeconomic and budgetary impact of tax reforms in a New Keynesian two-country model. Our results show that both income and consumption unilateral tax rate reductions do not constitute a "free lunch", in the sense that they have negative budgetary consequences for the country which implements them. In addition, the degree of self-financing implied by our model is in the 8½-24 percent range. Since the degree of self-financing estimated in previous literature was larger, we conclude that in our model not only the "lunch" is not "free", but is also not that "cheap". A comparison of alternative (income-tax versus consumption-tax based) fiscal stimulus packages shows that consumption tax cuts imply a larger short-run impact on domestic output but the income tax cuts stimulate the domestic economy more in the long run. We also look at the implications of a revenue-neutral tax reform in which consumption taxes are increased to compensate for lower income tax collection.

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Paper provided by International Monetary Fund in its series IMF Working Papers with number 08/227.

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Length: 30
Date of creation: 01 Sep 2008
Date of revision:
Handle: RePEc:imf:imfwpa:08/227
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