Taxation of Income, Consumption, and Wages in an Open Economy

The paper studies the short-run, dynamic, and steady-state effects of tax policy in an open economy, comparing the macroeconomic effects of a consumption tax with the effects of various types of income tax. The analyticl framework is a model of intertemporal optimization over finite expected lifetimes. An attempt is made to point out important differences in the effects of tax policy in closed and open economies. In the first version of the model the terms of trade are taken to be exogenous to the small open economy, and the complicating effects of endogenous labor supply are in focus. A second version of the model endogenizes the terms of trade, assuming a given supply of labor. The analysis suggests that the long run macroeconomic effects of a switch from income to consumption taxes could be quite favorable if labor supply is rather inelastic, although the short-run effects of such a reform are likely to be contradictory. However, if labor supply is relatively elastic, the consumption tax may lead to a long-run decline in consumption, employment, and output, even though it will raise national wealth.