IDEAS home Printed from https://ideas.repec.org/p/mie/wpaper/644.html
   My bibliography  Save this paper

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

Author

Listed:
  • Enrique G. Mendoza

    (University of Pennsylvania and NBER)

  • Linda L. Tesar

    (University of Michigan and NBER)

  • Jing Zhang

    (Federal Reserve Bank of Chicago)

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 crosscountry 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 Papers 644, Research Seminar in International Economics, University of Michigan.
  • Handle: RePEc:mie:wpaper:644
    as

    Download full text from publisher

    File URL: http://www.fordschool.umich.edu/rsie/workingpapers/Papers626-650/r644.pdf
    Download Restriction: no

    Other versions of this item:

    References listed on IDEAS

    as
    1. 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.
    2. Mathias Trabandt & Harald Uhlig, 2006. "How Far Are We From The Slippery Slope? The Laffer Curve Revisited," SFB 649 Discussion Papers SFB649DP2006-023, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
    3. Mendoza, Enrique G. & Tesar, Linda L., 2005. "Why hasn't tax competition triggered a race to the bottom? Some quantitative lessons from the EU," Journal of Monetary Economics, Elsevier, vol. 52(1), pages 163-204, January.
    4. Sorensen, Peter Birch, 1999. "Optimal tax progressivity in imperfect labour markets," Labour Economics, Elsevier, vol. 6(3), pages 435-452, September.
    5. Stephen J. Turnovsky, 1997. "International Macroeconomic Dynamics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262201119, January.
    6. Mendoza, Enrique G. & Ostry, Jonathan D., 2008. "International evidence on fiscal solvency: Is fiscal policy "responsible"?," Journal of Monetary Economics, Elsevier, vol. 55(6), pages 1081-1093, September.
    7. Jacob Frenkel & Assaf Razin & Efraim Sadka, 1991. "International Taxation in an Integrated World," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262061430, January.
    8. Mendoza, Enrique G. & Razin, Assaf & Tesar, Linda L., 1994. "Effective tax rates in macroeconomics: Cross-country estimates of tax rates on factor incomes and consumption," Journal of Monetary Economics, Elsevier, vol. 34(3), pages 297-323, December.
    9. Sørensen, Peter Birch, 2003. "International Tax Competition: A New Framework for Analysis," Economic Analysis and Policy, Elsevier, vol. 33(2), pages 179-192, September.
    10. MaCurdy, Thomas E, 1981. "An Empirical Model of Labor Supply in a Life-Cycle Setting," Journal of Political Economy, University of Chicago Press, vol. 89(6), pages 1059-1085, December.
    11. Mathias Trabandt & Harald Uhlig, 2012. "How Do Laffer Curves Differ across Countries?," NBER Chapters,in: Fiscal Policy after the Financial Crisis, pages 211-249 National Bureau of Economic Research, Inc.
    12. Enrique G. Mendoza & Linda L. Tesar, 1995. "Supply-Side Economics in a Global Economy," NBER Working Papers 5086, National Bureau of Economic Research, Inc.
    13. Mendoza, Enrique G. & Milesi-Ferretti, Gian Maria & Asea, Patrick, 1997. "On the ineffectiveness of tax policy in altering long-run growth: Harberger's superneutrality conjecture," Journal of Public Economics, Elsevier, vol. 66(1), pages 99-126, October.
    14. Mendoza, Enrique G & Tesar, Linda L, 1998. "The International Ramifications of Tax Reforms: Supply-Side Economics in a Global Economy," American Economic Review, American Economic Association, vol. 88(1), pages 226-245, March.
    15. 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.
    16. repec:wfo:wstudy:24931 is not listed on IDEAS
    17. 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.
    18. Dwenger, Nadja & Steiner, Viktor, 2012. "Profit Taxation and the Elasticity of the Corporate Income Tax Base: Evidence From German Corporate Tax Return Data," National Tax Journal, National Tax Association;National Tax Journal, vol. 65(1), pages 118-150, March.
    19. 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.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. 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.
    2. Enrique Mendoza, 2015. "EconomicDynamics Interviews Enrique Mendoza on Sovereign Debt," EconomicDynamics Newsletter, Review of Economic Dynamics, vol. 16(1), April.
    3. Christopher L. House & Linda L. Tesar, 2015. "Greek Budget Realities: No Easy Options," NBER Working Papers 21688, National Bureau of Economic Research, Inc.
    4. Xiaoshan Chen & Campbell Leith & Matta Ricci, 2018. "Debt Sustainability and Welfare along an Optimal Laffer Curve," Working Papers 2018-01, Business School - Economics, University of Glasgow.
    5. repec:prs:ecstat:estat_0336-1454_2017_num_494_1_10782 is not listed on IDEAS
    6. Curatola, Giuliano & Donadelli, Michael & Gioffré, Alessandro & Grüning, Patrick, 2014. "Austerity, fiscal volatility, and economic growth," SAFE Working Paper Series 56, Research Center SAFE - Sustainable Architecture for Finance in Europe, Goethe University Frankfurt.
    7. repec:nse:ecosta:ecostat_2017_494-495-496_5 is not listed on IDEAS
    8. repec:eee:macchp:v2-2493 is not listed on IDEAS
    9. repec:prs:ecsecs:estat_0336-1454_2017_num_494_1_10782 is not listed on IDEAS
    10. repec:eee:dyncon:v:85:y:2017:i:c:p:90-122 is not listed on IDEAS

    More about this item

    Keywords

    fiscal austerity; tax; public debt;

    JEL classification:

    • E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
    • 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
    • H6 - Public Economics - - National Budget, Deficit, and Debt

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:mie:wpaper:644. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (FSPP Webmaster). General contact details of provider: http://edirc.repec.org/data/riumius.html .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.