Welfare Effects of Tax Policy in Open Economies: Stabilization and Cooperation

This paper studies optimal tax policy problem by employing an open economy dynamic general equilibrium model with incomplete asset markets. We investigate the possibility of welfare-improving active tax policies (under which tax rates respond to changes in productivity) on factor incomes and consumption. Simulation results show that countercyclical tax policies are optimal in the closed economy. However, in the open economy, optimal tax policies become less countercyclical and under certain cases become procyclical, in particular capital income tax. Procyclical tax policy generates efficiency gains that outweigh stabilization loss. Two country analysis suggests that tax policy coordination on capital and labor income produces only small welfare gains, while consumption tax policy coordination produces sizable welfare gains