A Tale of Tax Policies in Open Economies

Financial crises in Europe, as well as the periodic battles in the U.S. over the debt ceiling, point to the importance of fiscal discipline among developed countries. This column presents recent research results concerning the impact of a reduction in the government deficit-to-GDP ratio through raising taxes, and about deficit-neutral tax changes. Deficit reduction through tax increases has limited effects on deficits due to their depressing effects on the tax base, and are costly in terms of welfare. Changes in the tax structure take quite a long time to exert positive (if any) effects. Therefore the easiest way of cutting deficits in the short-run is to achieve economic recovery and stimulate growth.

Recent events show that even highly developed economies can be susceptible to fiscal crises. Ireland and Greece immediately come to mind. Other countries, including Portugal, Spain and Italy, are on many watch lists. The U.K. imposed strict fiscal discipline even though there appeared to be no emergency. The recent debate in the U.S. over raising the federal government’s debt limit has likewise brought to the front tax and spending issues. Even though many of the adjustment plans that have been adopted lean on cuts in government expenditure to restore the sustainability of public debts, some countries (for example, the U.K. and France) have also implemented increases in taxes. In recent research (Auray, Eyquem and Gomme (2011)), we contribute to the study of these issues by constructing two dynamic general equilibrium, open economy models, of the U.S. and of a subset of the EMU.[1] The focus is on tax policies; the government imposes taxes on labor income, capital income, and consumption (a value added tax, or sales tax).

The first set of experiments consist of permanent tax increases aimed at reducing the government budget deficit-to-GDP ratio by one percentage point. Each of the three taxes is considered in turn. The government is assumed to behave rather naively in that it computes a tax increase based on the current tax base. In other words, the government ignores the general equilibrium effects of its fiscal reforms. The full transition path is characterized and reported in Figure 1.

For neither the U.S. nor the EMU do the tax reforms achieve their goal of a one percentage point reduction in the deficit-to-GDP ratio. The consumption tax is most successful in achieving the goal, followed by the labor income tax, then the capital income tax. The effects of raising the consumption tax and the labor income tax are broadly similar. In closed economy models, the effects would be virtually identical. However, in an open economy model, the consumption tax applies to both domestically-produced and imported goods, leading to some differences in the effects of these two taxes. For all three tax increases, output, consumption and hours of work fall sharply. Therefore the tax base shrinks and the actual reduction in the deficit-to-GDP ratio is much smaller than was targeted. Not surprisingly, there are welfare losses associated with all tax increases. Of the three taxes, the consumption tax increase is the least costly, followed by the labor income tax. However, the temporal pattern of the welfare losses are such that increasing the capital income tax leads to measured welfare gains over relatively short horizons (a few years) and implies welfare losses in the long run (Table 1)

Figure 1: Deficit reduction through an increase in taxes

Legend: Solid red line, increase in consumption tax; dotted blue line, increase in labor income tax; dashed black line, increase in capital income tax. For the USA, the increase in labor income tax is 1.4 percentage points; for the consumption tax, 1.6 percentage points; and for the capital income tax, 6.2 percentage points. For the EMU, the increase in labor income tax is 1.4 percentage points; for the consumption tax, 2 percentage points; and for the capital income tax, 6.5 percentage points.

Table 1: Deficit reductions – Welfare losses as a percentage of steady state output[2]

The second set of experiments consider replacing revenue from one tax with revenue from another. These experiments are motivated by a couple of observations. First, the optimal taxation literature typically calls for lower capital income taxes (in the long run, zero).[3] Experiments are conducted in which the capital income tax is lowered with the objective of lowering capital income tax revenue by one percent of GDP. This tax revenue is replaced by either an increase in the labor income tax or the consumption tax. As with the first set of experiments, the government takes the current tax base as given when computing the new tax system. As shown by Table 2, these tax reforms generate modest welfare gains — except for the increase in the labor income tax in the EMU — although again the temporal pattern of the welfare gains indicates that there is short term pain (welfare losses computed at short horizons) in return for long term gain. Second, it has been suggested that lowering the labor income tax rate — replacing that revenue with a higher consumption tax — may improve a country’s international competitiveness, reduce the inefficiency associated with the labor income tax, and that the reduced labor income tax revenue may be paid for in part by taxing imports. This effect arises since the consumption tax applies to all goods, whether domestically or foreign produced. Although the effects are fairly modest, this tax reform generates modest welfare gains — around 0.1% of income for the U.S. and 0.2% for the EMU. Viewed through the lens of the model, the claims for the gains of partially replacing the labor income tax with higher consumption tax appear to be justified.

The ongoing debate about solutions to bring government deficits within sustainable ranges in the short-run often comes to the conclusion that tax increases are necessary. In the above column, we argue that changes in the tax structure of economies such as the USA or the EMU are either inefficient in reducing deficit-to-GDP ratios and costly in terms of welfare or take long time to fully impact the economy and deliver welfare gains. An implication of our work is that economic growth and the corresponding widening of the tax base should have much more powerful effects on government deficit-to-GDP ratios and should be the priority of governments seeking to achieve fiscal sustainability.


Auray, S., A. Eyquem and P. Gomme (2011), “A Tale of Tax Policies in Open Economies”, Manuscript.

Chari, V., and P. J. Kehoe (1999): ”Optimal Fiscal and Monetary Policy,” in Handbook of Macroeconomics, ed. by J. B. Taylor, and M. Woodford, vol. 1 of Handbook of Macroeconomics, chap. 26, pp. 1671-1745. Elsevier.

Lucas, R., and N. Stokey (1983): ”Optimal Fiscal and Monetary Policy in an Economy without Capital,” Journal of Monetary Economics, 12(1), 55-93.

[1] We deviate from most open economy papers dealing with fiscal policy by imposing incomplete international financial markets, and an asymmetric steady state. These assumptions allow for potential wealth transfers and open up additional transmission mechanisms following tax reforms.

[2] The last line of the table is labelled “Steady state” because it computes the welfare losses from jumping directly from one steady state to another, while the upper lines take into account the full transition path.

[3] See Lucas and Stokey (1983) or Chari and Kehoe (1999) among many others.

One Response to "A Tale of Tax Policies in Open Economies"

  1. burkbraun   September 1, 2011 at 1:12 pm

    Prima facie, I find these studies highly suspicious, especially in their favorable treatment of capital income tax. I would surmise that they incorporate psychological models of investment response to such taxation. Yet the empirical evidence of today indicates that ultra-low capital tax rates do very little to encourage investment that is not otherwise economically justified. Additionally, the inefficiency of treating various sources of income differently in the tax code is obvious, creating a vast tax-avoidance industry and other systematic derangements.