Balanced-budget consumption taxes and aggregate stability in a small open economy
Introduction
A number of recent studies have examine the possibility of indeterminacy induced by balanced-budget fiscal policy rules based on consumption taxation. Giannitsarou (2007) shows that if public spending is financed by consumption tax with an endogenous tax rate then indeterminacy cannot occur. However, Nourry et al. (2013) find that her result is not robust to an alternative preference specification, and Nishimura et al. (2013) further demonstrate that indeterminacy can also arise in a multisector model. Both Nourry et al. (2013) and Nishimura et al. (2013) conclude that consumption taxation can be a source of beliefs-driven aggregate instability for most OECD countries.1
To our knowledge, all of the existing studies on this issue, including the articles cited above, use closed-economy frameworks. In this paper we investigate the issue in a neoclassical small open economy model. This is a necessary and realistic extension as most economies (including most OECD countries) are not closed but small and open. Indeed, under the same type of balanced-budget rule considered in the literature, we find that for a small open economy facing a perfect world capital market indeterminacy cannot occur, independently of both the utility function and the production function. This result is in contrast to those obtained in some recent closed economy models, and it suggests that unfettered international capital mobility can help stabilize the economy under the balanced-budget fiscal policy.
The intuition for our result can be understood by examining the indeterminacy results obtained in closed economy models. For example, in Nourry et al. (2013), indeterminacy arises when the intertemporal elasticity of substitution is sufficiently large and greater than 1. In that model, if the households expect that future tax rates on consumption will increase, their expected labor supply will fall (i.e., leisure will increase) due to the substitution effect, so their expected total income will fall. Because of the effect of the permanent income, households’ current labor supply increases and current consumption falls. In the closed economy, the increase in labor supply and the needed increase in investment goods also require a reduction in consumption.2 If the intertemporal elasticity of substitution in consumption is high, these changes and especially the reduction in consumption will be large enough to match the balanced-budget consumption tax rule, and hence the households’ expectations are self-fulfilling. If, however, the intertemporal elasticity is small, the change in consumption will be small and insufficient to match the policy rule, making indeterminacy impossible.
In a small open economy facing a perfect world capital market the situation is very different. Under the same policy, due to the permanent income effect, the increase in current labor supply and the associated increase in capital goods do not require a large drop in consumption, as the households can achieve consumption smoothing by borrowing abroad to finance the needed investment. The curvature of the utility function does not affect investment decisions, and the reduction in consumption if any is not sufficient to match the balanced-budget rule, which prevents households’ expectations from becoming self-fulfilling. Thus, in contrast to the policy implications of the results of Nourry et al. (2013) and Nishimura et al. (2013), the balanced-budget fiscal policy based on consumption taxation does not cause beliefs-driven aggregate instability in a small open economy.
The next section describes the model. Section 3 solves the dynamic equilibrium and proves the determinacy result. Section 4 concludes.
Section snippets
A small open economy model with endogenous consumption taxation
Firms
The production side of the small open economy consists of two sectors with one producing the traded consumption good and the other producing the nontraded investment good ,3 by means of constant returns to scale neoclassical production functions, which we write in intensive form
Equilibrium and dynamics
The representative household maximizes its lifetime utility (6) subject to constraints (8), (9), and conditions (3), (4), (5), (10). The present-value Hamiltonian is given by where and are the co-state variables. The household takes the consumption tax rate as given. Define . The first-order conditions are together with the
Conclusion
In this paper we show that for a small open economy facing a perfect capital market, indeterminacy cannot occur under the balanced budget fiscal policy based on consumption taxation. This result is in contrast to those obtained in some recent closed economy models, and it suggests that if the government relies on changes in consumption tax rates to achieve a balanced budget then an integrated world capital market can help stabilize the economy.
Acknowledgments
We are grateful to Pierre-Daniel Sarte (the editor) and an anonymous referee for their helpful comments and suggestions. Xue’s work in this project is supported by the Fundamental Research Funds for the Central Universities, and the Research Funds of Renmin University of China (11XNK004).
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