A TALE OF TAX POLICIES IN OPEN ECONOMIES

Abstract

To evaluate fiscal policy reforms for Euro‐area countries, this article develops and calibrates a small open economy model. Debt reduction reforms require higher tax rates in the short term in exchange for lower rates in the long term as the debt‐servicing burden falls. Using the capital income tax to implement such a policy leads to welfare gains; the consumption tax, a very small welfare gain; and the labor income tax, a welfare loss. Holding fixed the long‐run debt–output ratio, offsetting a lower capital income tax with either a higher labor income or consumption tax generally yields welfare gains.