Ramsey-optimal tax reforms and real exchange rate dynamics

Abstract

We solve the Ramsey-optimal tax plan for a small open economy with an endogenously-determined real exchange rate. The open economy constrains the government's setting of the capital income tax rate since physical capital cannot be dominated in rate of return by foreign assets. However, the endogenous real exchange rate loosens this constraint relative to a one good open economy model in which the real exchange rate is necessarily fixed. We find that the dynamics of the two good small open economy model more closely resemble those of a closed economy model than a one good small open economy model.