Taxes in a CGE Model

Abstract

This chapter examines the treatment of trade and domestic taxes in a computable general equilibrium (CGE) model. Trade taxes are imposed on imports and exports of goods and services. Domestic taxes are taxes paid by production activities on output and factor use and by purchasers on sales of intermediate and retail goods, and income taxes. We trace the tax data in a Social Accounting Matrix (SAM) to describe the agent and the economic activity on which the tax is levied and the amount of revenue generated by each tax; we also show how to use the SAM's data to calculate tax rates. Partial equilibrium diagrams then illustrate the theoretical effects of taxes on economic activity and welfare. The results of tax policy experiments using a CGE model support the theoretical predictions and offer insight into the economy-wide effects of each tax. Three applied examples of tax policy analysis explore the second-best welfare effects of a tax, the marginal welfare impacts of a country's entire tax structure, and the elimination of import tariffs in a preferential trade agreement. The large federal deficit in the United States has spurred intense debate on whether the sizeable tax cuts enacted by the previous administration should be maintained or allowed to lapse. The tax cuts were intended to spur consumer demand during the financial crisis. Economists argued that lower taxes would lead to increased consumer spending, thereby providing an economic stimulus as production and employment expanded to meet higher demand. Some economists also argued that lower tax rates motivate producers to invest and produce more, which also helps stimulate employment. Taxes influence the behavior of an economy's consumers and producers in important ways. CGE models have proven to be a valuable tool for researchers in empirically and comprehensively analyzing how taxes affect households’ and firms’ economic decisions about how much to consume, produce, and trade, and how these actions impact the economy as a whole. Governments impose taxes for many reasons. Foremost is the need to raise revenue to support the provision of public goods such as national defense and education. Governments sometimes use taxes to redress market failures such as externalities. For example, the government may impose carbon taxes to reduce the harm to public health that is associated with air pollution by private industry.