Taxation Rates and Stabilization in the Framework of Supply-side Distortions

Abstract

We use a simple macroeconomic modeling of a monetary union made of two structurally heterogeneous countries, with distortions in the supply function. We find that higher taxes are always output stabilizing in the event of demand shocks, but that stronger automatic stabilizers are often inflation destabilizing in the framework of large supply-side distortions. These inflationary risks are only limited if the transmission mechanisms of economic policies are more efficient, if countries are weakly open, and if economic authorities care more about price stability than instrument smoothing. Furthermore, our model also shows that in the event of supply shocks, higher taxation rates would be inflation as well as output destabilizing, and all the more as distortions are accentuated in the supply function. Therefore, reducing taxes may often improve economic stabilization. Indeed, there would be a ‘critical level of supply-side distortions’ above which some of the stabilization properties of automatic stabilizers become perverse even in case of demand shocks. Furthermore, the necessity to reduce the tax burden would be much more acute in the smallest and most open European countries.

Keywords:

• Automatic stabilizers
• demand shocks
• supply shocks
• supply-side distortions
• monetary union

JEL CLASSIFICATIONS:

• E61
• E62
• E63
• F42

Acknowledgements

The author would like to thank the two anonymous referees of the International Economic Journal for their helpful comments. Obviously, the author alone is responsible for any errors and omissions that remain in this paper.

Notes

¹See: Debrun et al. (2008) for a complete discussion of the economic literature about the efficiency of automatic stabilizers, about the link between government size and economic stabilization or output variability. In particular, they mention factors that can replace or complement fiscal policy and then also affect and interfere with macroeconomic stabilization: better discretionary policies (either monetary or fiscal), financial development (less credit constraints).

²Since expected inflation is zero, r denotes either nominal or real interest rate.

³In the traditional demand function, net exports depend on prices differentials. But in comparison with the steady state equilibrium, we suppose that a higher inflation damages the relative competitiveness of a country.

⁴With: ; ; ; . Therefore, these coefficients incorporate the negative effects of taxes on private consumption. They can be considered as quite stable, at least in the short run.

⁵The estimations are made with EXCEL. We have taken various values for the parameters and heterogeneities to check for the robustness of our results.

⁶Martinez-Mongay and Sekkat (2003), Buti and Van Den Noord (2003) or Buti et al. (2002) assume a very simple reaction function for the governments. The automatic stabilizers play symmetrically over the cycle: d=−ty.

⁷Brunila et al. (2003) find that stabilization would then be larger in the event of consumption shocks than in the event of investment or exports shocks.

⁸The structural parameters are supposed to vary in Tables 1 and 2 in country i, whereas they stick to the values of our basic calibration in the country j.

⁹However, the authors base their assessment on various budget sensitivities for various shocks, a channel that is not captured in our model.