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Budget Deficits Under Alternative Tax Systems International Effects

Author(s):
International Monetary Fund. Research Dept.
Published Date:
January 1988
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The international effects of budget deficits arise in part from tax and transfer policies; the specific consequences of these policies and the characteristics of the international transmission mechanism depend critically on the precise composition of taxes. Specifically, the international effects of a budget deficit of a given size differ sharply according to the types of taxes used to generate the deficit. On the one hand, under a value-added tax system a budget deficit arising from a cut in consumption taxes raises the world rate of interest and, thereby, crowds out domestic and foreign investment. It also worsens the trade balance of the domestic economy. On the other hand, a budget deficit that arises from a cut in income taxes lowers the world rate of interest and crowds out domestic investment but crowds in investment from abroad. In that case, the domestic economy’s trade balance improves. The great sensitivity of the consequences of a budget deficit to the specific tax policy generating the deficit underscores the desirability of using more detailed information than that provided by the statistic measuring the aggregate budget deficit.1

In order to focus on issues of public finance, we assume that the path of government spending is given, and we examine the implications of alternative time profiles of taxes and of public-debt issue. To conduct a meaningful analysis of budget deficits, we depart from the pure Ricardian model (in which the timing of taxes does not matter) by allowing for distortionary taxes and examine the effects of budget deficits arising from tax policies under alternative tax systems. We consider deficit policies involving taxes of different types: consumption taxes, taxes on income from domestic investment, taxes on income from foreign lending, and taxes on labor income.

Throughout, we assume that capital markets in the world economy are fully integrated and, therefore, that individuals and governments of different countries face the same world rate of interest. This feature provides the key channel through which the effects of policies undertaken in one country are transmitted to the rest of the world.

Much of the recent research in macroeconomics and public finance has been conducted in a closed-economy framework and has emphasized the intertemporal dimensions of tax policies and their effects on saving, investment, labor supply, and growth. In this context, special attention has been given to the implications of budget deficits.2 Our analysis extends the closed-economy framework to a two-country model of the world economy. This extension permits the treatment of questions that could not have been dealt with in a closed-economy framework. Further-more, we show that open-economy considerations lead to modifications of propositions derived previously in a closed-economy model.3

In Section I we develop a simple analytical framework with inelastic labor supply suitable for an analysis of distortionary taxes. The analysis extends the closed-economy framework developed by Barro (1979) and exposited in Aschauer and Greenwood (1985). The extension to the open economy is based on Frenkel and Razin (1986b). This framework is applied in the subsequent two sections to an examination of the international effects of budget deficits arising from cuts in consumption taxes, taxes on income from domestic investment, and taxes on international borrowing. The analytical framework is extended in Section IV to incorporate variable labor supply and to allow for the endogenous response of labor to income taxes. This extended framework is then used to examine the effects of budget deficits arising from a cut in income taxes. The paper concludes with an integrated summary of the main results.

I. The Analytical Framework

To incorporate the effects of taxes, consider a one-good stylized model. The private sector’s periodic budget constraints are

where τct, τyt, and τbt (t =0, 1) denote, respectively, the advalorem tax rates in period t on consumption, income, and new borrowing. In equation (1), the coefficient of C0 indicates that the unit cost of consumption is unity plus the corresponding advalorem tax. The coefficient of the level of income (¯Y0-I0) is unity minus the corresponding advalorem tax, reflecting taxes on income from existing capital and inelastic iabor supply (¯Y0) and a tax rebate on negative income from current investment (Io). This tax is a cash-flow capital income tax (with full expensing of investment, I0).4 Our formulation of the tax on international borrowing assumes that the tax applies to new net private-sector borrowing—(B0PB1P). This assumption can be verified by noting that the last two terms on the right-hand side of equation (1) could also be written as (1τb0)(B0PB1P)r1B1P. In this formulation, debt service is exempt from the tax. An analogous interpretation applies to the second budget constraint in equation (2). We note that in the second period there is negative new net borrowing (since past debt is repaid and no new debt is issued); therefore, the term τb1B0P corresponds to a tax rebate. As is evident from the formulation of equations (1) and (2), the three taxes are linked through an equivalence relation. This equivalence implies that the effect on the real equilibrium of any combination of the three taxes can be duplicated by a policy consisting of any two of them. Our formulation reveals that the celebrated equivalence between consumption and income taxes developed in the closed-economy context (see Auerbach and Kotlikoff (1987)) does not carry over to the open-economy context.5 In what follows, we use the equivalence property to suppress the tax on international borrowing. Thus, we set τb0 = τb1 = 0.

With consumption and income taxes, the periodic budget constraints of the government are

The private sector periodic budget constraints can be combined in order to yield the consolidated lifetime budget constraint.6 Adding equation (2), multiplied by α1, to equation (1) and dividing the resultant equation by (1 +τc0) yields

where ατ1 = [(1 + τc1))/(1 + τc0)] α1, αI1 = [(1 − τy1)/(1 − τy0)] α1. For subsequent use we recall that the world discount factor is denoted by α1 = 1/(1 + r0).

Equation (5) is the private sector consolidated budget constraint, which incorporates the role of taxes. The key point is that it is the tax-inclusive discount factors that are applicable to future period quantities. These are the effective discount factors relevant for private sector decisions. Accordingly, ατ1 measures the effective intertemporal price of C1 in terms of C0. This price reflects the prevailing tax structure. It is governed by the time profiles of the consumption tax [reflected by the ratio (1+τc1)/(1 + τc0)].

Analogously, the effective discount factor applicable for investment decisions is αI1. This effective discount factor is governed by the time profiles of the taxes on income. It does not depend on the time profile of the tax on consumption.

This dependence of the effective discount factors on the time profiles of the various taxes reflects the non-Ricardian feature of the model. A budget deficit arising from a current tax cut must be followed by a future tax hike in order to ensure government solvency. This change in the time profile of taxes alters the effective discount factors, opening up the principal channel through which budget deficits affect the intertemporal allocation of consumption and investment.

Finally, we note that if the time profile of any given tax is flat (so that τc0 = τc1, or τy0 = τy1), then this tax is nondistortionary, and its effect is similar to that of a lump-sum tax. This property underlies our choice of a cash-flow formulation of the income tax.

II. Deficits with Consumption Taxes

Next, the effects of a budget deficit induced by a cut in the tax on consumption are considered. We note in passing that this consumption tax is equivalent to a value-added tax (VAT) system under which investment and exports are exempt. In order to isolate the effect of this tax cut, we assume that all other taxes are zero. We also assume that the paths of foreign taxes are flat (so that the foreign tax system does not introduce a distortion) and that the foreign government runs a balanced budget (so that changes in the world rate of interest do not affect the foreign government’s solvency).

The initial equilibrium is described in Figure 1 by point A. The downward-sloping schedules portray the desired ratio of current-period to future-period consumption. We assume that the utility functions are homothetic and, therefore, the desired consumption ratios depend only on the rate of interest. The world relative demand is denoted by Dw, where Dw=C0w/C1w=(C0+C0*)/(C1+C1*). This quantity is a weighted average of the two countries’a relative demands, D=C0/C1, and D* =C*0/C*1. Accordingly,

Figure 1.Effects of a Budget Deficit Arising from a Cut in Consumption Taxes

where the domestic country’s weight is

The upward-sloping Sw schedule is the world relative supply of (current-period to future-period) output net of investment and government spending. Its positive slope reflects the fact that investment falls when the rate of interest rises. This relative supply is denoted in Figure 1 by the letter z. In Figure 1, the vertical axis measures the (tax-free) world rate of interest, which is initially r0. The schedules pertaining to the initial equilibrium (D, D*, Dw, and Sw) are drawn for the given initial configuration of taxes. A reduction in the current tax on consumption from τc0 to τ′c0, with a corresponding rise in the future tax from τc1 to τ′c1 (necessary to restore government solvency), raises the effective discount factor applicable to consumption, ατ1 (that is, it lowers the effective rate of interest), and induces a substitution toward current consumption. Thus, for every value of the world rate of interest, the domestic (relative) demand schedule shifts to the right from D to D′. The proportional vertical displacement of the schedule equals the proportional rise in the effective discount factor. This proportion is [(1 + τ′c1)/(1 + τc1)][(1 + τc0)/ (1 +τ′c0)]. Associated with the new domestic relative demand, the new world relative demand, (C0+ C*0)/(C1 + C*1), also shifts to the right from Dw to Dw′ in Figure 1. This shift reflects the substitution from future to current-period consumption in the domestic economy.7 Furthermore, the proportional displacement of the world relative demand schedule is smaller than the corresponding displacement of the domestic relative demand schedule.8

A rise in the effective discount factor applicable to consumption decisions, from ατ1 to α′τ1, does not affect the effective discount factor applicable to investment decisions. Therefore, the relative supply schedule in Figure 1 remains intact, and the equilibrium world rate of interest rises from r0 to r0. This higher rate discourages domestic investment as well as investment in the foreign country and therefore results in a positive cross-country correlation of investment.

To determine the incidence of this change in the time profile of taxes on the domestic effective rate of interest, we recall that the proportional vertical displacement of the D schedule equals the tax-induced percentage change in the effective discount factor. This change is represented by the distance BC in Figure 1. Accordingly, in order to determine the new equilibrium value of the domestic effective rate of interest, we subtract from 1 + r0 the distance BC. This yields 1 = ¯r0 in Figure 1. Evidently, the new equilibrium effective rate of interest ¯r0 is lower than the initial rate r0, since the vertical displacement of Dw is smaller than BC and the percentage fall in the world discount factor is even smaller than the vertical displacement of Dw.

The rise in the world rate of interest in the new equilibrium induces intertemporal substitution in foreign consumption toward the future, resulting in a higher growth rate of foreign consumption (represented by the move from point E to point E′ in Figure 1). Similarly, the fall in the domestic effective rate of interest induces intertemporal substitution of domestic consumption toward the current period, thereby lowering the growth rate of domestic consumption (represented by the move from point F to point B in Figure 1). Finally, we note that even though the growth rate of foreign consumption rises, the growth rate of world consumption falls (as represented by the move from point A to point A′ in Figure 1). This decline reflects the fall in world investment.

Through its influence on the world rate of interest, the domestic budget deficit is transmitted internationally. In general, because of possible conflicts between income and substitution effects induced by the tax policy and by the interest rate changes, the effects of the budget deficit on the levels of consumption and the trade balance are not clear cut. However, if the foreign economy has a flat tax profile, then—ruling out a backward-bending saving function—the rise in the world rate of interest operates to reduce current foreign consumption. In this case, since world investment falls while output is unchanged, the market-clearing condition for world output implies that domestic consumption rises. We conclude that, on the one hand, if the intertemporal elasticities of substitution between current and future consumption are relatively low, then the correlation between changes in domestic and foreign consumption consequent on the budget deficit may be positive or negative. On the other hand, if the elasticities of substitution are relatively high, then the budget deficit results in a negative correlation between domestic and foreign levels of consumption.

Finally, in the case in which the foreign saving function does not bend backwards, foreign absorption (consumption plus investment) falls, and therefore the foreign economy’s trade account improves. The counterpart of this improvement is a corresponding deterioration in the domestic balance of trade.

III. Deficits with Income Taxes

We now consider the effects of a deficit arising from a current cut in taxes on income. Under the assumption that all other taxes are zero, this tax cut must be accompanied by a corresponding rise in future taxes. Accordingly, suppose that the time profile of taxes is changed from (τy0, τy1) to a steeper profile (τ′y0, τ′y1). The initial equilibrium is described by point A in Figure 2. Since the taxes τy0 and τy1 do not influence the effective discount factor applicable to consumption decisions ατ1, changes in the time profile of this tax do not alter the desired ratio of intertemporal consumption. Therefore, the relative demand schedules in Figure 2 remain intact.

Figure 2.Effects of a Budget Deficit Arising from a Cut in Income Tax: Inelastic Labor Supply

Turning to the supply side, we note that, like the world relative demand schedule, the world relative supply schedule is also a weighted average of the two countries’ schedules, S and S*. Accordingly, Sw= μsS + (1 − μs)S*, where the domestic country weight is

By lowering the effective discount factor relevant for investment decisions αI1, the budget deficit displaces the domestic relative supply schedule downward from S to S′. The proportional displacement is equal to (1-τ′y1)(1 − τy0)/(1 − τy1) (1 − τ′y0), which measures the percentage change in αI1. The proportional downward displacement of the world relative supply schedule is smaller than the corresponding displacement of the domestic relative supply schedule.9

The new equilibrium obtains at the intersection of the (unchanged) world relative demand schedule, Dw, and the new world relative supply schedule, Sw′. This equilibrium is indicated by point A′, at which the world rate of interest falls, from r0 to r0, and (one plus) the effective interest rate applicable to domestic investment rises by the proportion (1 + ¯r0)/(1 + r0). This rise is indicated by the distance BC corresponding to the vertical displacement of the domestic relative supply schedule. In the new equilibrium the rates of growth of domestic and foreign consumption fall, as indicated by the respective moves from point F to point F′ and from point E to point E′. As a result, the rate of growth of world consumption must also fall. In view of the fall in the world rate of interest from r0 to r0, foreign investment rises, and, in view of the rise in the effective domestic rate of interest from r0 to ¯r0, domestic investment falls. Thus, a deficit arising from a cut in taxes on income crowds out domestic investment and crowds in foreign investment. These changes result in a negative correlation between domestic and foreign rates of growth of consumption.

The effects of this cut in taxes on the level of domestic consumption are unambiguous if the initial equilibrium is undistorted (that is, if the initial tax profile is flat). The reason is that the fall in the world rate of interest raises current consumption by increasing wealth (through the increased value of the discounted sum of gross domestic product (GDP)) and by inducing intertemporal substitution of consumption toward the current period. Similarly, if the time profile of foreign taxes is also flat, the fall in the world rate of interest raises foreign consumption for the same reasons. It follows that under these circumstances the domestic budget deficit crowds in both domestic and foreign private sector consumption and results in a positive cross-country correlation between the levels of consumption.

It is also noteworthy that, in contrast to the effects of a cut in consumption taxes, the reduction in taxes on income improves the domestic country trade balance. This improvement is the counterpart to the deterioration in the foreign trade account consequent on the rise in foreign absorption (consumption plus investment).

The foregoing analysis demonstrated that consumption tax policies influence the equilibrium in the world economy by altering the relative demand schedules, whereas capital income tax policies influence the equilibrium by altering the relative supply schedules. With a fixed labor supply, a tax on international borrowing is equivalent to a combination of consumption and income taxes (as can be seen from the budget constraints—equations (1) and (2)). It follows that such a tax policy influences the equilibrium by altering both the relative demand and the relative supply schedules. The effects of a deficit arising from a cut in taxes on international borrowing are, therefore, a combination of the effects of cuts in both consumption and income taxes.

IV. Budget Deficits with Variable Labor Supply

In this section we extend the stylized model to allow for a variable labor supply. The response of labor supply to changes in wages net of taxes adds an additional dimension to the intertemporal elasticity of the relative supply schedule. To highlight the supply-side effect induced by income taxes, we abstract from other taxes.

As in the previous sections, the individual who has access to the world capital market maximizes lifetime utility subject to the consolidated lifetime budget constraint. With variable labor supply, it is convenient to include in the definition of lifetime spending the imputed spending on leisure. Correspondingly, the definition of wealth includes the imputed value of labor endowment. Thus, the lifetime budget constraint is

where τyt, wIt, and rkt denote, respectively, the tax rates on income, the wage rate, and the rental rate on capital in period t (t = 0, 1), where K0 denotes the initial endowment of capital, and where lt, denotes the fraction of time spent on labor in period t (t = 0, 1); total endowment of time in each period is normalized to unity.10 As indicated in equation (6), the individual lifetime (full) income—-that is, the individual wealth (W0)—is the discounted sum of the value of time endowment and capital income (net of taxes and of the initial debt commitment). Capital income in the current period is the rental on existing capital, rk0K0, minus investment, I0; correspondingly, the stock of capital in the subsequent period is K0+K(I0)

Maximization of the utility function subject to the lifetime budget constraint yields the demand functions for ordinary consumption and for leisure in each period. These demand functions depend on the three relative prices (net wages in each of the two periods and the discount factor) and on wealth. Assuming that the amounts of leisure consumed in two consecutive periods are gross substitutes implies that for a given level of wealth a current tax cut lowers future labor supply, and a future tax cut lowers current labor supply. Furthermore, assuming that the utility function is separable between ordinary consumption and leisure implies that the utility-maximizing ratio of consumption in the two consecutive periods depends only on the rate of interest and not on the wage structure.11

In each period the level of outputs Y0 and y0, depends on labor and capital inputs. Under the assumptions that factor markets are competitive, and that the production functions are linear (the latter assumption being made for simplicity of exposition), the relative supply of world ordinary consumption is again denoted by z, which, as before, measures the ratio of world GDP net of investment and government spending in the two consecutive periods. That is,

where at and bt (t = 0, 1) denote, respectively, the marginal products of labor and capital in the home country in period r, and where a*t and b*t denote the corresponding foreign magnitudes.

The initial equilibrium of the system is described by point A in Figure 3. As before, the downward-sloping schedules D and D* denote the domestic and foreign relative demands for (ordinary goods) consumption in the two periods, and the schedule Dw is the weighted average of the domestic and foreign relative demands. The negative slopes of the schedules reflect the intertemporal substitution arising from changes in the rate of interest. The positively sloped schedule, Sw, reflects the response of z to the rate of interest.12

Figure 3.Effect of a Budget Deficit Arising from a Cut in income Tax; Variable Labor Supply

Consider now the effect of a budget deficit arising from a current reduction in the tax (τy0) on labor income (accompanied by a future rise in the tax (τy1). On the one hand, the assumption that the homothetic utility functions are separable between leisure and ordinary consumption implies that for a given rate of interest the change in the time profile of wages (net of taxes) does not alter the desired ratios of ordinary consumption in the two consecutive periods. Thus, the budget deficit does not alter the position of the relative demand schedules in Figure 3.

On the other hand, the assumption that the amounts of leisure consumed in the two periods are gross substitutes ensures that the rise in the current net wage raises the current labor supply, l0, and the fall in the future net wage lowers the future tabor supply, l1. These movements and the negative effect on investment cause the domestic relative supply schedule (not drawn) to shift to the right. Thus, as seen from equation (7), this change in the time profile of taxes raises the value of z for any given rate of interest. This is shown by the rightward shift of the world relative supply schedule from Sw to Sw′ in Figure 3.

The new equilibrium shifts from point A to point A′, the world rate of interest falls from r0 to r0, and the rates of growth of domestic, foreign, and world consumption fall. The lower rate of interest induces a positive correlation between growth rates of consumption. It also stimulates investment in both countries and, therefore, induces a positive correlation between domestic and foreign rates of investment.

A budget deficit arising from the change in the time profile of taxes on labor income also alters the levels of consumption in both countries. In the domestic economy the changes in the level of consumption reflect the combination of the induced changes in labor supply, the wealth and substitution effects induced by changes in the world rate of interest, and the response of investment. The fall in the world rate of interest raises the discounted sum of foreign GDP (provided that the foreign labor supply is not greatly reduced by the fall in the rate of interest). In addition (ruling out a backward-bending saving function), the fall in the rate of interest induces substitution of current consumption for future consumption. Hence, in this case, foreign consumption rises.

Finally, in the present framework the budget deficit may cause an improvement in the balance of trade. For example, if the foreign labor supply does not respond appreciably (positively) to the fall in the rate of interest and, correspondingly, if the foreign GDP (net of government spending) does not rise much, then the rise in foreign absorption (consumption plus investment) worsens the foreign trade balance and, correspondingly, improves the domestic balance of trade. Thus, in this case the budget deficit causes an improvement in the trade account. This improvement reflects the rise in current period output induced by the stimulative policy of the lower taxes on labor income.

V. Budget Deficits: Overview

The important role attached to the intertemporal substitution effects suggests that the various distortionary taxes can be usefully categorized according to whether they induce excess demand for current goods or for future goods or, equivalently, whether they stimulate current external borrowing (national dissaving) or lending (national saving). Tax policy that induces an excess demand for current goods by raising current consumption or investment, or by lowering current GDP relative to future GDP, is classified as a proborrowing policy; and tax policy that creates an excess supply of current goods by discouraging current consumption or investment, or by raising current GDP relative to future GDP, is classified as a prolending policy. Alternatively, the various tax policies associated with the budget deficit can be classified into expansionary supply-shift policies and expansionary demand-shift policies. Accordingly, a deficit arising from a cut in taxes on income reflects supply-shift policies, whereas a deficit arising from a cut in the consumption tax (value-added tax) reflects demand-shift policy. The former is a pro-lending policy; the latter is a proborrowing policy. From this classification we note that a budget deficit arising from a cut in taxes on international borrowing contains elements of both supply-and demand-shift policies. It can be shown, however, that the demand-shift component dominates, so that a cut in the tax on international borrowing is a proborrowing policy.13

The results of the analysis are summarized in Table 1. It is seen that the effects of the budget deficit on the world rate of interest, r0, depend on whether the deficit arises from a proborrowing or a prolending tax cut. A cut in current taxes on consumption and on international borrowing is a proborrowing tax policy that raises the world rate of interest; a cut in current taxes on capital income and on labor income is a pro-lending tax policy that lowers the world rate of interest. The table also shows that in the case of consumption and income taxes, domestic investment falls, whereas in the case of taxes on international borrowing, domestic investment rises.

Table 1.Effects of Budget Deficits Arising from Tax Cuts
Affected Variables
Tax Cutgcwr0¯r0gcgc*l0l0*C0C0*(TA)0
On consumption+++
On international+a+++?
borrowingb
On income++?++
Note: gcw, gc, and g*c denote, respectively, world, domestic, and foreign growth rates of consumption ; ¯r0 denotes the effective domestic rate of interest applicable to consumption. This effective rate also governs domestic investment decisions (except for the case of consumption taxes for which domestic investment depends on the world rate of interest r0). The ambiguities in the effects of taxes on domestic consumption reflect conflicting substitution and wealth effects. Domestic consumption rises if the substitution effect dominates the wealth effect. The latter depends on the initial borrowing-needs position. The assumption underlying the direction of the two changes in the levels of consumption and the trade account is the absence of backward-bending saving functions.

If μs > μd.

If μs < μd.

Note: gcw, gc, and g*c denote, respectively, world, domestic, and foreign growth rates of consumption ; ¯r0 denotes the effective domestic rate of interest applicable to consumption. This effective rate also governs domestic investment decisions (except for the case of consumption taxes for which domestic investment depends on the world rate of interest r0). The ambiguities in the effects of taxes on domestic consumption reflect conflicting substitution and wealth effects. Domestic consumption rises if the substitution effect dominates the wealth effect. The latter depends on the initial borrowing-needs position. The assumption underlying the direction of the two changes in the levels of consumption and the trade account is the absence of backward-bending saving functions.

If μs > μd.

If μs < μd.

The results reported in the table show that whether the tax cut is proborrowing or prolending, the budget deficit always lowers the growth rate of domestic consumption, gc = (C1/C0) − 1. However, the international transmission of the effects of the deficit does depend on whether the deficit arises from a proborrowing or prolending tax policy. If the tax policy is a proborrowing policy, then the growth rate of foreign consumption rises and foreign investment falls; a prolending tax policy will have the opposite effect.

Table 1 also reports the changes in the growth rates of world consumption, gcw=(1/z)1 (which is equal to the growth rate of world GDP net of investment and government spending). As has been shown, the direction of the change in the growth rate of world consumption depends on the characteristics of the taxes that are changed. Since the various taxes influence the levels of current and future consumption, investment, and GDP, the net effect reflects the interactions among these changes. Accordingly, on the one hand, the growth rate of world consumption rises if the (second-period) domestic trade account is in surplus and the budget deficit arises from a cut in taxes on international borrowing. On the other hand, the growth rate of world consumption falls if the tax cut on international borrowing occurs in the presence of a (second-period) domestic trade account deficit, or if the budget deficit stems from a cut in the other taxes.

Expressed in terms of correlations, Table 1 reveals that a budget deficit arising from a proborrowing tax policy results in negative cross-country correlations between growth rates of consumption. A budget deficit arising from a prolending tax policy results in positive cross-country correlations between the growth rates of consumption. The cross-country correlations between levels of investment are shown to be positive if the deficit arises from a cut in taxes on consumption or labor income, and negative if the budget deficit stems from a cut in taxes on international borrowing and capital income.

The effects of the budget deficit on the levels of domestic and foreign consumption and on the balance of trade depend in general on the shape of the initial time profile of taxes, on the initial borrowing needs of the country (being positive or negative), and on the size of the intertemporal elasticity of substitution. The signs of the effects indicated in the last three columns in Table 1 are based on the assumption that the initial tax profile is flat and that the saving functions are not backward bending. Under these assumptions, a budget deficit arising from a proborrowing tax policy lowers foreign consumption and worsens the domestic balance of trade, whereas a budget deficit arising from a prolending tax policy raises foreign consumption and improves the domestic balance of trade.

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Mr, Frenkel, Economic Counsellor of the International Monetary Fund and Director of the Research Department, is a graduate of the Hebrew University and the University of Chicago. Before joining the Fund in January 1987, he was David Rockefeller Professor of International Economics at the University of Chicago.

Mr. Razin, Daniel and Grace Ross Professor of International Economics at Tel-Aviv University, is a graduate of the Hebrew University and the University of Chicago. He was a consultant in the Research Department when this paper was completed.

The authors are indebted to Alan Auerbach. Thomas Krueger, and Jonathan Ostry for helpful comments.

The effects of government spending on the equilibrium in the world economy and on the international transmission mechanism have been analyzed in detail elsewhere; see Frenkel and Razin (1985, 1986b). The international effects of revenue-neutral tax reforms are analyzed in Frenkel and Razin (1987a). For a more comprehensive treatment, see Frenkel and Razin (1987b).

Representative research emphasizing intertemporal considerations in a closed-economy framework is found in Barro (1974, 1979), Feldstein (1974a, 1974b), King (1983), and Judd (1987). For recent surveys and integrations of the various issues, see Aschauer and Greenwood (1985) and Auerbach and Kotlikoff (1987).

Examples of previous analyses of the effects of distortionary taxes in the context of a small open economy are found in Aschauer and Greenwood (1985), Greenwood and Kimbrough (1985), and Razin and Svensson (1983). By adopting a two-country model we deal with the mterdependencies within the world economy, an issue that could not be addressed in the small-country framework. Some aspects of the mterdependencies are examined in van Wijnbergen (1986).

The assumption that the cost of investment is fully expensed in the initial period simplifies the analysis considerably without altering the main implications. In Frenkel and Razin (1987a) we consider the other extreme case under which capital outlays are expensed in the final period.

In a recent tax-reform proposal. Hall and Rabushka (1983) advocate the adoption of a consumption-tax system as proposed by Fisher (1939). In specifying the implementation of the consumption tax and its virtues over the conventional income tax, they use the closed-economy equivalence relation between a consumption tax and a cash-flow income tax (capital income lax with expensing plus a labor income tax). Being confined to a closed-economy framework, they abstract from the role that taxes on international borrowing play in this tax-equivalence relation. For a comprehensive discussion of the closed-economy tax-equivalence proposition, see Auerbach and Kotlikoff (1987).

Our specification in equations (1)(4) did not allow for government bond selling to the domestic private sector. This simplifying assumption was made for convenience only and does not affect the analysts. To illustrate this point, let − Bp denote foreign bonds purchased by the domestic government; Ag, domestic government bonds purchased by the domestic private sector; and −Bg, foreign bonds purchased by the domestic private sector. In the presence of a tax on international borrowing, arbitrage between government bonds and foreign bonds implies(1+r0τb1)/(1τb0)=1+r0g,(1+r1τb0)/(1τb,1)=1+r1g,where rg is the market rate of interest on government bonds sold to the domestic private sector. Accordingly, we can subtract [A0g(1+r1)A1g] from the right-hand side of equation (1) and add [(1+r0g)A0g]to the right-hand side of equation (2). Correspondingly, we can add the term [A0g(1+r1g¯)A1g] to the right-hand side of equation (3) and subtract [(1 + rg) Ag] from the right-hand side of equation (4). The reader can verify that these changes do not affect the results, and, for simplicity, we henceforth set A1g=A0g=0

Under the assumption that the initial equilibrium was undistorted, the real income effects induced by the departure from the flat tax pattern are dominated by the substitution effect.

To verify this point we note thatD^w=(C0C0+C0*)D^+(C0C0+C0*C1C1+C1*)C^1.Accordingly, the proportional change in the world relative demand is composed of two components. The first consists of the product of the proportional change of the domestic relative demand and a fraction (the relative share of current-period home consumption in world consumption), and the second consists of the product of the proportional change in future-period consumption and a term measuring the difference between the relative shares of current-and future-period home consumption in world consumption. This latter term reflects the difference between the domestic and foreign saving propensities. If the current-period trade balance deficit arises from a relative low domestic saving propensity, then this term is positive. We also note that C1 is negative, since the change in the time profile of consumption taxes induces a substitution away from future-period consumption. It follows that under such circumstances Dw<D and, therefore, the displacement of the D schedule exceeds that of the Dw schedule.

Differentiating the domestic and world supply ratios at a given world discount factor yieldsS^=[I0Y¯0I0G0+F(I0)I0Y¯1+F(I0)G1](I^0)andS^w=[I0Y¯0I0G0+Y¯0*I0*G0*+F(I0)I0Y¯1+F(I0)G1+Y¯1+F*(I0*)G1*](I^0),respectively. Evidently the proportional change in S (in absolute value) exceeds the corresponding change in Sw (in absolute value).

The specification of the tax structure in equation (6) presumes, for simplicity, that the tax rates applicable to labor income and capital income are the same. The present analytical framework can be easily used to examine the consequences of differential tax rates, as would be the case in the presence of a corporation income tax.

For a detailed derivation, see Frenkel and Razin (l987b, Chapter 8).

The Sw schedule is drawn with a positive slope for convenience. In fact, changes in the rate of interest affect the intertemporal prices of leisure and of ordinary goods as well as wealth. These changes may alter the supply of labor in a way that more than offsets the effect of the induced changes in investment on z. In that case the Sw schedule is negatively sloped, but, as long as it is steeper than the world relative demand schedule, our subsequent analysis remains intact.

For open-economy analyses emphasizing the pure wealth effects of lumpsum, nondistortionary tax policies, see Blanchard (1985), Buiter (1986), Frenkel and Razin (1986a), and Persson (1985). In these models the pure wealth effects of budget deficits arise from differences between the time horizons of individuals and of the economy at large.

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