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We are grateful to seminar participants, and in particular our discussant Nouriel Roubini, at FAD’s Academic Panel Conference in February 2006 in Washington, D.C., for many helpful comments and suggestions.
For applications of the model in the context of fiscal reform in respectively Canada and the United States see Bayoumi and Botman (2005), Bayoumi, Botman, and Kumar (2005), Kumhof, Laxton, and Muir (2005), and Botman and Laxton (2004).
See Obstfeld and Rogoff (1995, 1996), Betts and Devereux (2001), Caselli (2001), Corsetti and Pesenti (2001) and Ganelli (2003a). In a recent paper, Erceg, Guerrieri, and Gust (2005) add rule-of-thumb consumers to a model based on the representative agent paradigm and then use the model to study the effects of recent U.S. fiscal deficits on the current account deficit. Not surprisingly, they find much smaller effects than in models that allow for the possibility that permanent increases in government debt can have permanent consequences for the stock of net foreign liabilities and the world real interest rate.
See Frenkel and Razin (1992) for a diagrammatic exposition of a two-country overlapping-generations model without distortionary taxation.
Nevertheless, since increasing a VAT also taxes accumulated savings, it is likely to be less distortionary than a tax on labor income, which partly explains its popularity in many countries as an important source of revenue.
The calibration of the model broadly replicates the United States as the large economy, and the Czech Republic as the small economy, although it should be emphasized that the calibration is not intended to capture all the key characteristics of these two economies, but rather to provide an illustrative benchmark for the large and the small economies.
Although the version of the model discussed here features a two-country setup, a multi-country version exists (see Kumhof, Laxton, and Muir 2005 for an application of a four-country version).
For a collection of early models with these features, see Buiter (1981), Blanchard (1985), Weil (1989), McKibbin and Sachs (1991), Black and others (1994, 1997), Faruqee, Laxton, and Symansky (1997), Laxton and others (1998), and Faruqee and Laxton (2000).
Other studies, for example, McKibbin and Sachs (1991) assume an even shorter planning horizon. However, since GFM also incorporates liquidity-constrained consumers who essentially have a one-year planning horizon we use a longer planning horizon for optimizing agents.
Models without finite planning horizons, such as infinitely-lived representative agent models, sometimes assume a much larger share of liquidity-constrained consumers to generate a more plausible correlation between disposable income and consumption—see Erceg, Guerrieri and Gust (2005), who use a value of 0.5.
Consumption and labor effort are negatively correlated in the long term since leisure is a normal good.
By contrast, a model with Ricardian equivalence posits that net foreign liabilities and real interest rates do not depend on the level of government debt in the long run. Lane and Milesi-Ferretti (2002) find empirical support that the stock of public debt is an important determinant of the net foreign asset position in both industrial and developing countries.
The new view argues that borrowing by debt issuance rather than equity issuance is the main form of financing of investment. Since debt financing is tax deductible, capital income is effectively taxed only once, and hence there is no need to reduce the personal income taxation of capital. This has little impact on the simulations in this paper, which focus on the macroeconomic consequences of reducing the taxation of personal capital income, rather than on the welfare implications of taxation across factors of production.
If tax reform results in a reduction in the taxation of overall savings, instead of capital income only, the benefits are smaller. The reason is that increasing labor income taxes to reduce taxes on interest income increases distortions in the economy. Also, see Bayoumi, Botman, and Kumar (2005) for a discussion of the implications of non-revenue-neutral tax reform.
A more gradual introduction of PRAs in the context of the United States was assumed in Bayoumi, Botman, and Kumar (2005).
Reflecting the stylized nature of financial markets in the model, there is no equity premium to be exploited by owners of PRAs.