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)| false Aschauer, David A., and Jeremy Greenwood, “Macroeconomic Effects of Fiscal Policy,”in The New Monetary Economics, Fiscal issues and Unemployment, Carnegie-Rochester Conference Series on Public Policy, Vol. 23, ed. by ( Karl Brunnerand Alan H. Meltzer Amsterdam: North-Holland, 1985), pp. 91– 138.
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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
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 that
Differentiating the domestic and world supply ratios at a given world discount factor yields
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.