The Convergence of national policies within the European Monetary System (EMS) has received considerable attention over the years.1 The comprehensive financial integration within the EMS scheduled for 1992 has rendered the topic even more relevant in the minds of both researchers and policymakers. In particular, with reference to the implications of the EMS for national inflation rates, the discussion has focused on whether the system would impart an inflationary or a disinflationary bias. While some have argued that low-inflation countries would suffer from inflationary pressures from high-inflation countries, others have suggested that the opposite would take place. As pointed out by Guitián (1988), the evidence has been inconclusive, and it is therefore difficult to argue on a factual basis that the EMS has so far imparted either an inflationary or a disinflationary bias. Earlier work by Ungerer and others (1986), arguing that the EMS had been influential in reducing inflation among member countries, has recently been challenged by Collins (1988), who finds no evidence in support of the disinflationary bias hypothesis. Collins (1988) suggests that the disinflationary process that took place after 1979 in EMS member countries has not been significantly different from that which occurred in other industrial countries outside the EMS.
The issue of national inflation rates is in turn related to the fiscal policies of the individual countries, insofar as revenues from money creation may constitute an important percentage of government revenues.2 For some countries within the European Community (EC) (for instance, Italy, Spain, Portugal, and Greece), seigniorage accounts for between 6 percent and 12 percent of tax revenues.3 Furthermore, as suggested by Giavazzi and Giovannini (1989, p. 200), “differences in fiscal structures thus justify differences in the ‘optimal’ revenue from seigniorage. In all likelihood the ‘optimal’ inflation rate is not the same across Europe. …”
In view of the links between the convergence of national inflation rates, the revenues from money creation, and fiscal policies, it is important to provide a framework of analysis in which the essential features of these relationships can be isolated and analyzed in detail. Such a conceptual apparatus should in turn prove useful in the consideration of policy matters in which these issues may be involved but whose importance and implications may prove difficult to assess because of the presence of other macroeconomic problems (for instance, output effects of monetary policy).
To analyze these public finance issues, this paper extends to a two-country world the framework developed in Végh (1989a), in which the relative importance of seigniorage as a source of revenue results from high government spending coupled with inefficient tax administration systems that make it costly to rely solely on “conventional” taxes (that is, consumption or income taxes). It has long been recognized that a key feature that distinguishes the inflation tax from other, conventional, taxes is that the inflation tax is almost costless to collect. Aizenman (1987) incorporates this characteristic of the inflation tax into an optimal taxation problem by assuming that a consumption tax, which is the other tax available to the government besides the inflation tax, carries collection costs and concludes that the optimal tax is positive. The same result is obtained by Végh (1989a) in the context of a model in which money is introduced as reducing transaction costs, as in Kimbrough (1986).4 Moreover, Végh (1989a) shows that if the consumption tax carries constant marginal collection costs, the optimal inflation tax does not depend on government spending; whereas if marginal collection costs are increasing (that is, total collection costs are a convex function of revenues), the optimal inflation rate is an increasing and convex function of government spending.
Within the public finance framework just described, this paper investigates how the constraints imposed by a system like the EMS affect the optimal taxation structure that would prevail in the absence of those constraints. The first issue is the equalization across countries of nominal interest rates. Specifically, under flexible exchange rates, if collection costs and/or levels of government spending differed among individual countries, governments would optimally choose different taxation structures and, in particular, a different nominal interest rate.5 With an arrangement such as the EMS, exchange rates are supposed to remain fixed over the long haul, which imposes the constraint of a shared common nominal interest rate among its members. Two important questions arise: first, will the resulting common nominal interest rate be closer to that of the high-inflation country or to that of the low-inflation country (that is, will there be an inflationary or a disinflationary bias)? Second, how will levels and differences in government spending and the relative efficiency of the tax administration systems affect whether there is an inflationary or a disinflationary bias?
The second issue is the equalization across countries of consumption taxes. Given that the EMS contemplates the possibility of periodic realignments, and most likely still will after 1992, it follows that national inflation rates may differ across countries for a given period of time. This raises the question, which is also related to current discussions in the EMS, as to how the differential between national inflation rates would be affected by equating, say, consumption taxes across countries. Put differently, would such tax harmonization policies make it easier or more difficult to sustain fixed parities with only occasional realignments?
It is worth stressing at this point that the model does not explicitly incorporate whatever benefits may result from establishing a fixed exchange rate regime or from equalizing consumption taxes. The rationale for not doing so is twofold. First is the desire to maintain analytical tractability, since from an analytical point of view, the model is already quite complex without these additional features.6 Second, since there is no consensus on the advantages of fixed over flexible exchange rates or of tax harmonization, there is no obvious way of incorporating these potential benefits into the model.7 Therefore, this model should be viewed as a means of isolating and analyzing the costs associated with the types of constraints that the EMS may impose upon its members, while abstracting from the potential benefits. (Clearly, since we will be comparing solutions to an unconstrained optimization problem with solutions to a constrained optimization problem, in terms of welfare, the latter can, at most, be as good as the former.) Insofar as simulations of the model suggest, however, that the costs imposed by the constraints are negligible—as will be the case when a common nominal interest rate is required—the benefits of a system of fixed exchange rates, in terms, say, of more stable real exchange rates, could certainly be presumed to outweigh these costs.8
The paper proceeds as follows. Section I reviews the determination of the optimal inflation tax and its dependence on government spending and the efficiency of the tax administration system in each country under flexible exchange rates. This review provides the benchmark case against which the more complex two-country model with fixed exchange rates can be compared. Section II introduces the two-country model with fixed exchange rates and analyzes the consequences of imposing the constraint of nominal interest rate equalization across the two countries. It is shown that the common inflation tax is closer to that of the original high-inflation country. The inefficiency of the tax administration system is shown to play the crucial role, as opposed to that played by the different levels of government spending. The consumption taxes may either converge or diverge depending on the initial tax structure of each country. The effects on the revenues from money creation as a fraction of total revenues are also analyzed. Section III discusses the effects of the imposition of consumption tax equalization. The analysis suggests that national nominal interest rates would be subject to important changes as a result of the large changes in revenues produced by the equalization of the consumption tax rates due to the relative unimportance of seigniorage as a source of revenue. Section IV contains concluding remarks.
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van der Ploeg, Frederick, “International Policy Coordination in Interdependent Monetary Economies,” Journal of International Economics, Vol. 25 (1988), pp. 1–23.
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Carlos A. Végh, an economist in the Research Department, was an economist in the European Department when this paper was written. He holds a Ph.D. from the University of Chicago.
Pablo E. Guidotti is an economist in the Research Department and holds a Ph.D. from the University of Chicago.
The authors are grateful to Joshua Aizenman, Torsten Persson, Klaus-Walter Riechel, and participants at a seminar in the Research Department for helpful comments.
Drazen (1988) reports that for the period 1979–86, the share of seigniorage in tax revenues was 6.2 percent for Italy, 5.9 percent for Spain, 9.1 percent for Greece, and 11.9 percent for Portugal.
Extensions and evaluations of Kimbrough’s (1986) contribution include Faig (1988), Guidotti and Végh (1988), Végh (1989b), and Woodford (1989). The study of the optimal inflation tax in a public finance context was pioneered by Phelps (1973).
Since the model abstracts from capital accumulation, the real interest rate equals the common rate of time preference. Setting the nominal interest rate is thus equivalent to choosing the inflation rate.
The reason for the analytical complexity is that the exercises undertaken in this paper lead to third-best optima. These third-best optima result from the imposition of constraints on the initial second-best world economy’s equilibrium.
Canzoneri and Rogers (1988) assume that using multiple currencies is costly. In this way, they incorporate an explicit benefit associated with adopting a single currency for the EMS.
See Giavazzi and Giovannini (1989) for a discussion of the benefits that the members of the EMS perceive to result from a system of fixed exchange rates.
As long as we are dealing with stationary equilibria (that is, the system is always at the steady state), the results obtained for a closed economy, a small open economy under flexible exchange rates, or large economies operating under flexible rates are the same.
The foreign consumer holds only foreign money and the traded bond; that is, there is no currency substitution.
It should be clear that, given the nonnegativity constraint on the nominal interest rate, the consumer would never choose X > Xs, so that the constraint on the domain of v(X) does not imply any loss of generality.
As pointed out by Guidotti and Végh (1988), this assumption is critical in obtaining the result that the optimal inflation tax is zero in the absence of collection costs. If transaction costs are not zero when v’(Xs) = 0, the optimal inflation tax is positive. The assumption that transaction costs are eliminated when X = Xs allows us to motivate the use of the inflation tax based only on the presence of collection costs associated with the consumption tax.
If the primal approach to optimal taxation is used (Atkinson and Stiglitz (1972)), as in Kimbrough (1986) and Végh (1987), it follows immediately that if the exogenous variables are constant over time, the optimal social choices of (c, h, m) are constant over time. For this optimal social allocation to be the outcome of a competitive equilibrium, (I, θ) have to remain constant over time. The intuition is that constant expenditures across time are optimally financed from contemporaneous taxes, because it is optimal to smooth tax distortions over time (see, for instance, Lucas and Stokey (1983)). Therefore, the economy is always in the steady state where 1/(1 + r) = β = β*, and will adjust instantaneously to unanticipated changes in the exogenous parameters (Obstfeld and Stockman (1985)). Accordingly, in what follows the analysis will be conducted in the steady state and time subscripts will be dropped for notational simplicity.
The key results that obtain with this particular specification extend to any φ (θc), such that T(θc) is a convex function, as shown in Végh (1989a).
It should be pointed out that the slope of the isorevenue curve is [(cq qθ Γ + cΓθ)/[(cq q1Γ + cΓ1)] rather than (Γθ/ΓI). But, at an optimum, it can be verified that (qθ/qI) = [(cq qθ Γ +cΓI)] can be rewritten as (qθ/qI = (Γθ/ΓI). This is because the negative effect on revenues of q that results from an increase in θ, relative to that which results from an increase in I, is proportional to the relative distortion introduced by both taxes.
For simplicity, the real interest rate is assumed small enough so that the nominal interest rate can be identified with the inflation rate. Due to the highly abstract nature of the model, the specific numbers generated by the model throughout the paper should be viewed as illustrations rather than actual predictions.
For simplicity, GDP is defined gross of transactions costs.
The actual figures (average for 1985–87) for revenues from money creation as a fraction of total revenues are 3.0 percent for Italy and 1.33 percent for the Federal Republic of Germany (see Gros (1989)).
Note that at an optimum the denominators on both sides of equation (12) are positive. This follows from the first-order conditions. It should also be clear that no corner solution can be involved in this case, because if Iw = I°, then D = 0 but D* < 0, and if Iw = (I*)°, then D* =0 but D > 0.
Naturally, since potential benefits of fixed exchange rates in the EMS (as discussed, for instance, by Giavazzi and Giovannini (1989)) have not been incorporated into the model, fixing exchange rates will always reduce welfare. These costs, however, would be present even if some benefits were taken into account. The present model should be seen as providing an illustration of the costs that might be involved in unifying monetary policies; it does not address the cost-benefit issue of fixing exchange rates.
It is worth noting that these exercises represent comparative statics around a third-best optimum.
In the present context, consumption tax harmonization implies the harmonization of all taxes other than the inflation tax. Although this assumption makes this experiment rather extreme, it provides a useful benchmark (see the discussion below).
Again, the analysis begs the question of why the foreign country would willingly engage in equalization of consumption taxes to begin with. As was indicated earlier, however, the analysis abstracts from the potential benefits of tax harmonization.
It is not the case, however, that a corner solution necessarily implies the divergence of the nominal interest rates when one or both of the countries have positive values of k, as the reader can easily verify graphically.
As the reader will see from Table 4, the values of g and g* have to be quite close to avoid the corner solutions that have already been discussed. Because of the importance of the revenues from the consumption tax in terms of total fiscal revenues, any difference between levels of public spending that requires a substantially different consumption tax is likely to lead to a corner solution, because the country whose consumption tax increases generates too much revenue; if a negative inflation tax were allowed, this revenue would be handed back to the public. Table 4 reports results for i and i*, but the same results would hold for I and I*.