This paper uses a general equilibrium simulation model to gauge the impact of European fiscal harmonization on the French economy. For France, harmonization as currently envisaged will involve two main elements: first, a downward adjustment in value-added tax (VAT) rates compensated for by an increase in direct taxation; and, second, a general reduction in the level of savings taxes.
To gain some idea of the magnitude of the tax reforms such convergence would entail, note that to bring French VAT rates into line with German rates would mean an overall cut approaching 3 percentage points. The change in effective savings tax rates that will emerge from current discussions is harder to estimate, but a reasonable guess is that the general level of taxation on income from savings will fall by 10 percent. The total revenue losses associated with these tax cuts could amount to over 2 percent of gross domestic product (GDP).
Despite the scale of these changes, relatively little attention has been paid to their possible economic impact on European Community (EC) member countries. Initially, tax harmonization was viewed simply as a prerequisite to the broader movement toward a post-1992 single market. Studies such as those in Cecchini (1988) emphasized the economic implications of this integration of markets while ignoring the independent impact of tax harmonization.1
In fact, the planned harmonization raises broad questions concerning the desirability of different tax bases. If VAT rates in member states are to be brought into line, should indirect taxes in countries with high rates be lowered, or should those in countries with low rates be raised? Assuming that income and possibly other taxes are adjusted so that the VAT harmonization is revenue neutral, the answer will necessarily turn upon the relative advantages of different tax bases, in particular consumption versus income or wages.
There is a long tradition in public finance, associated with such authors as Fisher (1937), Kaldor (1955), and Meade (1978), of recommending the use of a consumption tax or VAT rather than income taxes. The basic argument is that taxes on consumption, like taxes on labor income, impose no burden on capital income and, therefore, do not distort a household’s intertemporal choice between consumption in different periods. Furthermore, the introduction of a new consumption tax effectively imposes a once-and-for-all tax on existing wealth, which is equivalent to a lump-sum tax.
Interest in these issues was reawakened by a series of empirical papers beginning with Boskin (1978) that suggested that the elasticity of savings with respect to the real interest rate was much higher than had previously been thought. If this were the case, then the deadweight losses involved in taxing capital income, or in relying on income rather than consumption taxes, would be higher.
As Feldstein (1978) pointed out, however, it is not the absolute level of savings elasticities that matters but, rather, their magnitude relative to labor supply elasticities. While savings taxes distort the choice between consumption at different dates, levying consumption taxes in their place increases the wedge between the prices of goods and leisure (the wage), and thereby exacerbates the distortionary impact of the tax system on labor supply decisions. Only if labor supply elasticities are very low is it possible to say unambiguously that the switch to consumption taxes will enhance welfare.2
Since the relative benefits of a consumption versus an income tax system depend in a more or less complex way on the level of agents’ demand elasticities, more recent work in this area has concentrated, first, on trying to refine estimates of the relevant elasticities and, second, on using general equilibrium simulation models to unravel the various ways in which different tax bases affect welfare.3
Although the above literature is relevant to evaluating the impact of savings tax cuts, it sheds little light on the relative merits of VAT and wage taxation. In a closed economy, VAT is usually superior to a tax on wages, since it generally has a broader base. Consumers’ budget constraints mean that consumption equals the sum of labor income and lump-sum endowments such as bequests, non-means-tested transfers from the government, and income tax allowances. For rational agents, a proportionate tax on consumption is equivalent to a similar proportional tax on wage income plus a lump-sum tax. Since lump-sum taxes are nondistortionary, a consumption tax will generally be preferable to a wage tax raising the same revenue.
However, there are two important qualifications to the above argument. First, in an open economy model, it is possible to show (Perraudin and Pujol (1990a)) that with inelastic demand for the country’s exports, terms of trade effects may divert welfare gains to the rest of the world, so that a lower VAT actually increases welfare. A second qualification to the superiority of VAT concerns the timing of consumption and wage tax liabilities over the life cycle. As Summers (1981) has pointed out, in a steady state with overlapping generations, a government may levy taxes on young or old and still raise the same amount of revenue. However, households will prefer taxes to be levied late in the life cycle, since they have positive discount rates. If wage income should be earned later in the life cycle than consumption expenditures are incurred, then a switch toward wage taxes could improve welfare.
These arguments mean that although the overall presumption must be that wage taxes are inferior to VAT in the excess burden they impose, in a particular case, such as the current French economy, this inferiority remains to be demonstrated. This paper develops a general equilibrium, overlapping generations, simulation model in which such questions may be analyzed.
Early papers that used such models, like Summers (1981), calculated the steady-state utilities of overlapping generations of households under various tax regimes. Summers argued strongly that the potential gains from switching to consumption taxes were extremely large. Unfortunately, steady-state calculations of this kind ignore the burden that policies may impose on households alive during the transition path and the adjustment costs borne by firms that have to revise their investment strategies. As a result, welfare gains may be significantly overstated.
The analysis of Auerbach and Kotlikoff (1987) confirms this criticism of studies that concentrate on steady-state results alone. As they demonstrate, the increase in economic welfare shown by Summers that follows from a switch from income to VAT is, in fact, partly the consequence of welfare transfers between generations. The utility gains of households in the terminal steady state are accompanied by utility losses for households in current generations. However, according to Auerbach and Kotlikoff, switching to income from wage taxes does produce a genuine Pareto improvement.
The approach taken in this study builds on the work of Auerbach and Kotlikoff. The model we develop extends their framework in three ways. First, given that French product and capital markets are closely integrated with those of its neighbors, it makes sense to incorporate a well-developed external sector. The demand for exports and the supply of savings from the rest of the world are assumed to be imperfectly elastic.4
Second, we assume that a fraction of the households in the model are limited in their ability to borrow against future labor income. A substantial body of empirical work points to the presence of such borrowing constraints in markets for consumer loans.5 This assumption may therefore be seen as realistic and is also desirable, given the questions posed by the present study. As Hubbard and Judd (1986) have stressed, if agents earn income late in life while their desired consumption has, say, a flat time profile, then switching from income taxes to VAT is likely to aggravate liquidity constraints leading to a reduction in welfare.
The third extension of Auerbach and Kotlikoff’s work is to incorporate two sorts of households with different levels of labor productivity. Since an important feature of VAT is that it is typically less progressive than income tax, comparisons of the relative merits of consumption versus income tax bases should ideally take distributional issues into account. To do this, it is of course essential to have a model that includes heterogeneous households.
Of the three extensions described above, the assumption of an open economy with variable terms of trade is the one that influences our results the most.6 To understand why this is the case, consider the effects of cutting VAT and savings taxes to a degree consistent with European harmonization and financing this through increases in lump-sum taxation. The primary effect is to make consumption goods more attractive compared to leisure, leading to an increase in labor supply and a significant boost in production. Selling the additional output in international markets necessitates a worsening in the terms of trade, which lowers domestic welfare despite the fact that domestic output has risen.
Results of this kind signal the considerable importance of addressing tax policy questions within an open economy framework. The implications of open economy effects for the relative attractiveness of different tax bases have only recently begun to receive their due recognition. Dixit’s (1985) survey of the theory of tax policy for open economies simply translates the results of Ramsey optimal tax theory into a version applicable to countries with trade. Such an approach ignores both terms of trade effects and the dynamic impact of taxation on savings and investment that have been the primary focus of the literature on consumption and income tax bases described above. More recent contributions by Frenkel and Razin (1987) and Frenkel, Razin, and Symansky (1991) have begun to analyze these topics, but more work in this area is an urgent research priority.
It is important to note that the analysis presented in this paper does not imply that harmonization by itself is necessarily welfare reducing.7 The problem is that harmonization, as currently envisaged, involves EC member countries adjusting their tax rates toward some overall average. The results suggest that if harmonization were achieved by tax changes that included more of a leveling-up of VAT rates in particular, with offsetting reductions in wage income tax, then the benefits to the Community would be distinctly greater.
The remainder of this paper is organized as follows. Section I describes discussions within the EC concerning fiscal harmonization and the design of VAT systems. The likely direct impact of the movement toward harmonization on French public finances is then analyzed. Section II provides a brief summary of the model used in the simulations. Section III reports the results of steady-state simulations of the model under a variety of assumptions about financing and the degree of openness of the economy. Section IV provides information on the short-term impact of tax harmonization by describing the economy’s transition path to the new long-run equilibrium. Section V states the conclusions. A description and solution of the model are provided in Appendix I and Appendix II.
APPENDIX I Model Description
This Appendix provides a derivation of the principal behavioral equations of the model. As mentioned in the text, agents are assumed to possess utility functions of the form
where Ci, t (i = 1, 2, 3) represents the consumption of the three goods in period t. Households face budget constraints given by
where T(.,.) is a differentiable function giving the level of taxes. We also assume that leisure is constrained to equal unity in the last two periods of the household’s life and that the household cannot borrow against its anticipated future labor income:38
Since there are no bequests, W0 = 0. The Lagrange multipliers associated with the budget, retirement, and liquidity constraints are Ωt, μt, and νt, respectively. The household’s first-order conditions may be rearranged to give
where Ti, t denotes the partial derivative of function T with respect to the ith variable in period t, and where the tax-inclusive price index, Pt,(1 + tt), is defined as
In formulating the model, the following properties of CES utility functions prove useful (see Dixit and Stiglitz (1977)).
Note that it is not possible to solve the above system analytically, because the shadow wage or Lagrange multiplier to the retirement constraint is not known.
The economy we examine has two production sectors producing goods 2 and 3 using capital and labor inputs. Each industry consists of identical firms with CES production functions of the form
Firms face convex costs of adjusting their inputs:
Each firm has a rate of capital depreciation, d, which is assumed to be constant over time. Given these assumptions, the long-run equilibrium will be independent of the adjustment costs.
Though French firms are subject to many different taxes, the most important are the profits tax (whose rate we denote τt) and social security contributions (with rate txt). We assume that social security contributions are paid exclusively by employers. So long as household behavior depends only on after-tax wages, this involves no loss of generality.
We further assume that the fiscal depreciation rate d′ is equal to the rate of economic depreciation, d. Although the actual fiscal rate almost certainly exceeds the economic rate, one may reasonably argue that the benefits to firms are counterbalanced by the fact that the calculation of depreciation allowances is based on nominal values. If
Since interest costs paid by firms are tax deductible, the Miller-Modigliani theorem does not hold, and it is necessary to specify the financial behavior of the firm. Assume that, at the margin, the percentage of investment financed by debt is θ, and the interest rate on this debt is
subject to Kt = (1 - d)Kt - 1 + It, where qt is the price of capital goods. Accordingly, we obtain the first-order conditions:
The implicit user cost of capital is
It follows that in a steady state, uct = q(1 - τZ)(r + d)/(1 - τ) with the two polar cases: uct = q(r + d) if θ = 1; and uct = q(r′ + d)/(1 - τ), if θ = 0. Only if θ = 1 will firms’ incentives to invest be unaffected by taxation. In the simulations reported in the text, we will assume that marginal investment is debt financed and hence profit taxes are nondistortionary. We assume that profits are paid to the government, which therefore becomes the implicit owner of the firm. This assumption removes the need to include a market in equities and, as we show below, does not necessarily affect households’ budget constraints. Moreover, in the long run returns to scale are constant, so that profits equal zero.
APPENDIX II Solution of the Model
Several approaches to solving general equilibrium models that are static and nonlinear have been discussed in the literature. These include, first, the Scarf algorithm, either in its original form or in one of the more recent improved versions. Second, standard numerical methods for solving nonlinear systems, such as Gauss-Seidel, Gradient, or optimization approaches, have been applied.41 Third, as advocated by Dervis, De Melo, and Robinson (1981), one may adopt techniques that exploit the structure of the particular model concerned.
The solution of multiperiod models presents additional difficulties, since the number of variables for which it is necessary to solve is effectively multiplied by the number of periods. The approach that is generally adopted consists of, first, solving for the initial steady state; second, computing the final steady state after policy changes; and, last, solving the transition path between the two steady states. If one assumes perfect foresight and rational expectations on the part of agents, it will not in general be possible to solve the model recursively over the transition path, since current behavior will depend on variables in future periods, which depend in turn on lagged variables (for instance, capital accumulation). Techniques to deal with this problem have been discussed by Fair and Taylor (1983) (the Fair-Taylor algorithm), by Lipton and others (1982) (multiple shooting methods), and by Spencer (1985) (optimization techniques).
For an application such as ours, the main difficulty is the combination of a nonrecursive dynamic structure and the nonlinear implicit form of many of the equations in the model. In particular, solving the household program with liquidity constraints is computationally costly. For this reason, it seems to be more efficient to solve for the transition path of the model directly, rather than attempting to use the model’s dynamic structure as suggested by, for example, Fair (1984) and Laitner (1984).
Figure 4 shows the algorithm for the steady-state solution of the model. Since prices are constant in the steady state, we only need to find the level of wages, the exchange rate, export prices, and the interest rate. Beginning with a guess for the interest rate, exchange rate, and the level of transfers to households, the optimality conditions of firms are used to establish both relative prices (via the factor price frontier) and the ratios of capital stocks and output to labor demands. Given relative prices, we solve the intertemporal optimization problem of households, including retirement and liquidity constraints, and then aggregate to obtain the aggregate levels of consumption and labor supply. Together with export demand (given by the exchange rate) and the exogenously determined level of government spending, we then have total goods demands and labor supply. Combining these with the capital stock and output ratios mentioned previously yields total output and labor demand in the two domestic industries. Given the total demands for domestic goods, we are then able to calculate the disequilibria in the labor market and the balance of payments and the degree to which government debt diverges from the initially assumed level. Using a Newton procedure, we then perturb the interest rate, exchange rate, and the level of transfers to households in order to reduce these three discrepancies.
Atkinson, A.B., and Joseph E. Stiglitz, “The Design of Tax Structure: Direct Versus Indirect Taxation,” Journal of Public Economics, Vol. 6 (July-August 1976), pp. 55–75.
Auerbach, Alan J., “Taxation, Corporate Financial Policy and the Cost of Capital,” Journal of Economic Literature, Vol. 21 (September 1983), pp. 905–40.
Boiteux, Marcel, Fiscalité et Marché Unique Européen, Rapport d’Etape au Ministre d’Etat, Ministre de l’Economic, des Finances et de la Privatisation (Paris: Documentation Francaise, 1988).
Boskin, Michael J., “Taxation, Saving, and the Rate of Interest,” Journal of Political Economy, Part 2, Vol. 86 (April 1978), pp. S3–S27.
De Melo, Jaime, and Sherman Robinson, “Product Differentiation and the Treatment of Foreign Trade in Computable General Equilibrium Models of Small Economies,” Journal of International Economics, Vol. 27 (August 1989), pp. 47–67.
Dervis, Kemal, Jaime De Melo, and Sherman Robinson, General Equilibrium Models for Development Policy (Cambridge; New York: Cambridge University Press, 1981).
Dixit, Avinash K., “Tax Policy in Open Economies,” in Handbook of Public Economics, ed. by Alan J. Auerbach and Martin Feldstein (Amsterdam: North-Holland, 1985).
Dixit, Avinash K., and Joseph E. Stiglitz, “Monopolistic Competition and Optimum Product Diversity,” American Economic Review, Vol. 67 (June 1977), pp. 297–308.
Fair, Ray C., Specification, Estimation, and Analysis of Macroeconomic Models (Cambridge, Massachusetts: Harvard University Press, 1984).
Fair, Ray C., and John B. Taylor, “Solution and Maximum Likelihood Estimation of Dynamic Nonlinear Rational Expectations Models,” Econometrica, Vol. 51 (July 1983), pp. 1169–1185.
Feldstein, Martin, “The Welfare Cost of Capital Income Taxation,” Journal of Political Economy, Part 2, Vol. 86 (April 1978), pp. S29–S51.
Frenkel, Jacob A., and Assaf Razin, and Stephen Symansky, “International Spillovers of Taxation,” IMF Working Paper 91/22 (Washington: International Monetary Fund, February 1991).
Hall, R.E., and F.S. Mishkin, “The Sensitivity of Consumption to Transitory Income: Estimates from Panel Data on Households,” Econometrica, Vol. 50 (March 1982), pp. 461–81.
Harberger, Arnold C., “Three Basic Postulates for Applied Welfare Economics: An Interpretative Essay,” Journal of Economic Literature, Vol. 9 (September 1971), pp. 785–97.
Harris, Richard G., “Alternative Solution Methods in Applied General Equilibrium Analysis,” OECD Working Paper 53 (Paris: Organization for Economic Cooperation and Development, 1988).
Hayashi, Fumio, “The Permanent Income Hypothesis: Estimation and Testing by Instrumental Variables,” Journal of Political Economy, Vol. 90 (October 1982), pp. 895–918.
Hubbard, R. Glenn, and Kenneth L. Judd, “Liquidity Constraints, Fiscal Policy and Consumption,” Brookings Papers on Economic Activity: 1 (Washington: The Brookings Institution, 1986), pp. 1–50.
Keen, Michael, “The Welfare Effects of Commodity Tax Harmonization,” Journal of Public Economics, Vol. 33 (June 1987), pp. 107–14.
Laitner, J., “Transition Time Paths for Overlapping-Generations Models,” Journal of Economic Dynamics and Control, Vol. 7 (May 1984), pp. 111–29.
Lebegue, D., La Fiscalité de l’Épargne dans le Cadre du Marché Intérieur Européen, Rapport du Conseil National du Credit (Paris: Direction des Journaux Officiels, 1988).
Lipton, David, James M. Poterba, Jeffrey Sachs, and Lawrence H. Summers, “Multiple Shooting in Rational Expectations Models,” Econometrica, Vol. 50 (September 1982), pp. 1329–33.
Meade, J.E., and Institute for Fiscal Studies, The Structure and Reform of Direct Taxation (London; Boston: Allen and Unwin, 1978).
Organization for Economic Cooperation and Development, Revenue Statistics of OECD Member Countries, 1965–1989 (Paris: OECD, 1990).
Perraudin, W.R.M., and T. Pujol (1990a), “Tax Efficiency in an Open Economy,” IMF Working Paper 90/94 (Washington: International Monetary Fund, 1990).
Perraudin, W.R.M., and T. Pujol (1990b), “European Tax Harmonization and the French Economy,” IMF Working Paper WP 90/96 (Washington: International Monetary Fund, 1990).
Spencer, Peter D., “Bounded Shooting: A Method for Solving Large Nonlinear Econometric Models Under the Assumption of Consistent Expectations,” Oxford Bulletin of Economics and Statistics, Vol. 47 (February 1985), pp. 79–82.
Summers, Lawrence H., “Capital Taxation and Accumulation in a Life Cycle Growth Model,” American Economic Review, Vol. 71 (September 1981), pp. 533–44.
Zeldes, Stephen P., “Consumption and Liquidity Constraints: An Empirical Investigation,” Journal of Political Economy, Vol. 97 (April 1989), pp. 305–46.
W.R.M. Perraudin is an Economist in the Research Department.
T. Pujol is an Economist in the European Department.
The authors would like to thank Krister Andersson, Alan Auerbach, Jonathan Skinner, Cuong Le Van, and numerous Fund colleagues for helpful comments.
Thus, the Cecchini report concentrates overwhelmingly on the gains from increased competition and economies of scale due to the removal of barriers between national markets.
Even then, the presence of liquidity constraints may reduce or even reverse the welfare gain, as we note below.
Some authors, such as Pechman (1990), also question the underlying life-cycle framework, which assumes that all income is eventually consumed by households. If this is not the case, then income will represent a broader tax base and a better indicator of ability to pay than consumption.
Hence, we do not make the commonly adopted small country assumption.
As discussed in Perraudin and Pujol (1990a), allowing for imperfectly elastic supplies of savings and demand for exports from the rest of the world may radically alter the traditional ranking of different tax bases from the point of view of their impact on economic welfare. For example, substituting distortionary VAT for a lump-sum tax may raise domestic welfare by improving the terms of trade.
As argued by Keen (1987), since deadweight losses depend on the square of tax rates, one would expect a Pareto improvement from a harmonization of EC rates to the average compensated by lump-sum transfers at an international level.
Differences in excise duties across different EC member states are in many instances larger than those in VAT rates. In this study, however, we focus attention only on appropriate levels for VAT rates, since excise duties are largely determined on public health rather than strictly economic grounds.
The following discussion of VAT harmonization and its effects on the French economy owes much to the detailed study by Boiteux (1988).
This broadly follows the provisions of the General Agreement on Tariffs and Trade relating to commodity taxation.
Although a clearinghouse for tax revenues is required.
In France, 30 percent of VAT receipts currently comes from the purchases of such organizations.
Some EC members might also have been worried by the intricacies of and the lack of control over the clearing system suggested by the Commission. Note again that the distortions referred to here concern tax-exempt firms.
Specifically, to increase expenditure on education and public wages.
Note that in our model, broadening the income tax base is equivalent to a reduction in lump-sum taxation.
The commonly adopted small country assumption under which interest rates and the prices of traded goods are exogenously given from abroad is a special case of this model.
Since households cannot adjust their levels of human capital through, for example, education, this analogy is of only partial relevance. It might be interesting in future work to allow for investment in human capital or, alternatively, to allow households to switch from one category to another.
Given average life expectancies in industrialized countries, each period of time in the model is regarded as representing approximately five years.
Since retirement payments are contingent upon withdrawal from the labor market, the shadow cost of leisure may be expected to fall dramatically, leading to a sharp drop in the participation rate.
Compared with those of the rich.
Capital is, in fact, a composite good made up of fixed shares of domestic and imported goods.
When this condition holds, the level of production is determined by demand, and any change in the real price of one input must be offset by an opposite change in the real price in the other input.
One may justify the latter assumption by saying that an overestimated fiscal rate (d′ > d) offsets the distortions due to the nominal tax regime prevailing in the French system.
See De Melo and Robinson (1989) for a careful examination of the treatment of the external sector in general equilibrium models.
Note that under our assumptions, a withholding tax is levied on foreign bondholders, which is not affected by changes in the income tax.
Recall that the model is formulated so that one period is equivalent to five years. Given that the tax changes will mostly take effect in the period 1990 to 1995, it seemed reasonable to take 1985 as the base.
What is actually held constant by adjusting labor income taxes in the simulations is the level of the government debt.
The proportion of households paying income tax slightly exceeds one half.
Such a general description of the Ramsey rule ignores the influence of cross elasticities between goods.
Estimating the true” level of government debt is far from easy, given the existence of offsetting items on the government’s balance sheet, such as public corporations and share holdings.
In the baseline simulation, these elasticities were set, respectively, to 5 and −1.
Strictly speaking, the real exchange rate is not fixed, since changes could in general take place in the relative price of tradables and nontradables. However, in this case, such price adjustments do not occur since the production functions in the two sectors are identical. This means that if firms in sector 1 are on their factor price frontiers, so also are firms in sector 3. This explains why the exchange rate does not change in the simulations reported in Table 5.
Interested readers may find a more detailed analysis of this result in Perraudin and Pujol (1990a).
And may easily be shown numerically.
In the model simulations, we assume that only poor households face such liquidity constraints. The utility maximization problem of rich households is the same as that described here, except that the Lagrange multipliers for the borrowing constraints are identically zero.
This will not, in general, equal that of households.
In this calculation, we implicitly ignore the potential nonlinearity resulting from different tax treatment of negative profits.