hero working papers

Tax Cuts in Open Economies

Number: 332
Year: 2008
Author(s): Alejandro Cuat, Szabolcs Dek and Marco Maffezzoli
A reduction in income tax rates generates substantial dynamic responses within the frame-
work of the standard neoclassical growth model. The short-run revenue loss after an in-
come tax cut is partly -- or, depending on parameter values, even completely -- offset
by growth in the long-run, due to the resulting incentives to further accumulate capital.
We study how the dynamic response of government revenue to a tax cut changes if we
allow a Ramsey economy to engage in international trade: the open economy's ability to
reallocate resources between labor-intensive and capital-intensive industries reduces the
negative effect of factor accumulation on factor returns, thus encouraging the economy to
accumulate more than it would do under autarky. We explore the quantitative implica-
tions of this intuition for the US in terms of two issues recently treated in the literature:
dynamic scoring and the Laffer curve. Our results demonstrate that international trade
enhances the response of government revenue to tax cuts by a relevant amount. In our
benchmark calibration, a reduction in the capital-income tax rate has virtually no effect
on government revenue in steady state.

Keywords: international trade, Heckscher-Ohlin, dynamic macroeconomics, taxation, revenue estimation, Laffer Curve
JEL codes: E13, E60, F11, F43, H20