Tax Reform in Two-Sector General Equilibrium

Abstract:     
We use a two-sector open economy model with an imperfectly competitive non traded sector to investigate the dynamic and steady-state effects of three tax reforms: [i] two revenue-neutral tax reforms shifting the tax burden from labor to consumption taxes and [ii] one labor tax reform keeping the marginal tax wedge constant. Regardless of its form, a tax restructuring crowds - in consumption and investment and raises employment. While tax multipliers for overall output are always positive, their size depends on the type of the tax reform and the financing scheme. Interestingly, the trade balance plays a key role in determining the relative size of sectoral tax multipliers: whereas the long-term tax multiplier is always slightly higher in the traded sector than in the non traded sector, this result is reversed in the short-term. Finally, time horizon matters in determining the relationships between both overall and sectoral tax multipliers and labor responsiveness.

Keywords: Non Traded Goods, Investment, Employment, Tax Multiplier

JEL Classification: F41, E62, E22, F32

working papers series