Saving Europe?: The Unpleasant Arithmetic of Fiscal Austerity in Integrated Economies

62 Pages Posted: 26 Sep 2014

See all articles by Enrique G. Mendoza

Enrique G. Mendoza

University of Pennsylvania; National Bureau of Economic Research (NBER)

Linda L. Tesar

University of Michigan at Ann Arbor - Department of Economics; National Bureau of Economic Research (NBER)

Jing Zhang

University of Michigan at Ann Arbor

Multiple version iconThere are 2 versions of this paper

Date Written: June 2014

Abstract

What are the macroeconomic effects of tax adjustments in response to large public debt shocks in highly integrated economies? The answer from standard closed-economy models is deceptive, because they underestimate the elasticity of capital tax revenues and ignore cross-country spillovers of tax changes. Instead, we examine this issue using a two-country model that matches the observed elasticity of the capital tax base by introducing endogenous capacity utilization and a partial depreciation allowance. Tax hikes have adverse effects on macro aggregates and welfare, and trigger strong cross-country externalities. Quantitative analysis calibrated to European data shows that unilateral capital tax increases cannot restore fiscal solvency, because the dynamic Laffer curve peaks below the required revenue increase. Unilateral labor tax hikes can do it, but have negative output and welfare effects at home and raise welfare and output abroad. Large spillovers also imply that unilateral capital tax hikes are much less costly under autarky than under free trade. Allowing for one-shot Nash tax competition, the model predicts a "race to the bottom" in capital taxes and higher labor taxes. The cooperative equilibrium is preferable, but capital (labor) taxes are still lower (higher) than initially. Moreover, autarky can produce higher welfare than both Nash and Cooperative equilibria.

Suggested Citation

Mendoza, Enrique G. and Tesar, Linda L. and Zhang, Jing, Saving Europe?: The Unpleasant Arithmetic of Fiscal Austerity in Integrated Economies (June 2014). NBER Working Paper No. w20200. Available at SSRN: https://ssrn.com/abstract=2501826

Enrique G. Mendoza (Contact Author)

University of Pennsylvania ( email )

Philadelphia, PA 19104
United States

HOME PAGE: http://www.sas.upenn.edu/~egme/index.html

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
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Linda L. Tesar

University of Michigan at Ann Arbor - Department of Economics ( email )

611 Tappan Street
Ann Arbor, MI 48109-1220
United States
734-763-2254 (Phone)
734-764-2769 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Jing Zhang

University of Michigan at Ann Arbor ( email )

500 S. State Street
Ann Arbor, MI 48109
United States

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