Working Paper: CEPR ID: DP7232
Authors: Gianluca Benigno; Bianca De Paoli
Abstract: This paper analyses the international dimension of fiscal policy using a small open economy framework in which the government finances its spending by levying distortionary taxation and issuing non-state-contingent debt. The main finding of the paper is that, once the open economy aspect of the policy problem is considered, it is not optimal to smooth taxes following idiosyncratic shocks. Even when prices are flexible and inflation can costlessly act as a shock absorber to restore fiscal equilibrium, the presence of a terms of trade externality lead to movements in the tax rate. Also in contrast with the closed economy, the introduction of sticky prices, can reduce the optimal volatility of taxes.
Keywords: Fiscal Policy; Optimal Policy; Small Open Economy
JEL Codes: E62; E63; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| terms of trade externality (F14) | distortionary taxes (H31) |
| distortionary taxes (H31) | welfare (I38) |
| idiosyncratic shocks (D89) | distortionary taxes (H31) |
| sticky prices (D41) | optimal volatility of taxes (H21) |
| inflation (E31) | shock absorber (Y60) |
| optimal policy (C61) | price stability (E31) |
| optimal policy (C61) | distortionary taxes (H31) |