Working Paper: NBER ID: w2080
Authors: Jacob A. Frenkel; Assaf Razin
Abstract: This paper deals with the international effects of budget deficits arising from distortionary tax and transfer policies. The analysis demonstrates that the consequences of tax policies and the characteristics of the international transmission mechanism depend critically on the precise composition of taxes. Specifically, the international effects of budget deficits of a given size differ sharply according to the types of taxes used to generate the deficit. We show that in determining the effects of taxes it is useful to divide the various distortionary taxes into two groups: those that stimulate current external borrowing (national dissaving) and those that stimulate current external lending (national saving). A pro-borrowing tax policy raises the world rate of interest while a pro-lending tax policy lowers it. The resulting change in the rate of interest is the channel through which the effects of budget deficits are transmitted to the rest of the world. The key propositions are illustrated by a series of examples involving consumption taxes (VAT), taxes on income of labor and capital and taxes on international borrowing.
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Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| probrowing tax policy (H29) | world rate of interest (E43) |
| prolending tax policy (H81) | world rate of interest (E43) |
| world rate of interest (E43) | national saving and dissaving behaviors (D14) |
| budget deficit from consumption taxes (H69) | external borrowing and lending (F34) |
| budget deficit from capital income taxes (H69) | external borrowing and lending (F34) |
| budget deficit from taxes on international borrowing (H69) | external borrowing and lending (F34) |
| cut in consumption taxes (H29) | current consumption (E20) |
| cut in consumption taxes (H29) | future consumption growth rates (E21) |
| budget deficit from cut in capital income taxes (H69) | domestic investment (E22) |
| budget deficit from cut in capital income taxes (H69) | foreign investment (F21) |
| budget deficit from cut in taxes on international borrowing (H69) | domestic investment (E22) |
| budget deficit from cut in taxes on international borrowing (H69) | foreign investment (F21) |