Welfare effects of tax policy in open economies: Stabilization and cooperation

This paper studies welfare implications of a simple operational tax policy (under which tax rates respond to changes in productivity) by employing an open-economy dynamic stochastic general equilibrium model with incomplete asset markets. We investigate the possibility of welfare-improving tax policies on factor incomes and consumption. Simulation results show that, in the closed economy, optimal tax policies are countercyclical since such policies would stabilize the economy by increasing the tax rates in a boom. However, in the open economy, optimal tax policies become less countercyclical and under certain cases can even become procyclical— in particular, for capital income tax. A two-country exercise suggests that tax policy cooperation on capital and labor income would yield only small welfare gains, while consumption tax policy cooperation would produce sizable welfare gains.