Welfare Effects of Tax Policy in Open Economies: Stabilization and Cooperation

Abstract

This paper studies optimal tax policy problem by employing a two-country dynamic general equilibrium model with incomplete asset markets. We investigate the possibility of welfare-improving active, contingent tax policies (under which tax rates respond to changes in productivity) on capital and labor income and consumption. Unlike the conventional wisdom regarding stabilization policies, procyclical factor-income tax policies in general improves welfare in open economies. Procyclical tax policies generate efficiency gains by correcting asset market incompleteness. Optimal tax policy under cooperative equilibrium is similar to that under the Nash equilibrium, and welfare gains from tax policy coordination is quite smalloptimal tax, procyclical, countercyclical, stabilization, cooperation