Fiscal Policy Reforms in a Global Economy

Two countries are populated by workers and capitalists. Their governments collect taxes to finance productive expenditure and income redistribution. The share of income redistributed defines the size of the welfare state. Although both groups benefit from an abolition of the welfare state in the long run, the optimal fiscal policy in autarky can be characterized by maintaining a large welfare state since transfer cuts would induce transitional losses. Starting in such a position of policy inertia free trade and capital mobility is introduced. Fiscal policy competition leads to a reduction of tax rates and a relative increase of productive expenditure. If both countries coordinate their fiscal policy the reduction of taxes and income transfers is less pronounced. Quantitative effects of increasing globalization are assessed in a calibrated model for an average Europe G-4 country and the United States. Copyright Kluwer Academic Publishers 2002