International Effects of Tax Reforms

This paper highlights the significance of open-economy considerations in the analysis of tax reforms. It focuses on domestic and international consequences of revenue-neutral conversions between income and value-added tax systems. The principal conclusion of this investigation is that the direction of changes in the world rate of interest, the domestic tax-adjusted rate of interest, domestic and foreign investment, growth rates of consumption, and other key macroeconomic variables consequent on revenue-neutral tax reforms depend on whether the country adopting the tax reform runs a surplus or a deficit in the current account of its balance of payments. For example, a conversion from an income to a value-added tax system lowers the world rate of interest if the country adopting the reform runs a surplus in the current account of its balance of payments, but raises the world rate of interest if its current account is in a deficit. The paper also examines the implications of such reforms in the presence of direct foreign investment and considers alternative specifications of tax treatments, one based on the source of income, and the other on the country of residence of the taxpayer. It demonstrates the robustness of the key propositions to these alternatives.