International VAT Harmonization: Macroeconomic Effects

International VAT Harmonization

Macroeconomic Effects

JACOB A. FRENKEL. ASSAF RAZIN. and STEYEN SYMANSKY*

Macroeconomic issues pertinent to the international and domestic effe cts of international VA T harmonization are highlighted, and VA T harmoniza tion policies envisaged for Europe in 1992 are outlined. An intertemporal model is developed to analyze the incentive effects of various tax policies and their welfare implications. Dynamic simulations reveal that the macroeconomic and welfare implications of VA T harmonization depend critically on the tax system and the degree of substitution governing tempo ral and intertemporal allocations of savings, investment, and tabor. The simulations also reveal a potential for significant conflictsof interest within each country and between countries. [JEL E2, E6, F4]

COORDINATION of fiscal policy in general, and tax policy in partic ular,HE poses a major challenge in the move toward the single market Tin Europe slated for 1992. With the growing integration of markets for

• Jacob A. Frenkel, Governor of the Bank of Israel, is also Professor of Economics at Tel Aviv University and a Research Associate of the National Bureau of Economic Research. He was Economic Counsellor and Director of the Research Department when this paper was written. He is a graduate of Hebrew University and the University of Chicago. Assaf Razin, Daniel and Grace Ross Professor of International Economics at Tel Aviv University and a Research Associate of the National Bureau of Eco nomic Research, is a graduate of the Hebrew University and the University of Chicago. He was a Visiting Scholar in the Research Department when this paper was written. Steven Symansky is Deputy Division Chief of the External Adjustment Divi sion of the Research Department. He is a graduate of the University of Wisconsin. The authors are grateful to A. Lans Bovenberg, David Bradford, Martin Fe ldstein, Peter Isard, Bennett McCallum, and Pat Kehoe for useful discussions, and Ravina Malkani for research assistance. 789

©International Monetary Fund. Not for Redistribution 790 FRENKEL • RAZIN • SYMANSKY

goods and services within the European Community (EC), the harmo nization of value-added taxes (VAT) has become a central issue in the discussion of fiscal policy convergence. VAT harmonization is seen as a means of recouping some of the revenues that have been lost in cross-border arbitrage. Also, in countries with high tax rates, the industrial sectors have been agitating for lower tax rates, which could help restore competitiveness and maintain market shares. In addition, in parallel with the integration of the goods and services market, the growing integration of capital markets has made the tax base associated with internationally mobile capital highly elastic. All of these factors suggest that European economic integration may well entail a significant restructuring of tax systems. Motivated by this background, this paper provides a dynamic analysis of key macro economic issues pertinent to an understanding of the international and domestic effects of VAT harmonization. In Section I we outline the VAT harmonization policies envisaged for Europe of 1991. In Section II we present the basic tax model. It is a neoclassical model with a microeconomic foundation and is therefore suitable for an analysis of the incentive effects of various tax policies and their welfare implications. The model allows for a rich tax structure and contains a detailed specification of public and private sector behavior. The analytical framework employs the saving-investment approach to analyzing international economic interdependence. It thus emphasizes the effects of changes in the time profile of various taxes on the inter temporal allocations of savings, investment, and tabor. These dynamic effects are supplemented by the more conventional effects of the level of flat-rate taxes on the margins governing the choice between tabor and leisure (such as the negative effect of consumption and income taxes on tabor supply), the choice between consumption and saving (such as the negative double-taxation effect of income tax on saving), and the choice of investment plans (such as the negative effect of the corporate income tax on investment). Our formulation focuses on the roles played by the level and time profile of taxes on income (wage and capital income tax), investment and saving incentives (investment and savings tax credit), taxes on consumption (VAT), and on international borrowing. In Section Ill we apply the tax model of Section II to examine the effects of international VAT harmonization. Throughout the analysis, the tax restructuring is constrained by the requirement that government solvency is maintained. Accordingly, changes in VAT rates are accompa nied by compensatory changes in other taxes. The effects of VAT harmo nization are illustrated by means of dynamic simulations. The simutations reveal that the effects of these tax changes on domestic and foreign levels

©International Monetary Fund. Not for Redistribution INTERNATIONAL VAT HARMONIZATION 791 of output, employment, investment. consumption, and other key macroeconomic variables depend critically on the degree of substitution governing temporal and intertemporal allocations, as well as on the tax system. Furthermore, it is shown that these characteristics of the eco nomic system also govern the precise welfare implications of VAT harmo nization. We show that VAT harmonization policy may generate signif icant conflicts of interest within each country as well as between countries. In Section IV we analyze the dynamic mechanism associated with changes in the time profile of taxes. Since VAT harmonization involves changes in the composition of taxes, we examine the dynamic conse quences of revenue-neutral tax conversions between income and con sumption (VAT) tax systems undertaken by a single country. The rev enue-neutrality requirement is motivated by inflationary fears or debt aversion. Reflecting our emphasis on the saving-investment balance, we demonstrate analytically that the effects of such changes in the composi tion of taxes depend critically on international differences in saving and investment propensities, which in turn govern the time profile of the current account of the balance of payments. These issues are examined by means of dynamic simulations in Section V, in which the role of current imbalances in global tax restructuring is analyzed. Concluding remarks are contained in Section Vl.

I. VAT Harmonization: Europe 1992

The VAT harmonization policies envisaged for 1992 have long been an important component of the wide-ranging measures associated with the move toward the single European market. The process of harmonization started with the First Council Directive of April 1967 and has continued through various succeeding directives. The process has involved the adoption of VAT and the continuous convergence of rates and structures among members of the Community. Over the years, the Commission of the EC has drawn up various proposals for the approximation of VAT rates and the harmonization of its structure. Much of the discussion on the practical implementation of the approximation of VAT rates has concerned the position and width of bands within which various VAT rates should be placed, the products to which a reduced rate would be applicable, and the problem of zero-rated products.1 1 Zero-rated products involve the reimbursement oftaxes levied on inputs, with the result that the final good is completely untaxed.

©International Monetary Fund. Not for Redistribution 1. VA T Rates in the European Community -..1 Table \0 (In percent) N Revenue Contribution ( 1990) Statutory Rates Percentage of total Percentage of Country• Reduced rate Standard rate Higher rate tax revenue (1987) GDP (1987) Belgium (1971) 1.0, 6.0, 7.0 19.0 25.0, 33.0 16.3 7.2 Denmark (1967) 0.0 22.0 26.9 9.8 (1968) 5.5, 7.0 18.6 25.0 20.0 8.7 France ., Germany (1968) 7.0 14.0b 13.1 3.8 ;:o rn (1987) 3.0, 6.0 16.0 36.0 20.9 7.8 z Greece rn;<; Ireland (1972) 0.0, 2.2, 10.0 23.0 18.9 8.0 Italy (1973) 2.0, 9.0 18.0 38.0 13.1 4.7 r (1970) 3.0, 6.0 12.0 13.3 6.0 ;:o Luxembourg >- Netherlands (1969) 6.0 18.5 15.2 7.9 N z Portugal (1986) 8.0 17.0 30.0 18.8 7.7 . V> Spain (1986) 6.0 12.0 33.0 16.0 5.3 -< United Kingdom (1973) 0.0 17S 16.3 6.0 3:: >- z Memorandum items: V> ;<; EC Commission proposal -< A 4.0 to 9.0 14.0 to 20.0 abolished B 4.0 to 9.0 15 minimum abolished (1987, 2.1); European Economy 1988, 3.5.1); Sources: Cnossen and Shoup Table (March Table Commission of the European Community, "The Evolution of VAT Rates Applicable in the Member States of the Community," Inter-tax (1987 /3), 85-88: International Bureau of Fiscal Documentation, Tax News Service (various issues); International Monetary Fund (1989):pp. and Organization for Economic Cooperation and Development ( 1989). "Year of VAT introduction in parentheses. bThe rate will increase to 15 percent in 1993.

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For 1992 the Commission initially proposed a standard VAT rate ranging between 14 percent and 20 percent, and a reduced rate (applied to selected categories, such as foodstuffs) ranging between 4 percent and 9 percent. 2 The Cornmission also wanted to abolish the higher rate that presently exists in some member countries on certain categories of goods. In subsequent discussions, an aJternative proposal was considered, ac cording to which the standard rate band would be replaced by a minimum rate, applicable from January 1. 1993. Each member state would choose a rate at least equal to the minimum rate, with due regard to the bud getary implications and to the "competitive pressures'· arising from the rates chosen by other neighboring states and main trading partners.3 Table 1 provides summary information on VAT in the EC and illustrates the disparities in VAT rates among the various member countries.4 A key issue in the deliberations is the specification of the VAT: should it be destination based (as is traditionally the case in Europe) or source based? The removal of fiscal frontiers through the abolishment of border controls could complicate the administration of a destination-based VAT, which requires levying the VAT on imports and rebating the VAT on exports. These administrative difficulties can be overcome, however, through such methods as those used for cross-border transactions among the Benelux countries since 1969 as well as between Ireland and the United Kingdom until 1984. The key feature of these methods involves computing border tax adjustment from books of accounts verified through written records (in the absence of border controls). An alter native method to protect the tax revenue of the country of destination is the establishment of a clearance mechanism among the various tax authorities. 5 In the next section we develop a tax model that will be used to assess the global implications of the move toward VAT harmonization. Al though the future system is envisaged to be source based, the Commis-

2 Until the end of 199'2 the only permissible changes in the standard rates must be within the 14-20 percent range, or, if the rate lies outside the range, only changes toward the range are allowed. The final agreement on the rate structure is planned to be reached by the end of 1991. 3Currently, the EC countries apply the destination principle to their VAT systems; that is, they exempt exports and tax imports. But due to direct consumer purchases (which were not reimbursed by a VAT system), the competitive base of firms may have been eroded in high-tax countries (see Frenkel, Razin, and Sadka (1991)). 4 For a broad survey of international practice and problems related to VAT, see Tait (1988) and Frenkel, Razin, and Sadka (1991).

5 Such a proposal is still under review by the Commission. For a further examination of the various proposals and considerations, see Cnossen and Shoup (1987).

©International Monetary Fund. Not for Redistribution 794 FRENKEL • RAZIN • SYMANSKY sion proposed in May 1990 (following the guidelines set by the Council of Economic and Finance Ministers in 1989) to maintain the present destination principle until January 1997. We will therefore specify the tax system as being destination based throughout. Our analysis. neverthe less, can also be used to shed light on the implications of harmonization with a source-based VAT system.

11. The Tax Model

We start with a formulation of the budget constraint.6 As usual, the budget constraint serves to focus attention on key economic variables and tax policy parameters that play a central role in the analysis. The home country's private sector (full-income) budget constraint applicable to , T- period t (t = 0, 1, . .. l) is (1 (1 - . ) + ,.(t)C, + ,.�, w(l - 1,) (1 )w (1 - )[h - 9)K,] = - ,.�, + ,.k, 1 t) - (1 - 'rfr )l,( + % i,)+ (8� - 8�- - (1 - 1'kr)(1+ 'rst)r, - 1 (1) B�- L• where 're, . ,.�,, and ,.k, denote the tax rates on consumption (VAT), tabor income, and capital income, respectively; all taxes are residence based.

The terms, ,.11 and ,..,, denote investment tax credit and saving tax credit, respectively. Levels of consumption. tabor supply, capital stock, invest ment, and international borrowing by the private sector are denoted, respectively, by C, /, K, I,, and a;. The wage rate, the capital-rental rate, and the interest rate are denoted, respectively, by w, rk > and r,; and e denotes the rate of depreciation. For convenience, we normalize the endowment of leisure to unity and assume costs of adjustment in capital formation of the form G)bl;IK,. We note that in the final period (period T) the private sector settles its debt commitments and no new investment

6The analytical framework underlying the international intertemporal ap proach to open economy macroeconomics is based on Frenkel and Razin {1987. 1988b). A fuller analysis of international taxation is contained in Frenkel, Razin, and Sadka {1991). For an analo�ous approach developed in a closed economy context, see Auerbach and Kothkoff ( 1987); for an analogous approach devel oped in the context of a two-country world economy, see Bovenberg and Goulder (1989); and for an extension to a model with borrowing constraints, see Perraudin and Pujol (1991). For a discussion of supply-side policies, see Tanzi and Boven berg (1989). In the present formulation capital markets are assumed to be inte grated through free access to credit markets; in Appendix II we consider taxes on international borrowing. To simplify, we exclude direct foreign investment. which is analyzed in Frenkel and Razin (1989).

©International Monetary Fund. Not for Redistribution INTERNATIONAL VAT HARMONIZATION 795 or new borrowing occurs. so that lr = B: = 0.7 To sum up. the left-hand side of equation (1) represents the value of consumption of ordinary goods and leisure; the right-hand side represents the value of labor endowment, capital income (net of investment). and new borrowing (net of debt service). All of these quantities are evaluated at the after-tax prices. To simplify the exposition, we assume a linear production function with fixed coefficients. Thus, the competitive equilibrium conditions imply that the wage rate and the capital-rental rates, w and '*' are constant. The periodic (full-income) budget constraints specified in equation l) can be consolidated to yield the lifetime present-value budget constraint( governing the decisions of the private sector. To facilitate the diagram matic analysis that follows. we illustrate the lifetime present-value budget constraint for a two-period case (t = 0, 1). Accordingly = ::: [w/o +

+ 1 Tt>J + + Ts1),J} Ko - (� =:: :)(1 1 + + T,o r { (1 Tko)(l ) -'}BP (2) _ -1 + Tro -I• where

7 Our fo rmulation reflects the assumption that except for the final period, bolted capital cannot be consumed. However, in the final period, the capital stock, Kr. can be transformed into consumption at a rate equal to aKr, where 0 s.a This assumption serves to mitigate abrupt changes in the behavior of s. L n y the economy arising in the final period of the finite horizon model. Accordi gl the budget constraint applicable to the final period (period T) is analogous to the, one shown in equation ( 1), with an added term on the rght-hand side equal to aKr. For a formulation of a model highlighting the interactioni between mvest ment, government spending policies, and international interdependence within an infinite-horizon model, see Buiter (1987) and Frenkel and Razin (1987).

©International Monetary Fund. Not for Redistribution 796 FRENKEL • RAZIN • SYMANSKY and

I - 'T�� -vu = --- . 1 + 'TC()

As indicated, a,, cx.L, and a1, are the effective (tax-adjusted) discount factors governing intertemporal consumption, leisure, and investment decisions, respectively.8 The inrratemporal choice between labor supply (leisure) and consumption of ordinary goods is governed by the prevailing effective intratemporaJ tax ratio, -y = (1 - 'T�,)/(1 + T,). The expressions in equation (2) show the key factors operating on the

various margins of substitution. The intratemporal tax ratio, -y, shows the conventional negative effect of labor income tax and consumption tax on

tabor supply. The effective discount factor governing consumption, a0 shows the conventiornalnegative effect of capital income tax, 'Tk (through double taxation), on saving. Likewise, the effective discount factor gov

erning investment, a1, shows the negative effects of capital income tax, 'Tk,on investment. In addition to these conventional channels, the expres sions in equation (2) highlight the dynamic channels of tax policies. Specifically, as can be seen, the effective discount factors depend on the time path of the various taxes.9 To understand the dynamic mechanisms underlying the effective dis count factors, it is useful to define a benchmark case in which the double taxation of savings is eliminated. Thus, the tax incentive rates on savings and investment are equalized and the common rate is equal to the capital income tax. Accordingly, these equalities imply that = = /(1 'Tk 'T1 'T, + 'T, ). Such a configuration of taxes yields the cash flow income tax system.10 lt is noteworthy that the cash flow income tax system is equivalent to a VAT system that is source based. 11 We note that in this benchmark case 8 Obviously, with more than two periods, these discount factors are replaced by the appropriate present value factors.

9The expression for aL reveals an added dynamic effect, whereby a rise in the capital income tax 'Tk, induces intertemporal substitution toward future tabor supply. , 10The tax systems in many countries include incentives to saving and invest ment and, thereby, contain important features of the cash flow income tax system. Such a system was advocated recently for the United States by Feldstein (1989). For a recent comparative analysis of capital income tax systems in various industrialized countries, see Pechman (1988). 11 To verify this point, we note from equation (1) that, under a destination based VAT system, the tax rate, l - (1/(1 + t,)), applies to the value of GNP (net of investment) minus exports, plus imports; thus in effect, imports are taxed while export taxes are rebated. In contrast. the cash flow income tax applies only to GNP (net of investment); thus, in effect, imports are not taxed, while export taxes are not rebated. Hence, this system is equivalent to a source-based VAT system. We are indebted to Sijbren Cnossen for providing us with this interpretation of the relation among the various VAT systems. For a detailed analysis of interna tional taxation and tax equivalences, see also Frenkel, Razin, and Sadka (1991).

©International Monetary Fund. Not for Redistribution INTERNATIONAL VAT HARMONIZATION 797 the effective discount factor governing intertemporal consumption deci sions, a:c, is independent of the income tax, whereas the effective discount factor governing investment and leisure decisions, and are indepen a:1 a:L, dent of the consumption tax.12 Since with such a cash flow tax system, the effective discount factors depend only on the time path of the various taxes rather than on their levels, it follows that if the various tax rates do not vary over time, then the effective discount factors ar. aL, and a1 are equal to the undistorted tax-free factor, a = 1 /(1 +r0). In that case, in which the time paths of the various tax rates are "flat," the intertemporal allocations are undistorted. Of course, as indicated earlier, the intra temporal allocations are distorted if the intratemporal tax ratio, -y, differs from unity. We turn next to the specification of the utility function. To facilitate the simulation analysis in subsequent sections, we need to adopt a specific form of the multiperiod utility function. Accordingly, we assume that the intraperiod utility function between consumption of ordinary goods and leisure is u, (13C(O' - t)rr = + (1 - 13)(1 - l,)!a - IJ"]'*'- I) (3) while the interperiod utility function is

U0 = f>' log(u,), (4) t•OL where a- is the temporal elasticity of substitution between leisure and consumption of ordinary goods, 13 is the distributive parameter of con sumption, and f> is the subjective discount factor. This formulation im plies a unitary intertemporal elasticity of substitution. Maximizing the utility functions in equations (3) and (4), subject to the lifetime present-value budget constraint (the multiperiod analogue to equation (2)) yields the consumption function and the labor supply function. The formal solutions are presented in Appendix I, where it is shown that consumption demand and tabor supply depend on wealth, the path of the tax-adjusted rates of interest, and the intratemporal and intertemporal tax structure. The maximization of wealth yields the invest ment function. Appendix I also shows that, in addition to the conven tional technological characteristics, investment depends on the path of the tax-adjusted rates of interest. As is evident. in this model economic welfare as well as the key behav ioral relations (consumption, labor supply, investment, and output) are determined within a dynamic context. Accordingly, the paths of saving

1zThis latter property is more general and not confinedonly to the benchmark s ca e.

©International Monetary Fund. Not for Redistribution 798 FRENKEL • RAZIN • SYMANSKY and investment and, thereby, the current account of the balance of pay ments are also governed by dynamic considerations. In the present con text, the model highlights the central role played by the dynamics of the tax structure. These dynamics are reflected in the temporal and intertem poral substitutions captured by the various tax-adjusted discount factors. It follows, of course, that a proper evaluation of positive and normative implications of trends in savings, investment, and the current account cannot be complete without an assessment of the expected paths of taxes and the other economic variables influencing income and spending.13 The foregoing discussion focused on the various channels and margins of substitution through which taxes affect economic behavior. Such changes in economic behavior also influence economic welfare. The welfare implications depend, as always, on the distorted margins of substitution arising from the tax wedges, and on the elasticities of re sponse to the implied changes in incentives. The behavioral responses to changes in the tax wedges are shown in the consumption demand, labor supply, and investment in Appendix I. Our formulation in equation (2) shows that in addition to their effects on the margins of substitution, the various taxes also contain elements that resemble lump-sum taxes. These elements are found in the taxes that fall on inelastic tax bases. For example, the capital income and consumption tax rates, Tk and T,, are also applied (directly, and indirectly) to the value of initial assets, K0 and (BP_1), which are obviously inelastic tax bases. These elements of the tax structure are nondistortive. Our simulation analysis of the welfare impli cations of alternative tax instruments incorporates these attributes of the tax system.

m. Simulations of VAT Harmonization: Alternative Tax Systems

In this section we present dynamic simulations of the effects of inter national harmonization of VAT. We use our two-country model and presume that prior to VAT harmonization, the two countries were using very different tax systems. The home country's tax revenue comes from high income tax, and the foreign country's revenue comes from high

131n the present model, the tax structure affects the economic system by altering the inter- and intraperiod margins of substitution as well as by altering wealth. An additional mechanism would recognize that in the context of an overlapping-generations model, intertemporal offsetting shifts of tax revenue of equal present value may alter private sector behavior through changes in the inter&enerational wealth distribution. This mechanism is analyzed in Blancbard (1985) and Frenkel and Razin (1986, 1987).

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VAT. The harmonization of VAT entails a rise in the home country VAT rate and an equivalent reduction in the foreign rate. The narrowing of international disparities between VAT rates, captures the EC Commis sion's proposal of reducing the disparities in VAT rates among member countries and categories of goods. Furthermore, in order to maintain fiscal solvency, we assume (in the absence of changes in government spending) that changes in the VAT rates are accompanied in each country by opposite changes in income tax rates. In performing the simulations, we consider first a benchmark case in which saving and investment propensities do not differ internationally, � �* so that = and rk = rt. This assumption ensures that the current account position (that is, the saving-investment gap) is zero, and thereby, the tax restructuring in and of itself does not affect the world rate of interest. In subsequent sections, we depart from this benchmark case. We first computed a baseline equilibrium. This equilibrium was then disrupted by the assumed VAT harmonization. The various figures presented below show the effects of the tax restructuring measured as percentage deviations from the baseline levels. Throughout, the home country was assumed to raise its VAT by 6 percent and to restore fiscal solvency by a corresponding reduction of its income tax. We considered various tax systems: cash flow income tax, labor income tax, capital income tax, capital income tax combined with saving incentives, and capital income tax combined with investment incentives. The results of these simulations are shown in Figures 1-5 and are summarized in Ta ble 2, which also reports the implied welfare implications of the VAT harmonization. To capture the essence of the dynamic evolution of the various variables, we report in Ta ble 2 the direction of changes for both the short run (SR) and the medium run (MR). The multiplicity of mechanisms and channels operating on the various tax incentives results in a variety of configurations of the response of the other key economic variables as illustrated for the cases shown in Table 2. Of special interest are the welfare effects indicated by the utility index in the simulations. The welfare change is measured by the percent age factor by which the postharmonization path of consumption must be raised in order to bring utility up to the preharmonization level. The welfare consequences of tax policies can be decomposed into two compo nents: first, those arising from changes in excess burden; and second, those arising from terms of trade effects. The changes in the degree of excess burden induced by VAT harmonization depend on the elasticity of the tax base as well as on the magnitude of the existing distortion. In the cases illustrated by the simulations, we have chosen parameters that result in relatively low investment and labor supply elasticities, and a

©International Monetary Fund. Not for Redistribution 00 8

Figure 1 . VA T Harmonization with Cash Flow Income Tax Adjustments (Percentage deviations)

Home owpu1 Foreign ou1p111 Home im·es/mem (riglll scale) Home lab01 Foreign im·eslnt/'111 (riglu scale) Foreign lahor Home sm•iltf: ra1io Home consump11011 Foreign sm·ing ra1io Foreign constunplion Home ewemal deb1 r(J(io (riglll scale) 1.0 16 ..------,2

·············· · · · ·· · ········· ······· ·········· ······ ···· · · · ·· ·· · 8 0.5 _ ...- . ------:= : __ = = =----"""' --:---- ��--c=: : : 0.0 1---=-::-::>""-o::..:;.__;;;;::::,-"""==�-----1 0 0

-0.5 - - -1 -.--·--.- . -0--·- -8

-1.0 L-L-L-..1...-L-..I...-L-L-L-L-L-L-..1...-..1...-L-L-� -2 �L-L-L-L-��L-�16 0 2 4 6 8 10 12 14 16 17 0 2 6 8 10 12 14 16 17

Note: Assuming a permanent increase of 6 percent in home country VAT and a permanent reduction of 6 percent in foreign country VAT.

©International Monetary Fund. Not for Redistribution Figure 2. VA T Harmonization with Wage Tax Adjustmems (Percentage deviations)

Homeourptll Forei!lll owptll Homr 111\'esmtelll (rig/u.�ca/e) � Home /ahm Forei!:ll im·e.wmenr lriglu smle/ :;o Forl'i!lll /ahor 1/ome sal'ing rorio z Home cnll,\ltiii(JII0/1 Foreign .WI'ill!l rorio � Foreif.(II I'0/1.\IIIII[JIWn 1/ome ('XIema/ dehr rario ln�:ltt .Kale/ z0 20 > 5.0 .------. 2 r . · · · ·········· ······ · · . . , . . . . 2.5 . .. . 10 � ...... J: . . > 0 0 , 0 . ------��----��c::--- :_ · :. - ::::� 0 - 3: - - - - - ... 0 -2.5 ------I ... - - - - 3 . N ...... - ·- � - .0 - -2 L-.IL...-L...... JL...-L.....JL...... JL...... JL...... JL...... I---J'---IL...... I---I.-.L-.L--L�-20 5 L--.L-.L-.J....__..I.-...1-.J....__...l--L--''--'.r_ ·.;;;!.;."'1.'==- · J...'--�...-· -_·J...... __.__, 0 0 2 6 8 10 12 14 16 17 0 2 4 6 8 10 12 14 16 17 z

Note: Assuming a permanent increase of 6 percent in home country VAT and a permanent reduction of 6 percent in foreign country VAT.

00 0 ......

©International Monetary Fund. Not for Redistribution Figure 3. VA T Harmonization with Capita/ Income Tax Adjustments (Percentage deviations)

Home outpw Foreign outpLII Home inl'esrmem (riglu sea/e) Home labor Foreign im•estmem (right.scall') Foreign lahor Home s01·ing ratio ., :0 Home consumption Forl'i�n savinfi ratw [T1 Foreign consumption Home I'.Xtema/ dt•IJt ratio (right scale z I ;>: 10 10 30 [T1 ,------� r ······ :0 . ···· ······ 20 .. · ·········· )> 5 ... 5 ··· N -- 10 z 0 0 - - - - · · -10 . - 5 - - -5 ------20 - - - - ·· � - lo ��-�· r�· · -10 -30 0 2 4 6 8 10 12 1.\ 16 17 0 2 4 6 8 10 14 16 12 17

Note: Assuming a permanent increase of 6 percent in home country VAT and a permanent reduction of 6 percent in foreign country VAT.

©International Monetary Fund. Not for Redistribution Figure 4. VA T Harmonization with Capital Income Tax and Saving Incentive Adjustments (Percentage deviations)

Homeowpw Foreign owput Home 111\'eStment (nght smle) Home labor Foreign im•estment (right scale) Foreign labor Home so1•ing ratio Home consumption Forei!(n sal'lll!! ratio Foreign consumpurJtl Home extrmol drbt ratio (right scale)

5.0 .------.10 30

20 2.5 5 10

0 0 0 ... . _ _ \ ·--. _ _ -10 \ ·-- . _

-2.5 ...... _ -5 - - - - \------� = = ·----� = = �- -� - -20 - - - �---'��__._�__.___.__.__._��1.-..J��--- -5.0 -- -10 - -30 0 2 4 6 8 10 12 14 16 17 0 2 4 6 8 10 12 14 16 17 '--1.-.JL...... JL...... l---l--L--L--L--'---'--'---'---'--'---'--...L...... I

Note: Assuming a permanent increase of 6 percent in home country VAT and a permanent reduction of 6 percent in foreign country VAT.

00 0 w

©International Monetary Fund. Not for Redistribution Figure 5. VA T Harmonization with Capital Income Tax and Jnvesunelll lncemive Adju.mnents (Percentage deviations)

Hvmeourpur Foreign outpur Home im·estmel/l (right \Ca/e) Honw labor Fore1gn inn.'stmel/1 (nglu scale I Foreign labor Home SUI•ing rmiv Home nmsumption Foreign sm•ing rmio Foreign consumption Home extemal debt rario (nf.!ht sm/e) 14 r------� 66 12 .-· -·- -·

...

0 2 6 10 12 14 16 17

Note: Assuming a permanent increase of 6 percent in home country VAT and a permanent reduction of 6 percent in foreign country VAT.

©International Monetary Fund. Not for Redistribution Table 2. Effects of VA T Harmonization Under Altemative Tax Systems (Deviations from baseline) Capital Income Capital Income Cash Flow Tax and Tax and Income Labor Income Capital Income Saving Investment Tax Tax Tax Incentives Incentives Variable SR MR SR MR SR MR SR MR SR MR z r 0 0 0 0 0 0 0 0 0 0 [TI-l I 0 0 + + + + z;;::1 J• + + 0 0 + + � 0 L + + + + + + z L• + + + + r;J> y + + + + + < ... � r + + + + :I: c + + + + ;J> C* + + + + + :s:;;::1 + z0 s + + + + + + N s• + + + + � 8 + + + z0 - u 0.3 -7.8 0.0 12 . 5 1.4 -7.0 1.2 -3.0 1.0 -7.8

u· -0.3 8.7 0.1 14.6 -1.0 7.3 -0.8 2.2 -0.8 8.4

Note: The VAT harmonization occurs through a permanent rise of 6 percent in T, and a corresponding fall in T:. Budgetary balance obtains through appropriate adjustments in the periodic rates of cash flow, labor income, and capital income taxes (with and without saving incent1ves). The technology and preference parameters of the two countries are assumed to be e�ual (so that the current account position is balanced). SR and MR are definedas short run and medium run, respectively. The we fare change 00 is measured by the percenta e factor by which the postharmonization consumption path must be raised in order to bring utility 0 up to the preharmonization fcevel. For the utility index, the SR pertains to the discounted sum of utilities over the entire period Vl except the final one; MR pertains to the final-period utility (reflecting the entire period beyond the simulation period). ©International Monetary Fund. Not for Redistribution 806 FRENKEL • RAZIN • SYMANSKY relatively high consumption elasticity.14 This choice suggests that in the case considered, the excess burden associated with a consumption tax is relatively high in comparison with the corresponding excess burden associated with an income tax. The assumption that saving and investment propensities do not differ internationally implies that the initial current account positions are bal anced. As a result. the international VAT harmonization does not alter the world rate of interest. The dynamjcs of adjustment in this case arise only from the effects of the tax wedges on the various incentives. In summarizing the results presented in Figures 1-5 and Table 2, we first note that with a labor income tax system, the VAT harmonization does not induce any change in the time path of domestic and foreign investment. Second, whenever the income tax system contains an investment incen tive component, its effect on the paths of investment is dominant. Indeed, under the cash flow income tax system (which obviously contains an investment incentive component) and under a capital income tax system combined with investment incentives, the path of domestic investment consequent on the reduced income tax is lowered for both the short and the medium runs. The opposite occurs in the foreign country. This pattern is reversed under the income tax systems that do not contain incentives to investment. Third, and analogous with the foregoing reasoning, whenever the income tax system contains a saving incentive component (such as the individual retirement account (IRA) system in the United States, which eliminates the double taxation of savings), its effect dominates the changes in consumption. Thus, under the cash flow income tax system and under a capital income tax system combined with saving incentives, the path of domestic consumption consequent on the VAT harmonization is lowered for both the short and the medium runs. The opposite occurs in the foreign country. This pattern is reversed under the tabor tax system. Fo urth, whenever, the income tax system contains a tax on tabor income, changes in that tax dominate the effect of the VAT harmoniza tion on employment. Thus, under both the cash flow and the tabor income tax systems, the path of domestic employment consequent on the

1 0.3; 4The intertemporal labor supply elasticity, indicated by 0', is the coeffi cient of cost of adjustment for investment. indicated by b, is 40; and the inter temporal elasticity of substitution for consumption is unitary. In fact, in searching for the Ramsey (second-best) tax structure for the range of parameter values, we found that income tax is superior to VAT. To examine the sensitivity of the results with respect to the values of the elasticities, we also simulated the model with a lower cost of adjustment coefficient and a higher labor supply elasticity. Under these circumstances the welfare cost of VAT diminished relatively, while the welfare cost of income taxes increased relatively.

©International Monetary Fund. Not for Redistribution INTERNATIONAL VAT HARMONIZATION 807 reduced income tax is raised for both the short and the medium runs. The opposite occurs in the foreign country in which income taxes rise. Finally, by inspecting the figures, one may infer the effects of the VAT harmonization under alternative tax systems on the growth rates of domestic and foreign output and on the path of external debt. 15 Figures 1-5 and Table 2 reveal the potential international conflicts of interest that could arise with the implementation of VAT harmonization. Under all the tax systems considered, the changes in domestic and foreign employment, output, consumption, saving, and investment consequent on international VAT harmonization go in opposite directions from each other in both the short and the medium runs. The utility indices of economic welfare reflect the same phenomenon. In all cases, the domestic and foreign SR utility indices (given by the discounted sums of utilities over the entire period except for the final one) move in opposite directions. In general, the same holds for the MR utility indices, reflecting the future beyond the simulation period. Furthermore, in the cases considered the VAT harmonization results in a redistribution of welfare between generations, evidenced by the opposite direction of changes in the SR and MR utility indices within each country. The simulations show that the changes in the utility indices reflect, by and large, a redistribution of world welfare, since the sum of the domestic and foreign utility indices does not change appreciably. This result strength ens the suggestion that the resolution of international conflicts of interest arising from VAT harmonization may require a compensation mecha nism between gainers and losers.

IV. Tax Conversions: Revenue Neutrality and Current Account Imbalances In this section we focus on a reform that introduces a consumption tax (VAT) system instead of the prevailing income tax system, allowing for current account imbalances. 16 To simplify, we consider a two-period case 15The results of the consequences of VAT harmonization accompanied by compensatory adjustments of the cash flow income tax can shed light on the likely effects of transforming a VAT system that is destination based to a system that is source based (since the cash flow income tax is equivalent to the source-based VAT). Under the destination-based system, the cross-country location of produc tion of tradable goods is undistorted while that of consumption is distorted. The opposite outcome holds under the source-based system. See Frenkel, Razin, and Sadka (1991). 16This analysis is based on Frenkel and Razin (1989). In order to highlight the pure effects of tax conversions, we consider cases of revenue neutrality only. In the absence of revenue neutrality, the tax conversion results in periodic budgetary deficits and surpluses. The effects of such budgetary imbalances are analyzed in Frenkel and Razin (1988a), and dynamic simulations are presented in Frenkel, Razin, and Symansky (1990).

©International Monetary Fund. Not for Redistribution 808 FRENKEL • RAZIN • SYMANSKY with a cash flow tax system. With this system. the effective discount factors governing consumption. investment, and tabor supply decisions (indicated in equation (2)) become

- 1- 1 TkJ = TwJ ( ) ex/ = --- 'ex exL ex, 5 1 - TkO 1 - Tw

'7 The simulation analysis relaxes these assumptions by considering multiperiod simulations with a richer tax structure that allows for the various taxes and incentives specified in the previous section. 18We note that even though the effective tax-adjusted discount factors do not change followin the firstcomponent of the tax conversion, the intratem poral tax (g ratio, (1 - ,. w) / 1 - Tc ), ri ses. As a result, the supply of labor in each penod rises. 19 Mo e precisely, since under the cash flow formulation the income tax base is the levelr of output net of investment, and the VAT base is the level of consumption, the difference between the two tax bases is the primary current account-that is, the current account net of debt service.

©International Monetary Fund. Not for Redistribution INTERNATIONAL VAT HARMONIZATION 809 in surplus, so that the first component of the conversion to a VAT system narrows the tax base. We now apply the analysis to a two-country model of the world econ omy. We carry out the analysis with a simple diagrammatic apparatus that portrays the rates of growth of consumption and output (net of invest ment) as functions of the corresponding tax-adjusted discount factors. In Figure 6 the upward-sloping schedule, sw, describes the ratio of future to present world output net of investment as an increasing function of the discount factor. The positive slope reflects the fact that a rise in the discount factor (a fall in the rate of interest) raises current investment and induces substitution away from present-period labor supply toward a future-period labor supply. These changes raise the ratio of future-to present-period output net of investment. This world relative supply

Figure 6. Dynamic Effe cts of a Revenue-Neutral Tax Conversion from Income Taxes to VA T with an Initial-Period Domestic Currem Accoum Deficit

s Discount factors

s a' a = --I 1 +I()

Growth rates

©International Monetary Fund. Not for Redistribution 810 FRENKEL • RAZIN • SYMANSKY schedule is a weighted average of the corresponding domestic, S, and foreign, S*, relative supply schedules. The downward-sloping schedule, D"', shows the world desired ratio of future to current consumption as a decreasing function of the discount factor. This world relative demand is a weighted average of the two countries' relative demand schedules (not drawn). As shown in Figure 6, the initial equilibrium obtains at point A, at which the world rate of interest is r0. Suppose that the domestic economy runs a present-period current account deficit. Under such circumstances, the shift toward a VAT broad ens the tax base. To maintain revenue neutrality, the current income taxes, and ,. fall, while future income taxes, and ,. rise. As seen ,.kO ,.,o , ,.ki wh from equation (5), the new configuration of income tax rates lowers the effective djscount factors applicable to investment and tabor decisions, a1 and aL. However, since the intertemporaJ ratio of consumption taxes remains unchanged, the effective discount factor applicable to consump tion decisions, a" remains intact. The fall in the effective discount factors applicable to investment and tabor supply induces an intertemporal substitution in the domestic econ omy toward current-period output (net of investment). Thus, for each and every value of the world discount factor, the domestic relative supply schedule shifts to the left from S to S'. The proportional vertical displace ment of the schedule equals the proportional tax-induced fall in the effective discount factor. Associated with the new level of domestic relative supply, the new world relative supply schedule also shifts to the left from S"' to S"'' . Note that the proportional displacement of the world relative supply schedule is smaller than the corresponding displacement of the domestic relative supply schedule. The new equjlibrium obtains at the intersection of the (unchanged) world relative demand schedule, D"', and the new world relative supply schedule, S",.. This equilibri um is indicated by point A', at which the world discount factor has ri sen from a to o.'. To determine the incidence of this change on the domestic discount factors, we subtract the tax wedge from a' and obtain the new lower domestic effective discount factors, a/ and a{. Thus, on the one hand, by raising the world discount factor, this tax conversion reduces the rates of growth of domestic and foreign consumption and crowds in foreign investment. On the other hand, the induced fall in the domestic tax-adjusted discount factor governing investment and labor supply crowds out domestic investment, and the rate of growth of domestic employment falls. Using similar reasoning, it is evident that if the country adopting the tax reform has a present-period current account surplus, then the tax conversion to a VAT system narrows the present -period tax base and lowers tax revenue. Restoration of revenue neutrality necessitates in-

©International Monetary Fund. Not for Redistribution INTERNATIONAL VAT HARMONIZATION 811

tertemporal adjustments of income tax rates in directions opposite to 6. those depicted in Figure In that case, the world discount factor falls and the domestic tax-adjusted discount factors, cx1 and cxL, rise. The tax reform then increases the rates of growth of domestic and foreign consumption, crowds out foreign investment, and crowds in domestic investment.20

V. Simulations of VAT Harmonization: Current Account Imbalances

In what follows, we present dynamic simulations of the consequences of international harmonization of VAT in the presence of current account imbalances. We use our two-country model and, as in Section Ill, pre sume that prior to the VAT harmonization the two countries were using very different tax systems. Tax revenue in the home country comes from high income tax and from high VAT in the foreign country. The harmo nization of VAT entails a rise in the home country VAT rate and an equivalent reduction in the foreign VAT rate. Our analysis can be illuminated by the analytical results obtained in the previous section on tax conversions. In fact, our specification of VAT harmonization entails various tax conversions that take place simulta neously in all countries. To avoid the budgetary imbalances consequent on the changes in the VAT rates, we ensure revenue neutrality by adopt ing the same procedure used in the analysis of tax conversions in Sec tion IV. Accordingly, the induced budgetary imbalances are corrected through changes in income tax rates. In performing the simulations, as in Section Ill, we first computed a baseline equiHbrium. This equilibrium was then disrupted by the as sumed VAT harmonization. The various figures presented below show the effects of the tax restructuring measured as percentage deviations from the baseline levels. As indicated by the analysis in Section IV, one of the key factors governing the effects of revenue-neutral tax conversions is the time pattern of the current account position. Since these positions can be expressed in terms of the saving-investment gap, they reflect

20The foregoing analysis assumed that revenue neutrality obtains through appropriate changes in income taxes. lf, however, budgetary corrections obtain through changes in consumption tax rates, then the effective djscount factor governing investment and labor supply decisions would not change, while the effective ruscount factor 8overning consumption decisions would change the supply of labor (the direct1on of the change would depend in an obvious way on the initial current account position). In that case the domestic (and thereby the world) relative demand schedules in Figure 1 would shjft while the relative supply schedules would remain intact. For an analysis of such changes, see Frenkel and Razin (1989).

©International Monetary Fund. Not for Redistribution 812 FRENKEL • RAZIN • SYMANSKY intercountry differences either in saving propensities, induced, for exam ple, by differences between the subjective discount factors, 3 and 3*, or in investment patterns induced, for example, by differences between the productivities of capital, rk and r% . ln Figures 7-10 we plot the simulation results for cases distinguished according to the time pattern of current account imbalances. In these figures, we assume that the income tax used in both countries is of the cash flow variety. As before, we assume throughout that the home country permanently raises its VAT by 6 percent and restores its tax revenue by lowering its cash flow income tax rates; the foreign country (whose initial VAT rate is assumed to be high) permanently lowers its VAT by 6 percent and restores its tax revenue by raising its cash flow income tax rates. The figures show the paths of domestic and foreign output, labor supply, saving, investment, and consumption, as well as the paths of the world rate of interest and the home country's external debt consequent on the VAT harmonization. All paths are expressed as per centage deviations from the baseline (except for the rate of interest whose deviation is expressed in basis points). The simulations reveal that the international VAT harmonization triggers a dynamic response in all of the key macroeconomic variables. The specific nature of the dynamic response reflects international differences in the parameters governing saving and investment patterns. The key features of the simulation analysis of tax harmonization under lying Figures 7-10 are summarized in Table 3, which also reports the implied welfare implications of the VAT harmonization. In order to capture the essence of the dynamic evolution of the various variables, Table 3 shows the direction of changes for both the short run (SR) and the medium run (MR). In conformity with the tax conversion analysis of Section IV, the results in Table 3 demonstrate the key role played by the current account posi tion. Specifically, if in the early stage the home country runs a current account deficit due to low saving or high investment (for example, if 3 < 8*, or rk > r; ), then the paths of domestic and foreign income tax rates ri se over time, so as to maintain tax revenue. As a result, the world rate of interest falls. 21 In that case, the rates of growth of domestic and

ntuitively, the rise in the home country VAT accompanied by an equipropor tional21 T fall in the income tax broadens the tax base and raises tax revenue in the current period if the home country runs a current account deficit. To restore tax revenue, the income tax rate must be lowered. The opposite changes occur in the future period in which the current account position is in surplus, reflecting the intertemporal budget constraint. Similar considerations imply that the path of income tax abroad also steepens. As a result, the tax incentives to investment decline, yielding a fall in the world rate of interest. See Frenkel and Razin (1987, chap. 8).

©International Monetary Fund. Not for Redistribution Figure 7. VA T Harmonization (8 < 8*) (Percentage deviations)

Hnmeoutplll Home im·e.1'tme111 z Foreign ompw Forec�:n cm·eslml'lll r;i Home tabor Home so1•in.� l'(llio ;>::) Foreignlahor Foreign so1·ing rmio z Home consumption Home extemal debt ro1io � Forei�n conscmcption !merest rote (rixlu busis poims) scale. 0 16 0.4 z > r < ... 8 0.2 -;> - - - · - - >;I: �:..:·.:.:-.�:�·�···································'"'·-- ;>::) 0 - -- - - 0 - 0 ------===- -·- - 'S: - 0 - z - I -8 N -16 � -2 0 0 2 4 6 8 10 12 14 16 17 0 2 4 6 8 10 12 14 16 z

Note: Assuming a permanent increase of 6 percent in home country VAT and a permanent reduction of 6 percent in foreign country VAT. 00 ...... w

©International Monetary Fund. Not for Redistribution 00 ...... �

Figure 8. VA T Harmonization (o > o*) (Percentage deviations)

Home ompm Homt' im·estment Foreign o111p11t Foreign im•e.mnem 1/ome lahor Home sa•·ing ratio .., Foreign tabor Forei!lll s01•ing ratio ;>:) Home COIISllmptiOII Home external deht ratio [Tl z Fnreigo consumption /merest rate (ri}llll .,c ale, hasi� potms) " 16 [Tl 2 0.4 r

8 ···· ··· ··· ··· - - -- ········· ····························-----,.--=-········ ------0 ·---�- 0 (I) · - -< - - - - - ·-· · -· · ·-· · · 3:: -8 > -I z (I) " -< -2 16 - 0 2 4 6 8 10 12 14 16 17 0 2 4 6 10 12 14 16 17

Note: Assuming a permanent increase of 6 percent in home country VAT and a permanent reduction of 6 percent in foreign country VAT.

©International Monetary Fund. Not for Redistribution Figure 9. VA T Harmonization (rk > r:) (Percentage deviations)

Homeoutplll Home im·estml!f/1 Foretgn output Foreixn iul'estme/11 � Home /abor Home sa1·ing ratio m " Foreignlahor Foreijin SOI'iiiJ! ratio z Home consumplton Home e.rtl'mal deht ra11o � Foreign cnn.\umption /merest rate fri.�lu .\et/le. hasis poims) 0 z 2 . 16 0.4 > . ....------, r . < - 8 - - - � - -- -_ -: .::.::::·. _ . -. . -_ ;. · 0 "� 0 :s: 0 -1 -8 3 N

-2 -16 � 10 12 14 16 17 z0

6 6 Note: Assuming a permanent increase of percent in home country VAT and a permanent reduction of percent in foreign country VAT.

00...... Ul

©International Monetary Fund. Not for Redistribution Figure 10. VA T Harmonization (rk < r:) (Percentage deviations)

Home ompw Home inl'estmem Fon•tgn output Forei[1n inl'estmem Homr /ahor Home sm·ing ratio Foreign labor Foreign sal'ing ra11o ., Home consumption Home extemal debt ratio z� Forei,�ll COIISII/1/{Itioll /merest rau• (right w·ale. hasi.1 powt,\1 :><: m 2 16 r------� 0.4 r " > 8 0.2 N

· · ···· z ······························-----······· --- - � ·=·=·= ·=· =·= ==·= - 0 -===-- 0 -:---.:.:.:_-.: �- - 0 - ·-·-·-·- · ·-·-·-·- -1 -8 --0.2

-2 I I 16 - L-.JL..-.L-.JL..-.L-L...... JL..-.L-L...... J'---'--L...... JL...... JL...... I.:...:-'---'-",.... -0.4 0 2 4 6 8 10 12 I� 16 17 () 2 4 6 8 10 12 16 17

Note: Assuming a permanent increase of 6 percent in home country VAT and a permanent reduction of 6 percent in foreign country VAT.

©International Monetary Fund. Not for Redistribution INTERNATIONAL VAT HARMONIZATION 817

foreign consumption (gr and g: . respectively) fall, both in the short and in the medium runs. If, however, the configuration of saving and investment propensities is such that the home country runs a current account surplus in the early stage, then the dynamic effects of the VAT harmonization on these variables are reversed. Specifically. if in the home country saving is high or investment is low (for example, if 8 > 8*. or r:). then the paths rk < of domestic and foreign income tax rates fall, and the world rate of interest rises. ln that case the rates of growth of domestic and foreign consumption rise. Thus, under the present cash flow system the direction of changes in the world rate of interest and in the growth rates of consumption consequent on international VAT harmonization depend exclusively on the paths of the saving-investment gap. The lower panel of Table 3 summarizes the corresponding short- and medium-run changes in other key economic variables. As can be seen, international VAT harmonization crowds out domestic investment and crowds in foreign investment independent of the current account posi tions. These investment responses reflect the induced changes in the domestic and foreign tax incentives and the world rate of interest. These changes yield two conflicting effects: the effect of the change in the world rate of interest, and the opposite effect of the change in the tax wedges induced by the alteration of the time paths of income tax rates. The welfare effects of terms of trade changes depend on the magnitude of the change in the terms of trade and on the gap between purchases and sales of the good whose relative price has changed. In our intertemporal context the terms of trade correspond to the world interest rate, and the gap between purchases and sales corresponds to the current account position. As illustrated in Table 3. in all cases the change in the terms of trade operates in favor of the country that raises its VAT. When the country runs a current account deficit (that is, when it borrows in the world economy), its intertemporal terms of trade improve since the rate of interest falls. Likewise, if the country's current account position is in surplus, its intertemporal terms of trade also improve, since the rate of interest rises. As Table 3 illustrates. this improvement in home country welfare induced by the changes in the world rate of interest can be mitigated (or even offset) by the excess-burden effects of the VAT har monization. Similar considerations apply to the welfare consequences of a reduction in VAT in the foreign economy. A comparison between the effects of the international VAT harmo nization on the domestic economy and the foreign economy reveals that in the two countries the levels of foreign employment, investment, out put, and some other key macroeconomic indicators change in opposite

©International Monetary Fund. Not for Redistribution ., ;o m Effects of VA T Harmonization Under Alternative Current Account Positions z Table 7' 3. m (Deviations from baseline) r Home Country Current Home Country Current Account Deficit Account Surplus B < B* B = B* B > 8* B = 8* rk rZ rk > rZ rk rZ rk < rZ = = Variable SR MR SR MR SR MR SR MR Path of 7y Rising Rising Rising Rising Falling Falling Falling Falling Path of 7; Rising Rising Rising Rising Falling Falling Falling Falling r + + + + 8c + + + + g: + + + + I I* + + + + + + + + L + + + + + + +

©International Monetary Fund. Not for Redistribution L* y + + + + + + + Y* + c + + + c• + + + + + s + + + s• + + + +

B m� ::0 u +0.2 -8.2 -0.1 -6.7 +0. 3 -7.6 +0.3 -8.5 z

- U* -0.3 +8.4 -0.3 + 10.9 0. 3 +9.2 -0.3 +7.5 �

Note: The VAT harmonization occurs through a permanent reduction of 6 percent in -re and a corresponding rise in -r:.Budgetary z6 balance obtains through appropriate adjustments in the periodic income tax rates, Ty and -r; . SR and MR denote, respectively, > the short run and the medium run. The tax system is a cash flow system. In general, the short run pertains to the first few periods. r while the medium run pertains to the remaining periods in the simulation. The welfare change is measured by the percentage factor � by which the postharmonization consumption path must be raised in order to bring utility up to the preharmonization level. For the utility index, SR pertains to the discounted sum of utilities over the entire period except the final one; MR pertains to the � final-penod utility (reflecting the entire future beyond the simulation period). ::0 3:: 0 Nz � z6

00 ..... \0

©International Monetary Fund. Not for Redistribution 820 FRENKEL • RAZIN • SYMANSKY directions. In most cases the utility index indicates that domestic and foreign welfare also move in opposite directions. These phenomena suggest that international VAT harmonization may induce international conflicts of interest. Resolution of such conflicts may require interna tional fiscal transfers from countries benefiting from the VAT harmoniza tion to countries that lose. The potential difficulties arising from interna tional conflicts of interest may be augmented by internal conflicts of interest associated with redistributions of income between tabor and capital in the short and medium runs.22 The foregoing analysis considered only the case in which cash flow income taxes were used to restore budgetary balance following the inter national VAT harmonization. In these circumstances, in conformity with the analytical results of Section IV, the current account positions played the key role in determining the direction of changes in the world rate of interest and the growth rates of domestic and foreign consumption. As indicated by the simulations in Figures 7-10 and in the summary results in the lower panel of Table 3, the dynamic effects of the international

VAT harmonization on the path of the other key macroeconomic vari ables did not depend only on the current account positions. In fact, for the cases shown in these simulations, domestic investment, foreign em ployment, foreign saving (in the short run), and the level of the domestic country's external debt aU fell independent of the current account posi tions, while foreign investment and foreign saving (in the medium run) always rose.

VI. Concluding Remarks

One of the major developments in the world economy during the 1990s is likely to be the move toward the single European market in 1992. The removal of barriers to trade and factor movements, unification of mar kets, development of new monetary arrangements, and increased harmo nization of fiscal policies and tax structures are all key factors in a process that is likely to affect the shape of the global economic system for years to come. One of the elements of the move toward tax harmonization in the EC is a convergence of the various VAT systems. In this paper we have

22 As an example of induced changes in the functional distribution of income, consider the left-hand column of Table 3. There, the VAT harmonization raises the share of tabor and lowers the share of capital income in the domestic economy for both the short and medium runs while inducing an opposite redistribution in the economy.

©International Monetary Fund. Not for Redistribution INTERNATIONAL VAT HARMONIZATION 821 analyzed the global effects of such an international VAT harmonization. For this purpose, we developed a model that encompasses a rich menu of tax systems. The model contains two countries and is therefore capable of highlighting the spill over effects of taxes across countries. The analyt ical framework is grounded on microeconomic foundations and is there fore suitable for an examination of the incentive effects as well as the welfare consequences of tax policies. To examine the quantitative implications of international VAT harmo nization, we performed dynamic simulations. The analysis as well as the simulations demonstrated that the effects of VAT harmonization on the key macroeconomic variables (such as output, employment, investment, consumption, interest rates, the current account, and the value of exter nal debt) are very significant. Furthermore, these effects (quantitatively and qualitatively) are not spread evenly across income groups, genera tions, and countries. As a result, a VAT harmonization may give rise to internal conflicts of interest within each country (arising from changes in the distribution of income among members of each generation as well as among generations) and between countries. The international differ ences in the incidence of the VAT harmonization arise from differences in the current account positions (reflecting underlying differences in saving and investment propensities) as well as from differences in tax structures. Resolution of the various conflicts of interest that adoption of VAT harmonization could engender may require the development of a fiscal mechanism by which gainers compensate losers within countries as well as between countries. Throughout, we have emphasized the dynamic features of the interac tions among economies as they operate through the integrated world capital market. Accordingly, we have focused on the intertemporal terms of trade-the rate of interest. Obviously, an additional channel through which the effects of tax policies spill over to the rest of the world is the temporal commodity terms of trade-the relative price of tradable to non tradable goods and the relative price of exportables to importables. 23 A useful extension would allow for a more refined aggregation of com modities. With this refinement, the model could also shed light on the effects of international VAT harmonization on the structures of industry and trade, as well as on the sectoral distribution of employment and investment. Finally, our analysis of the world economy has been conducted within

23 For an analysis of the effects of tax policies within a model that allows for such a commodity disaggregation, see Frenkel and Razin (1987, 1988b) and Bovenberg (1989).

©International Monetary Fund. Not for Redistribution 822 FRENKEL • RAZIN • SYMANSKY a two-country model. Since the effects of VAT harmonization among a subset of the countries may affect the rest of the world, it would be useful to extend the analysis to more than two countries, so as to allow for a more complete examination of the international spillovers of VAT har monization. Such an extension would facilitate an analysis of "trade , creation" and "trade diversion. in both goods and capital markets asso ciated with the establishment in 1992 of the single market in Europe. 24

APPENDIX l

Solution of the Model

In this Appendix we present the formal solution to the model. The maximiza tion of the utility functions subject to the lifetime present-value budget constraint yields [ T l W, "'' u' ] (6) = o' ,2: - n -2�P, d, " - ,., w)l-u]l(l-u) P, = "+ [13"(1 + T,y (! - 13) ((1 T ,) (7) 13"(1 p,u, C _ + Tc,r" w (8) 1- 13"(1 Tn 1 13)"((1 - T.,,) )' " + ) "+ (! - (1 - 13t((l - T..,,)w) "p,u, 1 _ I = 01 9 + + (1 - 13)"((1 - T..,, w 1 ( ) f3"(! Pct)1 - " ) ) where u is the utility-based real spending, P denotes the associated price index, C denotes consumption of ordinary goods, and 1 - I denotes leisure. In these equations r = I, 2, ... , T; d, is the tax-adjusted present-value factor applicable to period /-that is, d, = (1 Tk,)( 1 [1 + - + T,,)ror • · [1 (1 Tkz l • · · · [1 (1 - Tk,)(1 T.,)r, + - )( + T,z)r,r + + .r•;

24 Our preliminary simulations of an extended three-country model reveal that if the two countries joining the single market differ from each other significantly in terms of their saving and investment propensities, then the VAT harmonization significantly affects the levels of investment, employment, output, and welfare in the rest of the world (the third country). Furthermore, with some configuration of parameters, the presence of a third country affects some of the qualitative changes within the countries forming the single market. In order to examine some dimensions of the debate on "fortress" versus "open and enlarged" Europe, we report in Appendix IT some simulations of the effects of taxes on international borrowin within a three-country world. The si mutations reveal that impediments lg to apit mobility between Europe and the rest of the world may generate signifc icanta negative welfare effects on the rest of the world.

d, (l - Tw1)W + (1 - Tkr)(rk - B)K, Wo = £ [ r-tl - (1 - T,,)J, ( J + � �,)] + dr(1 - Tkr)aKr - [1 + {1 - Tko){l + 'T,o)r .]BP 1• (10)

The investment equation. /,. is obtained by a maximization of wealth. Wo , with respect to investment, /,. This yields

1 1 ' .. -(t - T,,)a, l + b + d (l - a)• ' (1 - T..,)(rk - e) ( K ) r2:.....1 [ , .J• t 1

Equation (11) represents an implicit investment rule. The negative term is equal to the marginal cost of investment in period 1. while the positive terms are equal to the marginal benefits consisting of the rise in output resulting from the increased capital stock (the terms with rk and a) and the fall in future costs of investment (the terms associated with (b 12)·(i!Kf). To illustrate, in the two period case the investment function implied by equation (11) is

1 (1 - Tk1) lo (a + rk - B) - 1 K0• (12) = b ( 0.1 (1 _ Tm) )

Equation (12), together with the assumption that (a + rk - B) exceeds unity (an assumption necessary for a positive level of investment in the two-period case), imp)jes that the level of investment rises wi th the initial capital stock, Ku, the effective (tax-adjusted) discount factor, a,, the rental rate net of depreciation, rk - B, and the consumption coefficient, a. attached to the final-period capital. However, investment falls with an increase in the cost of adjustment parameter, b. Substituting equation (12) into (5) yields the corresponding value of wealth:

1 - Wo = L d,(l Tw,)w + qoko - [1 +(I - Tko)(l + Tso)r- .}8�1, (13) r-u where q0 denotes the tax-adjusted market value of a unit of the capital stock (Tobin's q):

qo = (rk - B)[(1 - TkO) + (1 - Tkl)(l + a)ad

+ (1 + a)o.1(a + rk - B - 1)

I+ B) - · [(l- Tk1)o.1 - (1 - Tm) ( �(o.1(a + rk - 1))iJ.

APPENDIX 11

Tax on International Borrowing

In this Appendix we extend the tax structure to include a tax on international

borrowing, denoted by ,.b· With this added tax. the periodic budget constraint in equation (1) in the text becomes

(1 + Tc, )C, +(1 - Tw.)w(l - /,) = (1 - Tw1)w + (1 - Tkr)((rk - 9)K,)

,. ,)/,( 1 + (1 - Tb, )(B� - 8� ,) - (1 - / � �,)+ - (1 - Tkr)(J + T., - a)r,- a 8�_a · (14)

As formulated, the international borrowing tax applies to the accumulation of 11 external debt. Letting total debt be BP = (11(1 - T�>))B P + BFP, and applying the arbitrage condition by which the after-tax rates of return are equal, so that = (1 -rb)r , (1).25 rF - 11 yields the last two terms on the ri ght-hand side of equation Analogously, the Jjfetime present-value budget constraint applicable to the two period case becomes

1- lo T 1 - b = [ [ w/o + w/a] + [ Tro.., ][CY.t(rk - 9) - 1 + )] a.�. ,. ( 1 + T,.<>ea] 1 + 2 Ko lo

- Th(l ( - TkO 1 - + {(I ) rk - ek )[\-- + Tka Ko 1 1 - Tbo Tba + + 'rsa)ro]} ---+ 'rc(l . 1 - (1 - Tka)(l

_ + 'rk(J)(l T.o - a)r P 1 - Too (J - + { }8 (15) 1 + Tea -I'

(1) 25 Equation implicitly inco�orates both external and internal debt. To verify, denote internal debt by 8 P, and the corresponding rate of i.nterest, by Rff. Analogously, denote the external debt by BFP' and the corresponding rate ' · of interest, by F Debt tlows in the budget constraint for period t are then / 8: P-8:1 - (1 T., l)rHr 8:�1 + (1 - 'Tbr)(8;P 1 - 'rkr I)(J + 1 1) - (1 - 1"kt- 1)(1 + - 8;� 'rsr - lhr- I s;�l. As formulated, the international borrowin_8 tax appliesH to accumulation of ex ternal debt. Letting total debt be BP = (1/(1 - T�>)]B P + BFP and applying the arbitrage condjtion, by which the after-tax rates of return are equal so that rF = (1 - '�"�>)rH,yields the last two terms on the right-hand side of equation (1}.

a = -- �(__J +�� T,�, )�(�l --- Tbo��) � -�� c � �� - (l - + - + Tca)(( l 'Th,) (1 Tka)(l + T,,)ro)

a, = -- �(1__ -�� Tk�I )�( J --T��> � -�� Ttn)((l� � - ( 1 - - Tbl) + ( 1 - Tka)( l + T,o)ro) and

a = ..,...-- -�..,- -�< ;:_1 -__;;'T��· I)�(.::_l_-__;;TM�I:,-) ____ _ L - -- . (J - T�{l)((l - Thl) + (1 - Tki)(J t Tsa)ro) The formulation of the periodic budget constraint illustrates the equivalence relation existing among the taxes on consumption income (cash flow), and inter national borrowing. Indeed, the real effects of any given combination of the three

Table 4. Effe cts of a 10 Percentage Point Rise in the International Borrowing Tax Rate Between Europe and the Rest of the World (Percentage deviations from baseline) Budgetar 3alance Bugetar� Balance Main ned Maintaine Through ThrOU! VAT Cash Flow 1come Tax Variable SR MR SR MR E T, +0.30 -0.20 0.00 0.00 E T> 0.00 0.00 +0.23 -0.20 r -0.23 -0.20 -0.24 -0.18 j E -0.60 +3.50 -0.50 +3.00 IR +3.40 +2.50 +3.00 +2.50 LE +3.20 -3.00 +3.00 -2.70 LR -6.00 +5.40 -5.20 +5.20 y E +1.30 -1.30 +1.40 -1.20 yR -2.50 +3.40 -2.00 +3.00 CE -1.00 +0.80 -0.90 +0.70

en +1.50 -1.40 +1.40 -1.30 SE/YE +0.02 -0.02 +0.02 -0.02 SRIYR -0.04 +0.06 -0.03 +0.05 y BEf E -0.07 -0.10 -0.06 -0.10 UE +0.10 -2.00 +0.10 -2.00 UR -0.10 +2.40 -0.10 2.70 Note: European and foreign variables are designated by superscript E and R, respectively; SR and MR are defined as in Tables 2 and 3. The welfare change is measured by the percentage factor by which the post-tax consumption path must be raised in order to bring utility up to the pre-tax level.

©International Monetary Fund. Not for Redistribution 826 FRENKEL • RAZIN • SYMANSKY taxes can be duplicated by a policy consisting of any two of them. Denoting the cash flow income tax by Ty, the budget constraint is (1 + (1 - + (1 - Tb,)(B� - B�- T_,)C, = Ty,)Y, 1), where Y,denotes income net of investment. Now, consider an initial situation with a positive consumption tax rate, i'c, and zero income and international borrowing tax rates. If the consumption tax were eliminated and the income and interna tional borrowing taxes were both set equal to Tc /(1 + i'c). then the effective tax rates associated with this new combination of taxes are zero income and interna tional borrowing taxes and a positive (i'c)consumption tax. It follows that the real + equilibrium associated with the new tax pattern = 0, Ty = Tb = i'c/(1 i'c)) is (Tc = 0). identical to the one associated with the initial tax pattern (Tc i'c,Ty = Tb = This analytical framework of taxes on international borrowing can be used to examine the effects of a removal of impediments on capital movements within Europe of 1992 (while maintaining the impediments between Europe and the rest of the world) on the key economic variables within and outside Europe. Ta ble 4 presents preliminary simulations of such an experiment. Specifically, we consider the effects of an introduction of a common tax by the two countries forming the single market on international borrowing from the rest of the world (country R). In conducting the simulations, we assume that the periodic budget balance in Europe (country E) is maintained through appropriate adjustments either of VAT or of cash flow income taxes. To highlight the external effects,we focused the simulations on the case in which the domestic and foreign economies (forming the single European market) are identical. The opposite welfare impli cations of such a tax for Europe and the rest of the world underscore the international concern regarding the specific modalities of the integration process.

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