Modeling Fiscal Policy in the European Union

by Janusz Kudla (Author) Konrad Walczyk (Author) Robert Kruszewski (Author)
©2015 Monographs 139 Pages
Series: Polish Studies in Economics, Volume 5


The book discusses optimal fiscal policy for an internationally integrating economy when public borrowing is constrained. Various innovations have been introduced: the agglomeration effect, the fiscal solvency concept, the harmonization of capital income tax base with formula apportionment and transaction tax on financial transactions. Tax structure consists of taxes on labor, capital and consumption, and bonds – the study looks at equilibrium tax rates under international tax competition pressure, and estimates them econometrically. It also offers policy recommendations as a contribution to the discussion about the desired scope of fiscal integration in the European Union.

Table Of Contents

  • Cover
  • Title
  • Copyright
  • About the Authors
  • About the Book
  • This eBook can be cited
  • Contents
  • Introduction
  • Chapter 1: Taxation and debt in European countries
  • 1. Tax systems in theory
  • 2. The tendencies in European taxation
  • 3. The indebtedness problem
  • 4. The tax adjustment
  • Chapter 2: The static tax competition models with debt
  • 1. Introduction
  • 2. The one-country static model of taxation
  • 3. The optimal taxation in the one-country model
  • 4. Basic assumptions of Nash equilibrium model
  • 5. The new economic geography approach
  • 6. Transaction tax on bonds income
  • 7. Common tax base with formula apportionment
  • Chapter 3: Dynamic model of fiscal solvency with capital tax shifting
  • 1. Introduction
  • 2. The model
  • 3. Numerical analysis
  • Chapter 4: Spatial modeling of fiscal policy and debt
  • 1. Introduction
  • 2. The measurement of debt and tax changes
  • 3. Dataset
  • 4. Spatial modeling of debt determinants
  • 5. The implications from the model results for the tax-mix
  • 6. Conclusions
  • Chapter 5: Fiscal policy recommendations
  • References


The idea for this book has originated in the light of the ongoing debate on whether taxes should be harmonized in the European Union and, if so, to what degree. The discussion has been sparked further because of two reasons: firstly, because of the economic crisis and secondly, because of the impact of countries indebtedness. Debt crises in the European Union countries raise a question: what is the transfer mechanism between various economic phenomena – tax revenues, spending and debt. In all European Union countries public borrowing is necessary to supplement inefficient public revenue in order to provide the level of public goods and services required by its citizens. This need arises also when tax revenues decrease while the level of public goods and services remains roughly constant. Furthermore, obtaining the tax revenues from capital, labor and consumption a government can optimize the tax mix, in order to obtain the maximum budget revenue. However, in practice the tax mix is a result of not only economic optimization but also of public bargaining. This is why the analysis presented in this book has to include public debt with the tax mix optimization.

The purpose of this study is to derive some analytical economic models that will allow for the assessment of the consequences implied by various forms of fiscal integration in the short and long term. We especially focus on propositions postulated to implementation in European Union. It is our hope that undertaken study helps to explain the causes of existing discrepancies in the literature about the desired direction of fiscal policy integration at European Union level, including the impact of international tax competition specificity. While the earlier models of international tax competition theory pointed out the need for close harmonization of direct taxation – unifying their structure and rates (according to the previously conducted harmonization of indirect taxes) – the new ones, especially generated by new economic geography and extended models of traditional tax competition, undermine legitimacy of such a integration and even question it. It should be stressed that both mentioned streams of economic theory are relatively new and have not been unified yet, which indicates the potential benefits from the synergy of combining these two ideas into one new model. Therefore the conducted research could be useful for the further development of the tax competition theory as well as for altering the existing fiscal policy.

Considering the reviewed contemporary theories of the tax system design and existing empirical research (presented in Chapter 1), the tax competition static model with three tax rates and bonds issuance will be developed (in Chapter 2). The constructed ← 7 | 8 → analytical model, involving the equilibrium of tax rates between two countries, helps to investigate the impact of some important augmentations, such as the inclusion of agglomeration effect and the concept of fiscal solvency to the fiscal policy under international tax competition pressure. The fiscal solvency hypothesis is an extension of the theory of international tax competition related to the issue of sovereign debt and to the long-term credibility, whereas the agglomeration effect consists of the increasing productivity of capital gathered in neighboring localization. The basic static model analyses the direct economic impact of such policies as the harmonization of capital income tax base with formula apportionment and the imposition of transaction tax on income from financial transaction with government (bonds issuance).

We also strive to develop (in Chapter 3) the dynamic model of fiscal policy including three tax rates and bond issuance but with a slightly different objective function. It should allow for prediction of tax rates behavior in the long term when the purpose of government is to maximize fiscal revenues instead of maximization of representative consumer utility. These two models together shed some light on the confusion about the desired scope of fiscal integration in European Union.

Subsequently in Chapter 4, the relation between taxation and debt will be verified econometrically using regression of panel data and spatial econometrics methods. The data used should cover a longer period from 2002 to 2011. In addition, we are going to verify the predictions of derived models with econometric methods. The final result of the study is to identify the best options for fiscal reform at the EU level that could be recommended for political implementation in Chapter 5. Finally we will try to formulate some possible consequences of various kinds of fiscal integration, taking into account the predictions of our model. Special emphasis will be put on the proposals of tax and fiscal policy reform at European Union level.

Reliable models of fiscal competition can improve analysis of fiscal reform performed in the European Union. Eventually, it should prevent the recurrence of similar crisis in the future. The last statement seems very important for Europe’s development and the well-being of its residents. Recommendation formulated on the basis of the model can be used indirectly by the EU authorities and fiscal policy makers. These conclusions may be very important for Poland which is now considering an entry into the Eurozone. This entry will inevitably change the mechanisms Poland can use to adjust to economic shocks. It should be stressed that general structure of analysis does not preclude its usefulness in determining the assumptions and details of fiscal reforms in countries not intending to participate in monetary union. Formulating such a model can surely help to understand the transmission mechanism of debt crisis in applying it to recent debt crisis of southern European countries, while also helping to avoid future mistakes of public policy. ← 8 | 9 →


ISBN (Hardcover)
Publication date
2015 (April)
Steuersätze steuerlicher Wettbewerb Steuerpolitik
Frankfurt am Main, Berlin, Bern, Bruxelles, New York, Oxford, Wien, 2015. 139 pp., 8 tables, 39 graphs

Biographical notes

Janusz Kudla (Author) Konrad Walczyk (Author) Robert Kruszewski (Author)

Janusz Kudła is Associate Professor of Finance at the University of Warsaw. Konrad Walczyk is Deputy Director of the Research Institute for Economic Development at the Warsaw School of Economics. Katarzyna Kopczewska is Assistent Professor at the University of Warsaw. Robert Kruszewski is Associate Professor of Mathematical Economics at the Warsaw School of Economics. Agata Kocia is Assistent Professor at the University of Warsaw.


Title: Modeling Fiscal Policy in the European Union