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Modeling Fiscal Policy in the European Union

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Janusz Kudla, Konrad Walczyk and Robert Kruszewski

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.
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Chapter 1: Taxation and debt in European countries

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Chapter 1Taxation and debt in European countries

1.Tax systems in theory

In general, a government can raise revenues by taxation, borrowing or printing money, or charging for goods and services it provides. If we exclude the latter two options from consideration, the first two government financing alternatives1 are equivalent as long as they do not make an individual’s behavior dependent on the form of finance used. Economic agents are not, however, indifferent to the means by which a government covers its expenditure because various types of taxes affect the two, statically separate to each other, allocation decisions – how much to work (or spend time for leisure) and consume (or save). Instead, then, of draining any specific market (for labor, capital or consumption goods) ‘to the bottom’, a government diversifies funding sources. By doing this it achieves two goals simultaneously: it minimizes the welfare loss as a tax rate on a broader tax base can be lower, and prevents tax avoidance by substituting taxed by untaxed activities. If government spending is given, raising revenues from one source makes it possible to lower receipts from another. In this sense, the forms of finance a government uses are interrelated, or, in other words, they compose together a tax structure or a tax-mix – a system of related components, each measured by its share in total revenues.

The problem of the design of the tax structure is differently viewed in economic theory, depending on the perspective taken.

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