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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 2: The static tax competition models with debt

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Chapter 2The static tax competition models with debt

1.Introduction

On the one side the economics of taxation concentrates on tax competition models with two tax instruments and without the impact of debt. On the other side most of models capturing the impact of debt apply general equilibrium approach. Together these two approaches do not allow for the modeling of the tax changes triggered by the solely interaction of debt and tax rates with respect of predictions implied by tax competition model. However, it is worth of interest to check whether the predictions of model of tax competition with many tax rates and the debt are consistent with results obtained in the up-to-date literature. Precisely we would like to concern the equilibrium solutions of three tax rates and bonds issue. Trying to fulfill the existing gap in the theory, the two static tax competition models are developed with: three tax instruments, debt and cross-border ownership of capital and bonds. Our proposition is one-period only and does not include savings. The first model is the one-country model with indirect impact of tax competition on capital and consumption, where a government controls three tax rates and debt is set as exogenous. The maximization concerns the utility of representative consumer of the country. The model helps to derive some relatively simple implicit function on tax rates on capital and consumption showing the possible determinants of taxation in the multi-tax world.

The second proposition involves two-country static model with...

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