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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 3: Dynamic model of fiscal solvency with capital tax shifting

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Chapter 3Dynamic model of fiscal solvency with capital tax shifting

1.Introduction

Optimization is crucial in economic analysis. For this reason, calculus methods of solving unconstrained and constrained optimization problems occupy an important place in economist’s tool kit. Such methods are applicable frequently to static optimization problems, where the solution usually consists of a single optimal value for every choice of variables. Nevertheless the static model is very useful in the simulation of short term fiscal policies but falls short in the description of long term behavior of taxpayers and governments. Forward looking economic agents recognize that decisions made today influence those to be made in the future. Today’s decisions may expand or contract the set of admissible choices in the future by raising or lowering their cost. Such intertemporal linkage is embedded in dynamic optimization processes in economics. That’s why mathematical methods that account for such connections are fundamental to economic decisions. A dynamic optimization states the question about the optimal magnitude of a choice variable in each point of time. It also allows for considering an infinite planning horizon. The solution to the dynamic optimization problem takes the form of an optimal time path for every choice variable. The latter requires the maximization of discounted government revenue in the long-term equilibrium.

Therefore, to shed some light to this issue, we develop a dynamic optimization model of one-country government maximizing the revenue of taxes and bonds. Optimal Control Theory and the Maximum Principle have...

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