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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 4: Spatial modeling of fiscal policy and debt

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Chapter 4Spatial modeling of fiscal policy and debt

1.Introduction

European Union regulations as well as country level regulations, set the fiscal policy as the independent one, anchored in countries’ local conditions. As proved by theoretical models and literature review, fiscal policy is strongly related to the financial situation of governments. The debt changes as well as other variations of macroeconomic parameters should cause tax rates adjustments and subsequently should affect the budgetary revenues. However, in open economies most of macroeconomic parameters are interdependent between countries, because of trade relations and cross-border trade, the mobility of production factors, flows of goods, services, people and capital, common currency, interest and exchange rates differentials, historical or institutional factors etc. Thus even if fiscal policy is nominally independent then effects of fiscal policy do not impact only a given country but also the interconnected economies. There appears so called spillover effect which can be perceived as the broader interdependence occurring between fiscal parameters in different countries. Precisely the spatial spillovers effect is understood as an impact of government policy in one country on performance of other neighboring economies, with regard to the distance in space between them. Contrary to the predictions of tax (or fiscal) competition hypotheses these relations cover all intended (or direct) actions of the government but also any unintended (or indirect) changes of fiscal variables. Both elements taken together determine the total impact of fiscal policies on sovereign debt in open economies. Considering the reaction on the...

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