3867125

International VAT Harmonization: Macroeconomic Effects
Author(s): Jacob A. Frenkel, Assaf Razin and Steven Symansky

Source: Staff Papers (International Monetary Fund), Vol. 38, No. 4 (Dec., 1991), pp. 789-827
Published by: Palgrave Macmillan Journals on behalf of the International Monetary Fund
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IMF Staff Papers
Vol. 38, No. 4 (December 1991)
? 1991 International Monetary Fund
International VAT Harmonization
Macroeconomic Effects
JACOB A. FRENKEL, ASSAF RAZIN,

and STEVEN SYMANSKY*
Macroeconomic issues pertinent to the international and domestic effe

of international VAT harmonization are highlighted, and VAT harmon
tion policies envisaged for Europe in 1992 are outlined. An intertempor
model is developed to analyze the incentive effects of various tax polic
and their welfare implications. Dynamic simulations reveal that
macroeconomic and welfare implications of VAT harmonization de
critically on the tax system and the degree of substitution governing te
ral and intertemporal allocations of savings, investment, and labor
simulations also reveal a potentialfor significant conflicts of interest wi
each country and between countries. [JEL E2, E6, F4]
T HE COORDINATION of fiscal policy in general, and tax policy in part

ular, poses a major challenge in the move toward the single mar
in Europe slated for 1992. With the growing integration of market
*Jacob A. Frenkel, Governor of the Bank of Israel, is also Professor of

Economics at Tel Aviv University and a Research Associate of the National
Bureau of Economic Research. He was Economic Counsellor and Director of the
Research Department when this paper was written. He is a graduate of Hebrew
University and the University of Chicago.
Assaf Razin, Daniel and Grace Ross Professor of International Economics at
Tel Aviv University and a Research Associate of the National Bureau of Eco-
nomic Research, is a graduate of the Hebrew University and the University of
Chicago. He was a Visiting Scholar in the Research Department when this paper
was written.
Steven Symansky is Deputy Division Chief of the External Adjustment Divi-
sion of the Research Department. He is a graduate of the University of Wisconsin.
The authors are grateful to A. Lans Bovenberg, David Bradford, Martin
Feldstein, Peter Isard, Bennett McCallum, and Pat Kehoe for useful discussions,
and Ravina Malkani for research assistance.
789
790 FRENKEL RAZIN * SYMANSKY
goods and services within the European Community (EC),

nization of value-added taxes (VAT) has become a central i
discussion of fiscal policy convergence.
VAT harmonization is seen as a means of recouping so
revenues that have been lost in cross-border arbitrage. Also, in
with high tax rates, the industrial sectors have been agitatin
tax rates, which could help restore competitiveness and mainta
shares. In addition, in parallel with the integration of the
services market, the growing integration of capital markets ha
tax base associated with internationally mobile capital high
All of these factors suggest that European economic integ
well entail a significant restructuring of tax systems. Motivate
background, this paper provides a dynamic analysis of ke
economic issues pertinent to an understanding of the inter
domestic effects of VAT harmonization.
In Section I we outline the VAT harmonization policies envisaged for
Europe of 1991. In Section II we present the basic tax model. It is a
neoclassical model with a microeconomic foundation and is therefore
suitable for an analysis of the incentive effects of various tax policies and
their welfare implications. The model allows for a rich tax structure and
contains a detailed specification of public and private sector behavior.
The analytical framework employs the saving-investment approach to
analyzing international economic interdependence. It thus emphasizes
the effects of changes in the time profile of various taxes on the inter-
temporal allocations of savings, investment, and labor. These dynamic
effects are supplemented by the more conventional effects of the level of
flat-rate taxes on the margins governing the choice between labor and
leisure (such as the negative effect of consumption and income taxes on
labor supply), the choice between consumption and saving (such as the
negative double-taxation effect of income tax on saving), and the choice
of investment plans (such as the negative effect of the corporate income
tax on investment). Our formulation focuses on the roles played by the
level and time profile of taxes on income (wage and capital income tax),
investment and saving incentives (investment and savings tax credit),
taxes on consumption (VAT), and on international borrowing.
In Section III we apply the tax model of Section II to examine the
effects of international VAT harmonization. Throughout the analysis,
the tax restructuring is constrained by the requirement that government
solvency is maintained. Accordingly, changes in VAT rates are accompa-
nied by compensatory changes in other taxes. The effects of VAT harmo-
nization are illustrated by means of dynamic simulations. The simulations
reveal that the effects of these tax changes on domestic and foreign levels
INTERNATIONAL VAT HARMONIZATION 791
of output, employment, investment, consumption, and ot

macroeconomic variables depend critically on the degree of sub
governing temporal and intertemporal allocations, as well as on
system. Furthermore, it is shown that these characteristics of
nomic system also govern the precise welfare implications of VAT
nization. We show that VAT harmonization policy may generate
icant conflicts of interest within each country as well as
countries.
In Section IV we analyze the dynamic mechanism associated with
changes in the time profile of taxes. Since VAT harmonization involves
changes in the composition of taxes, we examine the dynamic conse-
quences of revenue-neutral tax conversions between income and con-
sumption (VAT) tax systems undertaken by a single country. The rev-
enue-neutrality requirement is motivated by inflationary fears or debt
aversion. Reflecting our emphasis on the saving-investment balance, we
demonstrate analytically that the effects of such changes in the composi-
tion of taxes depend critically on international differences in saving and
investment propensities, which in turn govern the time profile of the
current account of the balance of payments. These issues are examined
by means of dynamic simulations in Section V, in which the role of current
imbalances in global tax restructuring is analyzed. Concluding remarks
are contained in Section VI.
I. VAT Harmonization: Europe 1992
The VAT harmonization policies envisaged for 1992 have long been an
important component of the wide-ranging measures associated with the
move toward the single European market. The process of harmonization
started with the First Council Directive of April 1967 and has continued
through various succeeding directives. The process has involved the
adoption of VAT and the continuous convergence of rates and structures
among members of the Community.
Over the years, the Commission of the EC has drawn up various
proposals for the approximation of VAT rates and the harmonization of
its structure. Much of the discussion on the practical implementation of
the approximation of VAT rates has concerned the position and width of
bands within which various VAT rates should be placed, the products to
which a reduced rate would be applicable, and the problem of zero-rated
products.1
1 Zero-rated products involve the reimbursement of taxes levied on inputs, with

the result that the final good is completely untaxed.
Table 1. VAT Rates in the European Community
(In percent)
Statutory Rates (1990) Pe

Countrya Reduced rate Standard rate Higher rate tax
Belgium (1971) 1.0, 6.0, 7.0 19.0 25.0
Denmark (1967) 0.0 22.0
France (1968) 5.5, 7.0 18.6 25
Germany (1968) 7.0 14.0b
Greece (1987) 3.0, 6.0 16.0 36
Ireland (1972) 0.0, 2.2, 10.0 23.
Italy (1973) 2.0, 9.0 18.0 38
Luxembourg (1970) 3.0, 6.0 12
Netherlands (1969) 6.0 18.5
Portugal (1986) 8.0 17.0 30
Spain (1986) 6.0 12.0 33.0
United Kingdom (1973) 0.0 17.
Memorandum items:
EC Commission proposal
A 4.0 to 9.0 14.0 to 20.0 abolished
B 4.0 to 9.0 15 minimum abolished
Sources: Cnossen and Shoup (198

Community, "The Evolution of V
International Bureau of Fiscal D
Organization for Economic Coope
aYear of VAT introduction in pa
bThe rate will increase to 15 per
CThe rate was changed from 15
For 1992 the Commission initially proposed a standard VAT r

ranging between 14 percent and 20 percent, and a reduced rate (appl
to selected categories, such as foodstuffs) ranging between 4 percent an
9 percent.2 The Commission also wanted to abolish the higher rate t
presently exists in some member countries on certain categories of good
In subsequent discussions, an alternative proposal was considered,
cording to which the standard rate band would be replaced by a minimu
rate, applicable from January 1, 1993. Each member state would cho
a rate at least equal to the minimum rate, with due regard to the b
getary implications and to the "competitive pressures" arising from
rates chosen by other neighboring states and main trading partner
Table 1 provides summary information on VAT in the EC and illustr
the disparities in VAT rates among the various member countries.4
A key issue in the deliberations is the specification of the VAT: should
it be destination based (as is traditionally the case in Europe) or sou
based? The removal of fiscal frontiers through the abolishment of bord
controls could complicate the administration of a destination-based VAT
which requires levying the VAT on imports and rebating the VAT
exports. These administrative difficulties can be overcome, howev
through such methods as those used for cross-border transactions amon
the Benelux countries since 1969 as well as between Ireland and the
United Kingdom until 1984. The key feature of these methods involves
computing border tax adjustment from books of accounts verified
through written records (in the absence of border controls). An alter-
native method to protect the tax revenue of the country of destination
is the establishment of a clearance mechanism among the various tax
authorities.5
In the next section we develop a tax model that will be used to assess
the global implications of the move toward VAT harmonization. Al-
though the future system is envisaged to be source based, the Commis-
2 Until the end of 1992 the only permissible changes in the standard rates must
be within the 14-20 percent range, or, if the rate lies outside the range, only
changes toward the range are allowed. The final agreement on the rate structure
is planned to be reached by the end of 1991.
3Currently, the EC countries apply the destination principle to their VAT
systems; that is, they exempt exports and tax imports. But due to direct consumer
purchases (which were not reimbursed by a VAT system), the competitive base
of firms may have been eroded in high-tax countries (see Frenkel, Razin, and
Sadka (1991)).
4For a broad survey of international practice and problems related to VAT, see
Tait (1988) and Frenkel, Razin, and Sadka (1991).
5Such a proposal is still under review by the Commission. For a further
examination of the various proposals and considerations, see Cnossen and Shoup
(1987).
794 FRENKEL * RAZIN * SYMANSKY
sion proposed in May 1990 (following the guidelines set by the

of Economic and Finance Ministers in 1989) to maintain the p
destination principle until January 1997. We will therefore specify
system as being destination based throughout. Our analysis, ne
less, can also be used to shed light on the implications of harmo
with a source-based VAT system.
II. The Tax Model
We start with a formulation of the budget constraint.6 As usua

budget constraint serves to focus attention on key economic variables
tax policy parameters that play a central role in the analysis. The
country's private sector (full-income) budget constraint applicab
period t (t = 0,1,..., T - 1) is
(1 + T,t)C, + (1 - tt)W(1 - l,)
= (1 - Tw,)W + (1 - Tkt)[(rk - O)Kt]
-(1 - T,)I, 1 + ) + (BP - BPf_)

-(1 - Tk)(l+7st)rt 1B f_ , (1)
where Tc,, Tw,, and 'kt denote the tax rates on cons
income, and capital income, respectively; all taxe
The terms, T,r and T,,, denote investment tax credi
respectively. Levels of consumption, labor supply
ment, and international borrowing by the privat
respectively, by C,, I, K,, I,, and BP. The wage ra
rate, and the interest rate are denoted, respectively
0 denotes the rate of depreciation. For convenien
endowment of leisure to unity and assume costs of
formation of the form ()bI2 /K,. We note that in th
T) the private sector settles its debt commitments a
6The analytical framework underlying the internati

proach to open economy macroeconomics is based on F
1988b). A fuller analysis of international taxation is con
and Sadka (1991). For an analogous approach develope
context, see Auerbach and Kotlikoff (1987); for an an
oped in the context of a two-country world economy, s
(1989); and for an extension to a model with borrowing c
and Pujol (1991). For a discussion of supply-side polici
berg (1989). In the present formulation capital market
grated through free access to credit markets; in Appe
on international borrowing. To simplify, we exclude dir
which is analyzed in Frenkel and Razin (1989).
or new borrowing occurs, so that IT = BP = 0.7 To sum up, the lef

side of equation (1) represents the value of consumption of o
goods and leisure; the right-hand side represents the value o
endowment, capital income (net of investment), and new borrowi
of debt service). All of these quantities are evaluated at the
prices. To simplify the exposition, we assume a linear production
with fixed coefficients. Thus, the competitive equilibrium c
imply that the wage rate and the capital-rental rates, w and
constant.
The periodic (full-income) budget constraints specified in equation

can be consolidated to yield the lifetime present-value budget constrain
governing the decisions of the private sector. To facilitate the diagr
matic analysis that follows, we illustrate the lifetime present-value bud
constraint for a two-period case (t = 0, 1). Accordingly
Co + aC1 = Two [wlo + aL Wl1] + 1 o T aL(r - 0)

_1 + Tc0_ _1 + T0,o__
( 2 Ko!
+(1
+L1- +TT,)(rk - Ok) 1 - TkO
+ - Tkl lKo
1 - Tbl + (1 - Tkl)(l + Tsl
1 + (1 - Tko)(l + Tso)r - (2)

- l+To c -1, (2)
where
+(1 + Tcl) 1
(1 + Tco) 1 + (1 - Tl)(1 + T'r)r
=(1 - kl) 1
L (1
(1--T10)
Two)1 + (1- Tkl)(l + 'rsl)rO
1 + (1 - TOk)(1 + T,i)ro
7Our formulation reflects the assumption that except for the final per
bolted capital cannot be consumed. However, in the final period, the ca
stock, KT, can be transformed into consumption at a rate equal to aKT, w
0 < a - 1. This assumption serves to mitigate abrupt changes in the behavi
the economy arising in the final period of the finite horizon model. Accordin
the budget constraint applicable to the final period (period T) is analogous to
one shown in equation (1), with an added term on the right-hand side equ
aKT. For a formulation of a model highlighting the interaction between in
ment, government spending policies, and international interdependence w
an infinite-horizon model, see Buiter (1987) and Frenkel and Razin (1987)
and
1l - T,-
?wO
1 + TcO
As indicated, cxc, oL, and ao, are the effective (tax-adjusted) discount
factors governing intertemporal consumption, leisure, and investment
decisions, respectively.8 The intratemporal choice between labor supply
(leisure) and consumption of ordinary goods is governed by the prevailing
effective intratemporal tax ratio, y = (1 - 'T) /(1 + Tc).
The expressions in equation (2) show the key factors operating on the
various margins of substitution. The intratemporal tax ratio, y, shows the
conventional negative effect of labor income tax and consumption tax on
labor supply. The effective discount factor governing consumption, ac,
shows the conventional negative effect of capital income tax, Tk (through
double taxation), on saving. Likewise, the effective discount factor gov-
erning investment, cxo, shows the negative effects of capital income tax,
Tk, on investment. In addition to these conventional channels, the expres-
sions in equation (2) highlight the dynamic channels of tax policies.
Specifically, as can be seen, the effective discount factors depend on the
time path of the various taxes.9
To understand the dynamic mechanisms underlying the effective dis-
count factors, it is useful to define a benchmark case in which the double
taxation of savings is eliminated. Thus, the tax incentive rates on savings
and investment are equalized and the common rate is equal to the capital
income tax. Accordingly, these equalities imply that Tk = Tj = T, /(1 + T,).
Such a configuration of taxes yields the cash flow income tax system.10
It is noteworthy that the cash flow income tax system is equivalent to
a VAT system that is source based.1 We note that in this benchmark case
8 Obviously, with more than two periods, these discount factors are replaced
by the appropriate present value factors.
9 The expression for oL reveals an added dynamic effect, whereby a rise in the
capital income tax, Tk, induces intertemporal substitution toward future labor
supply.
0 The tax systems in many countries include incentives to saving and invest-
ment and, thereby, contain important features of the cash flow income tax
system. Such a system was advocated recently for the United States by Feldstein
(1989). For a recent comparative analysis of capital income tax systems in various
industrialized countries, see Pechman (1988).
"To verify this point, we note from equation (1) that, under a destination-
based VAT system, the tax rate, 1 - (1/(1 + tc)), applies to the value of GNP (net
of investment) minus exports, plus imports; thus in effect, imports are taxed while
export taxes are rebated. In contrast, the cash flow income tax applies only to
GNP (net of investment); thus, in effect, imports are not taxed, while export taxes
are not rebated. Hence, this system is equivalent to a source-based VAT system.
We are indebted to Sijbren Cnossen for providing us with this interpretation of
the relation among the various VAT systems. For a detailed analysis of interna-
tional taxation and tax equivalences, see also Frenkel, Razin, and Sadka (1991).
the effective discount factor governing intertemporal consumptio

sions, ac, is independent of the income tax, whereas the effective
factor governing investment and leisure decisions, a, and OeL, are
dent of the consumption tax.12 Since with such a cash flow tax syst
effective discount factors depend only on the time path of the
taxes rather than on their levels, it follows that if the various tax
not vary over time, then the effective discount factors a,, tL, and
equal to the undistorted tax-free factor, ao = 1/(1 + ro). In tha
which the time paths of the various tax rates are "flat," the intert
allocations are undistorted. Of course, as indicated earlier, th
temporal allocations are distorted if the intratemporal tax ratio, y
from unity.
We turn next to the specification of the utility function. To facilitate
the simulation analysis in subsequent sections, we need to adopt a specific
form of the multiperiod utility function. Accordingly, we assume that the
intraperiod utility function between consumption of ordinary goods and
leisure is
Ut = [PC( - 1)" + (1 - 13)(1 - / )( - 1)d]u(U- 1) (3)

while the interperiod utility function is
T
Uo = S 8 log(ut), (4)
t=0
where a is the temporal elasticity of substitution betwee

consumption of ordinary goods, P is the distributive para
sumption, and 8 is the subjective discount factor. This for
plies a unitary intertemporal elasticity of substitution.
Maximizing the utility functions in equations (3) and (4), su
lifetime present-value budget constraint (the multiperiod
equation (2)) yields the consumption function and the
function. The formal solutions are presented in Appendix
shown that consumption demand and labor supply depend on
path of the tax-adjusted rates of interest, and the intra
intertemporal tax structure. The maximization of wealth yiel
ment function. Appendix I also shows that, in addition to
tional technological characteristics, investment depends o
the tax-adjusted rates of interest.
As is evident, in this model economic welfare as well as the
ioral relations (consumption, labor supply, investment, an
determined within a dynamic context. Accordingly, the p
12 This latter property is more general and not confined only to

case.
and investment and, thereby, the current account of the balance of pay-
ments are also governed by dynamic considerations. In the present con-
text, the model highlights the central role played by the dynamics of the
tax structure. These dynamics are reflected in the temporal and intertem-
poral substitutions captured by the various tax-adjusted discount factors.
It follows, of course, that a proper evaluation of positive and normative
implications of trends in savings, investment, and the current account
cannot be complete without an assessment of the expected paths of taxes
and the other economic variables influencing income and spending.13
The foregoing discussion focused on the various channels and margins
of substitution through which taxes affect economic behavior. Such
changes in economic behavior also influence economic welfare. The
welfare implications depend, as always, on the distorted margins of
substitution arising from the tax wedges, and on the elasticities of re-
sponse to the implied changes in incentives. The behavioral responses to
changes in the tax wedges are shown in the consumption demand, labor
supply, and investment in Appendix I. Our formulation in equation (2)
shows that in addition to their effects on the margins of substitution, the
various taxes also contain elements that resemble lump-sum taxes. These
elements are found in the taxes that fall on inelastic tax bases. For
example, the capital income and consumption tax rates, Tk and Tc, are als
applied (directly, and indirectly) to the value of initial assets, Ko an
(BP 1), which are obviously inelastic tax bases. These elements of the t
structure are nondistortive. Our simulation analysis of the welfare impli-
cations of alternative tax instruments incorporates these attributes of th
tax system.
III. Simulations of VAT Harmonization: Alternative Tax System
In this section we present dynamic simulations of the effects of inter-

national harmonization of VAT. We use our two-country model and
presume that prior to VAT harmonization, the two countries were using
very different tax systems. The home country's tax revenue comes from
high income tax, and the foreign country's revenue comes from hig
3 In the present model, the tax structure affects the economic system by
altering the inter- and intraperiod margins of substitution as well as by alterin
wealth. An additional mechanism would recognize that in the context of a
overlapping-generations model, intertemporal offsetting shifts of tax revenue
equal present value may alter private sector behavior through changes in th
intergenerational wealth distribution. This mechanism is analyzed in Blancha
(1985) and Frenkel and Razin (1986, 1987).
VAT. The harmonization of VAT entails a rise in the home cou

rate and an equivalent reduction in the foreign rate. The nar
international disparities between VAT rates, captures the EC
sion's proposal of reducing the disparities in VAT rates among
countries and categories of goods. Furthermore, in order to
fiscal solvency, we assume (in the absence of changes in gov
spending) that changes in the VAT rates are accompanied in each
by opposite changes in income tax rates.
In performing the simulations, we consider first a benchma
which saving and investment propensities do not differ inter
so that 8 = 8* and rk = rk. This assumption ensures that th
account position (that is, the saving-investment gap) is zero, and
the tax restructuring in and of itself does not affect the wo
interest. In subsequent sections, we depart from this benchm
We first computed a baseline equilibrium. This equilibrium
disrupted by the assumed VAT harmonization. The variou
presented below show the effects of the tax restructuring m
percentage deviations from the baseline levels. Throughout,
country was assumed to raise its VAT by 6 percent and to res
solvency by a corresponding reduction of its income tax. We
various tax systems: cash flow income tax, labor income tax
income tax, capital income tax combined with saving incent
capital income tax combined with investment incentives. The
these simulations are shown in Figures 1-5 and are summariz
ble 2, which also reports the implied welfare implications of
harmonization. To capture the essence of the dynamic evolut
various variables, we report in Table 2 the direction of changes f
the short run (SR) and the medium run (MR).
The multiplicity of mechanisms and channels operating on the
tax incentives results in a variety of configurations of the r
the other key economic variables as illustrated for the cases
Table 2. Of special interest are the welfare effects indicated by t
index in the simulations. The welfare change is measured by the
age factor by which the postharmonization path of consumption
raised in order to bring utility up to the preharmonization
welfare consequences of tax policies can be decomposed into t
nents: first, those arising from changes in excess burden; an
those arising from terms of trade effects. The changes in the
excess burden induced by VAT harmonization depend on the
of the tax base as well as on the magnitude of the existing distor
the cases illustrated by the simulations, we have chosen param
result in relatively low investment and labor supply elasticit
Figure 1. VAT Harmonization with Cash Flow Incom
(Percentage deviations)
Home output
-?-?-- - -Foreign output H
.............. Home labor
----- -
- . - -- Foreign labor .............. Home s
Home consumption - - -.- Foreign
"----- - Foreign consumption Hom
1.0 2
0.5 1
~t = C z~ ~ -~ r rC ---___
0.0 0
- - - - - - - - - - - - - - - -
= =.I
-0.5 -1
-1.0 -2
0 2 4 6 8 10 12 14 16 17 0 2 4 6 8
Note: Assuming a permanent inc

in
foreign country VAT.
Figure 2. VAT Harmonization with Wage Tax Adjustm
Home output
- .-.-.- - Foreign output H
.............. Home labor ..-.-.-- -
-.-.-.- Foreign labor .............. Home
Home consumption - . - -- Foreign
---- - Foreign consumption - Hom
5.0 2
2.5 1
0' 0
-2.5 _ _~~ * .
-1
,I I I I a , I i " .- -'- ,
-5.0 * *, *, , tr -.,r -2
0 2 4 6 8 10 12 14 16 17 0 2 4 6 8
Note: Assuming a permanen

in foreign country VAT.
Figure 3. VAT Harmonization with Capital Income Tax Adjustm
Home output
.-. - -- Foreign output ...........
.............. Home labor .-----
.- - - .- Foreign labor Ho
Home consumption Fo
- - Foreign consumption -____
10
5 ...........
-5
-if
][v
0 2 4 6 8 10 12 14 16 17 0 2 4 6 8 1
Note: Assuming a permanent i

Figure 4. VAT Harmonization with Capital Income Tax and Saving Incent
Home output
- Foreign output .............. Home inves
.............. Home labor ..... ?Foreign in
-*-*-*. Foreign labor Home s
Home consumption - - - - Foreign sav
- - - - - Foreign consumption Home
5.0 10
,.,
2.5 5
-- _ _---_- - - -
_ _~~~~~~~~~~~~~?
0 0
.
-2.5 I g I I ? I I I t t -5
Ir I 111 I, I I
I i ! I II I I I i I I I -10 1 1 '
-5.0
0 2 4 6 8 10 12 14 16 17 0 2 4 6
Note: Assuming a permanent increase of 6 percent in home country V

Figure 5. VAT Harmonization with Capital Income Tax and Investment I
Home output
-?--.- - -Foreign output H
.............. Home labor F
-.-.. -. - - Foreign labor H
..... ..... ..
Home consumption _ . . . . . .
F
?- -- - - Foreign consumption H
12
6
?
0
V -- N--
-6
0 *
-12
0 2 4 6 8 10 12 14 16 17 0 2 4 6
Note: Assuming a permanent increase of 6 percent in home country VAT an

Table 2. Effects of VAT Harmonization Under Alternative Tax
(Deviations from baseline)
C
Cash Flow Tax and
Income Labor Income Capital Income
Tax Tax Tax Incentives
Variable SR MR SR MR SR MR S
r 0 0 0 0 0 0 0
I - - 0 0 + + +
1* + + 0 0 -
L + + + + +
L* - -- - + +
Y + - + + - _
Y* - + - - + +
C - - + + - + -
C* +4 + - - + -
S - - + + - +
S* - + + - + -
B - - +- - +
U 0.3 -7.8 0.0 -12.5 1.4 -7.0 1.2

U* -0.3 8.7 0.1 14.6 -1.0 7.3 -0
Note: The VAT harmonizati

balance obtains through app
and without saving incentiv
the current account position
is measured by the percenta
up to the preharmonization
except the final one; MR pe
806 FRENKEL ?RAZIN * SYMANSKY
relatively high consumption elasticity.14 This choice suggests that in t

case considered, the excess burden associated with a consumption
is relatively high in comparison with the corresponding excess bu
associated with an income tax.
The assumption that saving and investment propensities do not differ
internationally implies that the initial current account positions are bal-
anced. As a result, the international VAT harmonization does not alter
the world rate of interest. The dynamics of adjustment in this case arise
only from the effects of the tax wedges on the various incentives.
In summarizing the results presented in Figures 1-5 and Table 2, we
first note that with a labor income tax system, the VAT harmonization
does not induce any change in the time path of domestic and foreign
investment.
Second, whenever the income tax system contains an investment incen-
tive component, its effect on the paths of investment is dominant. Indeed,
under the cash flow income tax system (which obviously contains an
investment incentive component) and under a capital income tax system
combined with investment incentives, the path of domestic investment
consequent on the reduced income tax is lowered for both the short and
the medium runs. The opposite occurs in the foreign country. This
pattern is reversed under the income tax systems that do not contain
incentives to investment.
Third, and analogous with the foregoing reasoning, whenever the
income tax system contains a saving incentive component (such as the
individual retirement account (IRA) system in the United States, which
eliminates the double taxation of savings), its effect dominates the
changes in consumption. Thus, under the cash flow income tax system
and under a capital income tax system combined with saving incentives,
the path of domestic consumption consequent on the VAT harmonization
is lowered for both the short and the medium runs. The opposite occurs
in the foreign country. This pattern is reversed under the labor tax system.
Fourth, whenever, the income tax system contains a tax on labor
income, changes in that tax dominate the effect of the VAT harmoniza-
tion on employment. Thus, under both the cash flow and the labor
income tax systems, the path of domestic employment consequent on the
14The intertemporal labor supply elasticity, indicated by t, is 0.3; the coeffi-

cient of cost of adjustment for investment, indicated by b, is 40; and the inter-
temporal elasticity of substitution for consumption is unitary. In fact, in searching
for the Ramsey (second-best) tax structure for the range of parameter values, we
found that income tax is superior to VAT. To examine the sensitivity of the results
with respect to the values of the elasticities, we also simulated the model with a
lower cost of adjustment coefficient and a higher labor supply elasticity. Under
these circumstances the welfare cost of VAT diminished relatively, while the
welfare cost of income taxes increased relatively.
reduced income tax is raised for both the short and the medium ru
opposite occurs in the foreign country in which income taxes
Finally, by inspecting the figures, one may infer the effects o
harmonization under alternative tax systems on the growth
domestic and foreign output and on the path of external deb
Figures 1-5 and Table 2 reveal the potential international co
interest that could arise with the implementation of VAT harmo
Under all the tax systems considered, the changes in domestic an
employment, output, consumption, saving, and investment c
on international VAT harmonization go in opposite directions
other in both the short and the medium runs.
The utility indices of economic welfare reflect the same phenomenon.
In all cases, the domestic and foreign SR utility indices (given by the
discounted sums of utilities over the entire period except for the final one)
move in opposite directions. In general, the same holds for the MR utility
indices, reflecting the future beyond the simulation period. Furthermore,
in the cases considered the VAT harmonization results in a redistribution
of welfare between generations, evidenced by the opposite direction of
changes in the SR and MR utility indices within each country. The
simulations show that the changes in the utility indices reflect, by and
large, a redistribution of world welfare, since the sum of the domestic and
foreign utility indices does not change appreciably. This result strength-
ens the suggestion that the resolution of international conflicts of interest
arising from VAT harmonization may require a compensation mecha-
nism between gainers and losers.
IV. Tax Conversions: Revenue Neutrality and Current

Account Imbalances
In this section we focus on a reform that introduces a consumption tax

(VAT) system instead of the prevailing income tax system, allowing for
current account imbalances.16 To simplify, we consider a two-period case
15The results of the consequences of VAT harmonization accompanied by

compensatory adjustments of the cash flow income tax can shed light on the likely
effects of transforming a VAT system that is destination based to a system that
is source based (since the cash flow income tax is equivalent to the source-based
VAT). Under the destination-based system, the cross-country location of produc-
tion of tradable goods is undistorted while that of consumption is distorted. The
opposite outcome holds under the source-based system. See Frenkel, Razin, and
Sadka (1991).
6 This analysis is based on Frenkel and Razin (1989). In order to highlight the
pure effects of tax conversions, we consider cases of revenue neutrality only. In
the absence of revenue neutrality, the tax conversion results in periodic budgetary
deficits and surpluses. The effects of such budgetary imbalances are analyzed in
Frenkel and Razin (1988a), and dynamic simulations are presented in Frenkel,
Razin, and Symansky (1990).
with a cash flow tax system. With this system, the effective d
factors governing consumption, investment, and labor supply de
(indicated in equation (2)) become
1 + Tc 1 - Tkl 1 - T,1
^+1l+T7a-,-1
- 1 - Tk L T a -T ,
where a = 1/(1 + ro) denotes t
The tax conversion consists
permanent reduction of the
tional rise in VAT. Second, it in
tax aimed at restoring the in
evident from equation (5), with
component of the tax conver
factors governing decisions abo
the level of investment. As a re
equilibrium (involving the lev
of output rem and consumption)
the equiproportional changes i
further adjustments in income
mining whether the tax conve
tax revenue is the economy's in
sion from an income tax syst
if the level of consumption e
ment-that is, if the country ru
balance of payments.19 In th
conversion raises government
To ensure revenue neutrality
ward adjustment in the pres
temporal solvency implies th
surplus in the future period,
necessitates an upward adjustme
Opposite adjustments in curr
necessary if the economy's pr
17 The simulation analysis relaxes

simulations with a richer tax structure that allows for the various taxes and
incentives specified in the previous section.
18 We note that even though the effective tax-adjusted discount factors do not
change following the first component of the tax conversion, the intratemporal tax
ratio, (1 - T,) /(1 - T), rises. As a result, the supply of labor in each period rises.
19 More precisely, since under the cash flow formulation the income tax base
is the level of output net of investment, and the VAT base is the level of
consumption, the difference between the two tax bases is the primary current
account-that is, the current account net of debt service.
in surplus, so that the first component of the conversion to a VA

narrows the tax base.
We now apply the analysis to a two-country model of the world econ-
omy. We carry out the analysis with a simple diagrammatic apparatus that
portrays the rates of growth of consumption and output (net of invest-
ment) as functions of the corresponding tax-adjusted discount factors. In
Figure 6 the upward-sloping schedule, SW, describes the ratio of future
to present world output net of investment as an increasing function of the
discount factor. The positive slope reflects the fact that a rise in the
discount factor (a fall in the rate of interest) raises current investment and
induces substitution away from present-period labor supply toward a
future-period labor supply. These changes raise the ratio of future-to-
present-period output net of investment. This world relative supply
Figure 6. Dynamic Effects of a Revenue-Neutral Tax Conversion

from Income Taxes to VAT with an Initial-Period
Domestic Current Account Deficit
A S*
Discount
factors
/ S SS
5s
=l/ /
0= :- /,' /
... ...........
a'L =+u..'x
. .. . . . . /
. .................... ......... '
Cl _ Growth rates
schedule is a weighted average of the corresponding domestic, S

foreign, S*, relative supply schedules. The downward-sloping sch
DW, shows the world desired ratio of future to current consumption
decreasing function of the discount factor. This world relative deman
a weighted average of the two countries' relative demand schedule
drawn). As shown in Figure 6, the initial equilibrium obtains at po
at which the world rate of interest is ro.
Suppose that the domestic economy runs a present-period cur
account deficit. Under such circumstances, the shift toward a VAT br
ens the tax base. To maintain revenue neutrality, the current in
taxes, Tk0 and T0, fall, while future income taxes, Tkl and T,w, rise. A
from equation (5), the new configuration of income tax rates lowe
effective discount factors applicable to investment and labor decis
ca and aL. However, since the intertemporal ratio of consumption
remains unchanged, the effective discount factor applicable to consum
tion decisions, atc, remains intact.
The fall in the effective discount factors applicable to investment a
labor supply induces an intertemporal substitution in the domestic ec
omy toward current-period output (net of investment). Thus, fo
and every value of the world discount factor, the domestic relative su
schedule shifts to the left from S to S'. The proportional vertical disp
ment of the schedule equals the proportional tax-induced fall in
effective discount factor. Associated with the new level of domestic
relative supply, the new world relative supply schedule also shifts to the
left from Sw to Sw'. Note that the proportional displacement of the world
relative supply schedule is smaller than the corresponding displacement
of the domestic relative supply schedule. The new equilibrium obtains at
the intersection of the (unchanged) world relative demand schedule, DW,
and the new world relative supply schedule, SW'. This equilibrium is
indicated by point A', at which the world discount factor has risen from
ot to a'. To determine the incidence of this change on the domestic
discount factors, we subtract the tax wedge from a' and obtain the new
lower domestic effective discount factors, ac' and otL. Thus, on the one
hand, by raising the world discount factor, this tax conversion reduces the
rates of growth of domestic and foreign consumption and crowds in
foreign investment. On the other hand, the induced fall in the domestic
tax-adjusted discount factor governing investment and labor supply
crowds out domestic investment, and the rate of growth of domestic
employment falls.
Using similar reasoning, it is evident that if the country adopting the
tax reform has a present-period current account surplus, then the tax
conversion to a VAT system narrows the present-period tax base and
lowers tax revenue. Restoration of revenue neutrality necessitates in-
tertemporal adjustments of income tax rates in directions oppo

those depicted in Figure 6. In that case, the world discount fac
and the domestic tax-adjusted discount factors, a, and axL, ri
tax reform then increases the rates of growth of domestic and
consumption, crowds out foreign investment, and crowds in d
investment.20
V. Simulations of VAT Harmonization:

Current Account Imbalances
In what follows, we present dynamic simulations of the consequences

of international harmonization of VAT in the presence of current account
imbalances. We use our two-country model and, as in Section III, pre-
sume that prior to the VAT harmonization the two countries were using
very different tax systems. Tax revenue in the home country comes from
high income tax and from high VAT in the foreign country. The harmo-
nization of VAT entails a rise in the home country VAT rate and an
equivalent reduction in the foreign VAT rate.
Our analysis can be illuminated by the analytical results obtained in the
previous section on tax conversions. In fact, our specification of VAT
harmonization entails various tax conversions that take place simulta-
neously in all countries. To avoid the budgetary imbalances consequent
on the changes in the VAT rates, we ensure revenue neutrality by adopt-
ing the same procedure used in the analysis of tax conversions in Sec-
tion IV. Accordingly, the induced budgetary imbalances are corrected
through changes in income tax rates.
In performing the simulations, as in Section III, we first computed a
baseline equilibrium. This equilibrium was then disrupted by the as-
sumed VAT harmonization. The various figures presented below show
the effects of the tax restructuring measured as percentage deviations
from the baseline levels. As indicated by the analysis in Section IV, one
of the key factors governing the effects of revenue-neutral tax conversions
is the time pattern of the current account position. Since these positions
can be expressed in terms of the saving-investment gap, they reflect
20The foregoing analysis assumed that revenue neutrality obtains through

appropriate changes in income taxes. If, however, budgetary corrections obtain
through changes in consumption tax rates, then the effective discount facto
governing investment and labor supply decisions would not change, while th
effective discount factor governing consumption decisions would change the
supply of labor (the direction of the change would depend in an obvious way on
the initial current account position). In that case the domestic (and thereby th
world) relative demand schedules in Figure 1 would shift while the relative supply
schedules would remain intact. For an analysis of such changes, see Frenkel an
Razin (1989).
intercountry differences either in saving propensities, induced, fo

ple, by differences between the subjective discount factors, 8 an
in investment patterns induced, for example, by differences betwe
productivities of capital, rk and rk.
In Figures 7-10 we plot the simulation results for cases distin
according to the time pattern of current account imbalances. I
figures, we assume that the income tax used in both countries i
cash flow variety. As before, we assume throughout that the
country permanently raises its VAT by 6 percent and restores
revenue by lowering its cash flow income tax rates; the foreign co
(whose initial VAT rate is assumed to be high) permanently low
VAT by 6 percent and restores its tax revenue by raising its c
income tax rates. The figures show the paths of domestic and
output, labor supply, saving, investment, and consumption, as well
paths of the world rate of interest and the home country's externa
consequent on the VAT harmonization. All paths are expressed
centage deviations from the baseline (except for the rate of interes
deviation is expressed in basis points). The simulations reveal th
international VAT harmonization triggers a dynamic response
the key macroeconomic variables. The specific nature of the d
response reflects international differences in the parameters go
saving and investment patterns.
The key features of the simulation analysis of tax harmonization
lying Figures 7-10 are summarized in Table 3, which also repo
implied welfare implications of the VAT harmonization. In or
capture the essence of the dynamic evolution of the various va
Table 3 shows the direction of changes for both the short run
the medium run (MR).
In conformity with the tax conversion analysis of Section IV, the
in Table 3 demonstrate the key role played by the current accou
tion. Specifically, if in the early stage the home country runs a
account deficit due to low saving or high investment (for exam
8 < 5*, or rk > rk), then the paths of domestic and foreign inc
rates rise over time, so as to maintain tax revenue. As a result, the
rate of interest falls.21 In that case, the rates of growth of domest
21 Intuitively, the rise in the home country VAT accompanied by an equ

tional fall in the income tax broadens the tax base and raises tax revenue in the
current period if the home country runs a current account deficit. To restore tax
revenue, the income tax rate must be lowered. The opposite changes occur in the
future period in which the current account position is in surplus, reflecting the
intertemporal budget constraint. Similar considerations imply that the path of
income tax abroad also steepens. As a result, the tax incentives to investment
decline, yielding a fall in the world rate of interest. See Frenkel and Razin (1987,
chap. 8).
Figure 7. VAT Harmonization (6 < 8*)
Home output .............. Home

--?--.- Foreign output ... - - - - - F
.............. Home labor H
. -. -. . .- Foreign labor -.. - . - . - Foreig
Home consumption .-....-- Home
.----.- .- Foreign consumption - -..-... Interest r
16
1 . _ 8 - -
Lllll~~~~~~~~~l- -~~~~~"-1~~
I ................... -.
._.
0
-.. . - me . .
0
.' C
-1 -8 I I I
-2 I I I I I I I I I I I I j I I I -16 ,,,,,,,I
0 2 4 6 8 10 12 14 16 17 0 2 4 6 8
Note: Assum i ncrease of 6 percent in home country VAT and a perma

Figure 8. VAT Harmonization (8 > 8*)
Home output .............. Home inves

-- .-- - Foreign output .- .-.-- - - Fore
............. Home labor Home
- -. -- Foreign labor - -. -- Foreign savi
Home consumption Home ext
.- - - - - Foreign consumption .- .- - i- nInterest r
2 16
1 8
...*.
"I".1illwor - - nmmomm
._* _..*_* _*_ aw W?..
.~~~~~~~ . . . . . . . _. . . _. . _. . . _._. . . . . . . . . . . . . . . . . . . . _ '
0 0
M ,,,. ,.... . ..... . . ....
-1 -8 r
-2 I ? - - ?%
-16 J ? ?
0 2 4 6 8 10 12 14 16 17 0 2 4 6 8 10
Note: Assuming a permanent

inforeign country VAT.
Figure 9. VAT Harmonization (rk > rt)
Home output .............. Home inve

- - - - Foreign output .....- Foreig
.............. Home labor .............. Home savi
- .- . - - Foreign labor -.-.-.- Foreign sav
Home consumption Home e
- -- .- - - Foreign consumption .----. Interest ra
2 16
1 8
- -
--o
0 0
-1 -8
(1 J I I I J I I J i I J ! I I I ! I
-2 -16
0 2 4 6 8 10 12 14 16 17 0 2 4 6 8 1
Note: Assuming a permanent increase of 6 percent in home

Figure 10. VAT Harmoniz
(Percentage deviation
Home output .............. ome invest

.....- Foreign output - - -- -- -' Foreign inve
.............. Home labor .............. Home saving
-... .- Foreign labor - - .- .- Foreign savin
Home consumption .Home ex
.-..--. Foreign consumption - - - - - Interest rate (r
2 16
1 8 i
... . . . ......................................... . . . .. ...
0 0
?I~ _n I I I
i__
-1 -I I ! - I - I l-l -l -l It -l -8 le 9 ? I 9ll m . .
l l l | l
-2 -16 0 2 4I I
0 2 4 6 8 10 12 14 16 17 0 2 4 6 8 10
Note: Assuming a permanent

foreign consumption (gc and g*, respectively) fall, both in the sho
in the medium runs.
If, however, the configuration of saving and investment propensities is
such that the home country runs a current account surplus in the early
stage, then the dynamic effects of the VAT harmonization on these
variables are reversed. Specifically, if in the home country saving is high
or investment is low (for example, if 8 > 8*, or rk < rk), then the paths
of domestic and foreign income tax rates fall, and the world rate of
interest rises. In that case the rates of growth of domestic and foreign
consumption rise. Thus, under the present cash flow system the direction
of changes in the world rate of interest and in the growth rates of
consumption consequent on international VAT harmonization depend
exclusively on the paths of the saving-investment gap.
The lower panel of Table 3 summarizes the corresponding short- and
medium-run changes in other key economic variables. As can be seen,
international VAT harmonization crowds out domestic investment and
crowds in foreign investment independent of the current account posi-
tions. These investment responses reflect the induced changes in the
domestic and foreign tax incentives and the world rate of interest. These
changes yield two conflicting effects: the effect of the change in the world
rate of interest, and the opposite effect of the change in the tax wedges
induced by the alteration of the time paths of income tax rates.
The welfare effects of terms of trade changes depend on the magnitude
of the change in the terms of trade and on the gap between purchases and
sales of the good whose relative price has changed. In our intertemporal
context the terms of trade correspond to the world interest rate, and the
gap between purchases and sales corresponds to the current account
position. As illustrated in Table 3, in all cases the change in the terms of
trade operates in favor of the country that raises its VAT. When the
country runs a current account deficit (that is, when it borrows in the
world economy), its intertemporal terms of trade improve since the rate
of interest falls. Likewise, if the country's current account position is in
surplus, its intertemporal terms of trade also improve, since the rate of
interest rises. As Table 3 illustrates, this improvement in home country
welfare induced by the changes in the world rate of interest can be
mitigated (or even offset) by the excess-burden effects of the VAT har-
monization. Similar considerations apply to the welfare consequences of
a reduction in VAT in the foreign economy.
A comparison between the effects of the international VAT harmo-
nization on the domestic economy and the foreign economy reveals that
in the two countries the levels of foreign employment, investment, out-
put, and some other key macroeconomic indicators change in opposite
Table 3. Effects of VAT Harmonization Under Alternative Current Ac
(Deviations from baseline)
Home Country Current Home C

Account Deficit Accou
5 < 5* 6 = 8* 5>
<* _>*
rk = rf rk > rk rk - rk
Variable SR MR SR MR SR M
Path of Ty Rising Rising Rising Rising Falling Fa

Path of ;, Rising Rising Rising Rising Falling Fa
r + +
gc + +
g* + +
I
I* + + + + +
L + + +
Y + - - + -
y*- + - + -
C + - + - -
C* +-+ - + -
S + - - - +
S* -- + -
B - - - - _ _
U +0.2 -8.2 -0.1 -6.7 +0.3 -7
U* -0.3 +8.4 -0.3 +10.9 -0.3 +
Note: The VAT harmonizati
balance obtains through app
the short run and the mediu
while the medium run pert
by which the postharmoniz
the utility index, SR pertai
final-period utility (reflecting the entire future beyond
directions. In most cases the utility index indicates that domes

foreign welfare also move in opposite directions. These pheno
suggest that international VAT harmonization may induce inter
conflicts of interest. Resolution of such conflicts may require i
tional fiscal transfers from countries benefiting from the VAT har
tion to countries that lose. The potential difficulties arising from i
tional conflicts of interest may be augmented by internal conf
interest associated with redistributions of income between labor and
capital in the short and medium runs.22
The foregoing analysis considered only the case in which cash flow
income taxes were used to restore budgetary balance following the inter-
national VAT harmonization. In these circumstances, in conformity with
the analytical results of Section IV, the current account positions playe
the key role in determining the direction of changes in the world rate of
interest and the growth rates of domestic and foreign consumption. A
indicated by the simulations in Figures 7-10 and in the summary results
in the lower panel of Table 3, the dynamic effects of the internationa
VAT harmonization on the path of the other key macroeconomic vari-
ables did not depend only on the current account positions. In fact, fo
the cases shown in these simulations, domestic investment, foreign em
ployment, foreign saving (in the short run), and the level of the domestic
country's external debt all fell independent of the current account posi-
tions, while foreign investment and foreign saving (in the medium run)
always rose.
VI. Concluding Remarks
One of the major developments in the world economy during the 1990s
is likely to be the move toward the single European market in 1992. The
removal of barriers to trade and factor movements, unification of mar-
kets, development of new monetary arrangements, and increased harmo-
nization of fiscal policies and tax structures are all key factors in a process
that is likely to affect the shape of the global economic system for years
to come.
One of the elements of the move toward tax harmonization in the EC
is a convergence of the various VAT systems. In this paper we have
22 As an example of induced changes in the functional distribution of income,

consider the left-hand column of Table 3. There, the VAT harmonization raises
the share of labor and lowers the share of capital income in the domestic economy
for both the short and medium runs while inducing an opposite redistribution in
the economy.
analyzed the global effects of such an international VAT h

For this purpose, we developed a model that encompasses
of tax systems. The model contains two countries and is there
of highlighting the spillover effects of taxes across countries
ical framework is grounded on microeconomic foundations
fore suitable for an examination of the incentive effects as well as the
welfare consequences of tax policies.
To examine the quantitative implications of international VAT harmo-
nization, we performed dynamic simulations. The analysis as well as the
simulations demonstrated that the effects of VAT harmonization on the
key macroeconomic variables (such as output, employment, investment,
consumption, interest rates, the current account, and the value of exter-
nal debt) are very significant. Furthermore, these effects (quantitatively
and qualitatively) are not spread evenly across income groups, genera-
tions, and countries. As a result, a VAT harmonization may give rise to
internal conflicts of interest within each country (arising from changes in
the distribution of income among members of each generation as well as
among generations) and between countries. The international differ-
ences in the incidence of the VAT harmonization arise from differences
in the current account positions (reflecting underlying differences in
saving and investment propensities) as well as from differences in tax
structures. Resolution of the various conflicts of interest that adoption of
VAT harmonization could engender may require the development of a
fiscal mechanism by which gainers compensate losers within countries as
well as between countries.
Throughout, we have emphasized the dynamic features of the interac-
tions among economies as they operate through the integrated world
capital market. Accordingly, we have focused on the intertemporal terms
of trade-the rate of interest. Obviously, an additional channel through
which the effects of tax policies spill over to the rest of the world is the
temporal commodity terms of trade-the relative price of tradable to
nontradable goods and the relative price of exportables to importables.23
A useful extension would allow for a more refined aggregation of com-
modities. With this refinement, the model could also shed light on the
effects of international VAT harmonization on the structures of industry
and trade, as well as on the sectoral distribution of employment and
investment.
Finally, our analysis of the world economy has been conducted within
23 For an analysis of the effects of tax policies within a model that allows for
such a commodity disaggregation, see Frenkel and Razin (1987, 1988b) and
Bovenberg (1989).
a two-country model. Since the effects of VAT harmonization amo

subset of the countries may affect the rest of the world, it would be us
to extend the analysis to more than two countries, so as to allow f
more complete examination of the international spillovers of VAT
monization. Such an extension would facilitate an analysis of "tra
creation" and "trade diversion" in both goods and capital markets
ciated with the establishment in 1992 of the single market in Euro
APPENDIX I
Solution of the Model
In this Appendix we present the formal solution to the model. The maximiza-
tion of the utility functions subject to the lifetime present-value budget constraint
yields
T _1 t
u,=
_s = P d,
s - W ' (6)
P = [p(1 + ) + c (1 - P) ((1 - 'wt)W)l- ]1(1 -a) (7)
ct P3(1 + tct)- ptU,

1 (1 + T,)1 + (1 - p)((1 - rwt)W) - (8)
(1 - p)"((1 - Tw)W) -p,tU

p'(1 + pc)l -) + (1 - P3)((l - ,t)W) -' (9)
where u is the utility-based real spending, P denotes the associa
C denotes consumption of ordinary goods, and 1 - I denotes lei
equations t = 1, 2,..., T; d, is the tax-adjusted present-value fa
to period t-that is,
d, = [1 + (1 - Tkl)(1 + ,sl)ro]1
[1 + (1 - Tk2)(1 + T,2)r]- * * [1 + (1 - Tkt)(l + Ts,)r,- ]-1
24 Our preliminary simulations of an extended three-country m

if the two countries joining the single market differ from each othe
in terms of their saving and investment propensities, then the VA
significantly affects the levels of investment, employment, outpu
the rest of the world (the third country). Furthermore, with som
of parameters, the presence of a third country affects some of
changes within the countries forming the single market. In order
dimensions of the debate on "fortress" versus "open and enlarg
report in Appendix II some simulations of the effects of taxes o
borrowing within a three-country world. The simulations reveal th
to capital mobility between Europe and the rest of the world
significant negative welfare effects on the rest of the world.
and wealth, Wo, is

T
Wo = d, (1 - w,,)w + (1 - kt)(rk - O)K,

t=O
-(1 - r,)I,ti + b )
+ dT(1 - TkT)aKT - [1 + (1 - Tko)(1 + Tro)r- ]BP. (10)
The investment equation, It, is obtained by a maximization of wealth, Wo, with

respect to investment, It. This yields
it\ T-1
-(1 - TIt)dt 1 + b -) + E ds(1 - 0)s t (1 - ks)(rk - 0)
\b rI, )2+
+ (1 - Tis)- 2K) + d,(l - )T- - ( - TkT)(rk + a - 0) = 0. (11)
Equation (11) represents an implicit investment rule. The negative term is equal
to the marginal cost of investment in period t, while the positive terms are equal
to the marginal benefits consisting of the rise in output resulting from the
increased capital stock (the terms with rk and a) and the fall in future costs of
investment (the terms associated with (b /2).(I/K)2). To illustrate, in the two-
period case the investment function implied by equation (11) is
1( = ( ( Tk(a + rk -0)- 1)Ko. (12)
Equation (12), together with the assumption that (a

(an assumption necessary for a positive level of inves
case), implies that the level of investment rises with th
the effective (tax-adjusted) discount factor, ot, the rent
rk - 0, and the consumption coefficient, a, attached t
However, investment falls with an increase in the cost
b. Substituting equation (12) into (5) yields the corres
1
Wo = E d,(1 - w,,)w + qoko - [1 + (1 - Tko)(1 + To)r_1]BP,, (13)

t =
where qo denotes the tax-adjusted mar

(Tobin's q):
qo = (rk - 0)[(1 - Tko) + (1 - kl)(1

+ (1 + a)ac(a + rk - - 1)
(1 - Tk)al- (1 - To)(1 + (aot(a + rk ) - )) .

2 9-1
APPENDIX II
Tax on International Borrowing
In this Appendix we extend the tax structure to include a tax on inte

borrowing, denoted by Tb. With this added tax, the periodic budget con
equation (1) in the text becomes
(1 + T,1)C, + (1 - Twt)w(1 - l,) = (1 - Tw,)w + (1 - Tk,)[(rk - O)K
-(1 - T)I(1 +2 + (1- b)(B, - B,_ ,)

- (1 - Tk,)(1 + T, - 1)r, - B_ ,. (14)
As formulated, the international borrowing tax applies

external debt. Letting total debt be BP = (1/(1 - Tb))B
the arbitrage condition by which the after-tax rates of r
rF = (1 - Tb)rH, yields the last two terms on the right-ha
Analogously, the lifetime present-value budget constrain
period case becomes
Co + acC1
= 1
1 ++
[wlo [+ aL 2
,co Wl]Ko
+ 1 + o l(rk 0
+?:(-1 -T - 1kO _r 1 - Tkl o

+ T T o(rk -k) - 1 - T + (1 - Tkl)(1 + T%
+ (1 - TTk)( + (1 - 1o))r + p (15)

1 + Tco
25Equation (1) implicitly incorporates both external and inte

verify, denote internal debt by B P, and the corresponding rate of
RH. Analogously, denote the external debt by BFP, and the corre
of interest, by rF. Debt flows in the budget constraint for period
HP H HP
B, B - (1 - Tk - )(1 + Trs- 1)rH - Bt , + (1 - Tb,)(B
FP HP
- B, ) - (1 -
As formulated
ternal debt. L
arbitrage cond
rF = (1 - Tb)rH
where
(1 + T,1)(1 - TbO)
(1 + Tco)((1 - Tbl) + (1 - Tkl)(l + T,,)ro)
(1 - Tkl)(1 - TbO)
(1 - T/o)((l - Tbl) + (1 - Tkl)(l + T,o)ro)
and
(1 - (1 - T Tw)(l - To)
aL (1 - Two)((l - Tbl) + (1 - Tkl)(l + T,l)ro) '
The formulation of the periodic budget constraint illustrates the equivalence
relation existing among the taxes on consumption income (cash flow), and inter-
national borrowing. Indeed, the real effects of any given combination of the three
Table 4. Effects of a 10 Percentage Point Rise in the International Borrowing

Tax Rate Between Europe and the Rest of the World
(Percentage deviations from baseline)
Budgetary Balance Bugetary Balance

Maintained Maintained Through
Through VAT Cash Flow Income Tax
Variable SR MR SR MR
Ic +0.30 -0.20 0.00 0.00

Ty 0.00 0.00 +0.23 -0.20
r -0.23 -0.20 -0.24 -0.18
IE -0.60 +3.50 -0.50 +3.00
IR +3.40 +2.50 +3.00 +2.50
LE +3.20 -3.00 +3.00 -2.70
LR -6.00 +5.40 -5.20 +5.20
YE +1.30 -1.30 +1.40 -1.20
yR -2.50 +3.40 -2.00 +3.00
CE -1.00 +0.80 -0.90 +0.70
CR +1.50 -1.40 +1.40 -1.30
SE/yE +0.02 -0.02 +0.02 -0.02
R /yR -0.04 +0.06 -0.03 +0.05
BE/yE -0.07 -0.10 -0.06 -0.10
UE +0.10 -2.00 +0.10 -2.00
UR -0.10 +2.40 -0.10 2.70
Note: European and foreign
respectively; SR and MR are
is measured by the percentag
must be raised in order to bri
taxes can be duplicated by a policy consisting of any two of them. Denoting t

cash flow income tax by Ty, the budget constraint is
(1 + cT,)C, = (1 - Tyt)Yt + (1 - Tt)(Bf - BP_ ),

where Y, denotes income net of investment. Now, consider an initial situation w
a positive consumption tax rate, Tc, and zero income and international borrow
tax rates. If the consumption tax were eliminated and the income and inter
tional borrowing taxes were both set equal to Tc /(1 + Tc), then the effective
rates associated with this new combination of taxes are zero income and interna-
tional borrowing taxes and a positive (Tc) consumption tax. It follows that the real
equilibrium associated with the new tax pattern (Tc = 0, Ty = Tb = Tc /(1 + Tc)) is
identical to the one associated with the initial tax pattern (Tc = c, Ty = Tb = 0).
This analytical framework of taxes on international borrowing can be used to
examine the effects of a removal of impediments on capital movements within
Europe of 1992 (while maintaining the impediments between Europe and the rest
of the world) on the key economic variables within and outside Europe. Ta-
ble 4 presents preliminary simulations of such an experiment. Specifically, we
consider the effects of an introduction of a common tax by the two countries
forming the single market on international borrowing from the rest of the world
(country R). In conducting the simulations, we assume that the periodic budget
balance in Europe (country E) is maintained through appropriate adjustments
either of VAT or of cash flow income taxes. To highlight the external effects, we
focused the simulations on the case in which the domestic and foreign economies
(forming the single European market) are identical. The opposite welfare impli-
cations of such a tax for Europe and the rest of the world underscore the
international concern regarding the specific modalities of the integration process.
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International VAT Harmonization: Macroeconomic Effects

Author(s): Jacob A. Frenkel, Assaf Razin and Steven Symansky

International VAT Harmonization

JACOB A. FRENKEL, ASSAF RAZIN,

Macroeconomic issues pertinent to the international and domestic effe

T HE COORDINATION of fiscal policy in general, and tax policy in part

*Jacob A. Frenkel, Governor of the Bank of Israel, is also Professor of

goods and services within the European Community (EC),

of output, employment, investment, consumption, and ot

I. VAT Harmonization: Europe 1992

1 Zero-rated products involve the reimbursement of taxes levied on inputs, with

Statutory Rates (1990) Pe

Sources: Cnossen and Shoup (198

For 1992 the Commission initially proposed a standard VAT r

sion proposed in May 1990 (following the guidelines set by the

II. The Tax Model

We start with a formulation of the budget constraint.6 As usua

-(1 - T,)I, 1 + ) + (BP - BPf_)

6The analytical framework underlying the internati

or new borrowing occurs, so that IT = BP = 0.7 To sum up, the lef

The periodic (full-income) budget constraints specified in equation

Co + aC1 = Two [wlo + aL Wl1] + 1 o T aL(r - 0)

1 + (1 - Tko)(l + Tso)r - (2)

the effective discount factor governing intertemporal consumptio

Ut = [PC( - 1)" + (1 - 13)(1 - / )( - 1)d]u(U- 1) (3)

where a is the temporal elasticity of substitution betwee

12 This latter property is more general and not confined only to

III. Simulations of VAT Harmonization: Alternative Tax System

In this section we present dynamic simulations of the effects of inter-

VAT. The harmonization of VAT entails a rise in the home cou

Note: Assuming a permanent inc

Note: Assuming a permanen

Note: Assuming a permanent i

Note: Assuming a permanent increase of 6 percent in home country V

Note: Assuming a permanent increase of 6 percent in home country VAT an

U 0.3 -7.8 0.0 -12.5 1.4 -7.0 1.2

Note: The VAT harmonizati

relatively high consumption elasticity.14 This choice suggests that in t

14The intertemporal labor supply elasticity, indicated by t, is 0.3; the coeffi-

IV. Tax Conversions: Revenue Neutrality and Current

In this section we focus on a reform that introduces a consumption tax

15The results of the consequences of VAT harmonization accompanied by

17 The simulation analysis relaxes

in surplus, so that the first component of the conversion to a VA

Figure 6. Dynamic Effects of a Revenue-Neutral Tax Conversion

schedule is a weighted average of the corresponding domestic, S

tertemporal adjustments of income tax rates in directions oppo

V. Simulations of VAT Harmonization:

In what follows, we present dynamic simulations of the consequences

20The foregoing analysis assumed that revenue neutrality obtains through

intercountry differences either in saving propensities, induced, fo

21 Intuitively, the rise in the home country VAT accompanied by an equ

Home output .............. Home

Note: Assum i ncrease of 6 percent in home country VAT and a perma

Home output .............. Home inves

Note: Assuming a permanent

Home output .............. Home inve

Note: Assuming a permanent increase of 6 percent in home

Home output .............. ome invest

Note: Assuming a permanent

Home Country Current Home C

Path of Ty Rising Rising Rising Rising Falling Fa

directions. In most cases the utility index indicates that domes

VI. Concluding Remarks