Product Market Integration and Income Taxation: Distortions and Gains from Trade

35 Pages Posted: 19 Dec 2007

See all articles by Torben M. Andersen

Torben M. Andersen

University of Aarhus - Department of Economics; CESifo (Center for Economic Studies and Ifo Institute); Centre for Economic Policy Research (CEPR); IZA Institute of Labor Economics

Allan Sorensen

Aarhus University, Economics and Business

Date Written: December 2007

Abstract

It is widely perceived that globalization is a threat to tax financed public sector activities. The argument is that public activities (public consumption and transfers) financed by income taxes may distort labour markets and cause higher wages and thus a loss of competitiveness. If the importance of the latter effect is reinforced by globalization, it is inferred that the marginal costs of public funds increase and a retrenchment of the public sector follows. We consider this issue in a Ricardian trade model in which production and specialization structures are endogenous. Even though income taxation unambiguously worsens wage competitiveness, it does not follow that tax distortions or marginal costs of public funds increase with product market integration. The reason is that gains from trade tend to reduce both. Moreover, non-cooperative fiscal policies do not have a bias towards retrenchment due to a positive terms of trade effect from taxation.

Keywords: labour taxation, open economy, policy spill-over, marginal costs of public funds

JEL Classification: H2, F1, J22

Suggested Citation

Andersen, Torben M. and Sorensen, Allan, Product Market Integration and Income Taxation: Distortions and Gains from Trade (December 2007). CESifo Working Paper Series No. 2170, Available at SSRN: https://ssrn.com/abstract=1077059

Torben M. Andersen (Contact Author)

University of Aarhus - Department of Economics ( email )

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CESifo (Center for Economic Studies and Ifo Institute)

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Centre for Economic Policy Research (CEPR)

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United Kingdom

IZA Institute of Labor Economics

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Bonn, D-53072
Germany

Allan Sorensen

Aarhus University, Economics and Business ( email )

Fuglesangsalle 4
Aarhus V, 8210
Denmark

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