Globalization, Tax Distortions and Public Sector Retrenchment
Univ. of Aarhus Working Paper No. 2010-9
37 Pages Posted: 27 Jun 2010
Date Written: June 24, 2010
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 distort labour markets and cause higher wages and thus a loss of competitiveness. Since this link is strengthened by globalization, it is inferred that the marginal costs of public funds increase and a retrenchment of the public sector follows. We challenge whether these conclusions have support in a general equilibrium model featuring standard effects from open macroeconomics and trade theory. Even though income taxation unambiguously worsens wage competitiveness, it does not follow that marginal costs of public funds increase with product market integration due to gains from trade. Moreover, non-cooperative fiscal policies do not have a race-to-the-bottom bias despite that taxes harm competitiveness. In fact we identify an expansionary bias in fiscal policies that is likely to increase with globalization when taxes finance either public consumption or transfers.
Keywords: labour taxation, open economy, policy spill-over, marginal costs of public funds
JEL Classification: H2, F1, J22
Suggested Citation: Suggested Citation