Taxing Consumption in an Open Economy

Abstract

This article examines the effects of consumption taxation on capital accumulation, net foreign asset holdings, the trade balance, and welfare in a two-country overlap ping generations model. Government finances its lump-sum transfers by taxing consumption. An increase in the domestic consumption tax rate decreases the real interest rate and increases the capital-labor ratio and the wage rate in both countries. An increase in the domestic consumption tax rate raises the domestic country's net foreign asset holdings and trade surplus but may either increase or reduce the welfare of the representative domestic individual.