Stochastic growth, taxation policy and welfare cost in an open emerging economy

Abstract

We studied the unstable tax policy effects on the welfare and growth in the emerging economies. This is in a more general approach than those of Turnovsky (Dynamic macroeconomic analysis, pp 155–211, 2003) and Hopenhayn and Maniagurria (Rev Econ Stud 63:611–625, 1996), neglecting the emergent economy structure, and only taking the tax policy at random, not establishing endogenous stochastic adjustments. Through our elaborate stochastic growth model in continuous time and simulations for small open emerging economies that imitates foreign technology, the findings are as follows: (1) the higher the initial productivity in the technology adoption sector, the weaker the tax variation needed to offset the effects of a rise in international interest and inflation rates. (2) A high volatility of international prices has a contraction effect on the foreign capital inflows, deprives the domestic agents of foreign technology and reduces the opportunities to invest in imitation. (3) The expected negative tax volatility effect on investment stops from a threshold where the income effect starts to prevailing over the substitution effect. (4) The resulting welfare cost from an unstable tax policy suggests a need for stabilisation or compensation transfers measures.