A large, diversified economy recently instituted a substantial tax cut, primarily aimed at reducing business taxes. Some provisions of the new law were designed to stem the tide of domestic firms moving production facilities abroad and encourage an increase in corporate investment in the domestic economy. There was no reduction in government spending. Prior to the tax cut, the country had both a current account deficit and a government deficit.
Questions:
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What impact is this tax cut likely to have on
- the country’s current account balance?
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the country’s capital account balance?
- growth in other countries?
- the current and capital accounts of other countries?
- What adjustments is the tax cut likely to induce in the financial markets?
Guideline answers
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- The deficit on current account will almost certainly increase. The government deficit will increase which, all else the same, will result in a one-for-one increase in the current account deficit. If the tax cut works as intended, domestic investment will increase, reducing net private saving and further increasing the current account deficit. Private saving will increase as a result of rising income (GDP), which will diminish the impact on the current account somewhat. Unless saving increases by the full amount of the tax cut plus the increase in investment spending, however, the net effect will be an increase in the current account deficit. In principle, this increase could be thwarted by movements in the financial markets that make it impossible to fund it, but this is unlikely.
- Because the current account deficit will increase, the country’s capital account surplus must increase by the same amount. In effect, the tax cut will be funded primarily by borrowing from abroad and/or selling assets to non-domestic investors. Part of the adjustment is likely to come from a reduction in FDI by domestic firms (i.e., purchases of productive assets abroad) provided the new tax provisions work as intended.
- Growth in other countries is likely to increase as the tax cut stimulates demand for their exports and that increase in turn generates additional demand within their domestic economies.
- In the aggregate, other countries must already be running current account surpluses and capital account deficits matching the balances of the country that has cut taxes. Their aggregate current account surplus and capital account deficit will increase by the same amount as the increase in current account deficit and capital account surplus of the tax-cutting country.
- The country must attract additional capital flows from abroad. This endeavor is likely to be facilitated, at least in part, by the expectation of rising after-tax profits resulting from the business taxes. Equity values should therefore rise. The adjustment may also require interest rates and bond yields to rise relative to the rest of the world. The impact on the exchange rate is less clear. Because the current account and the capital account represent exactly offsetting flows, there is no a priori change in demand for the currency. The net impact will be determined by what investors expect to happen. (See the following section for a discussion of exchange rate linkages.)
Can you please explain this in detail?
Sir has discussed this question in class / notes. Please refer there.
Can someone please explain this? I don’t have access to sanjay sir’s notes.