This paper studies the welfare effects of a consumption tax rise based on the two-sector small open economy model of Obstfeld and Rogoff (1995) and Lane (1997). The main findings of our analysis are that 1) in the case of free trade, the consumption tax rise has no effect on welfare, 2) when there is the nontraded goods sector, the consumption tax rise has a negative effect on welfare, and 3) the larger the share of nontraded goods in consumption is, the larger the negative welfare effect of consumption tax will be.
P. R. Lane and G. Ganelli, “Dynamic General Equilibrium Analysis: The Open Economy Dimension,” In: A. Altug, J. S. Chaddha and C. Nolan, Eds., Dynamic Macroeconomic Analysis, Cambridge University Press, Cambridge, 2003, pp. 308-334.
J. Lee and M. D. Chinn, “Current Account and Real Exchange Rate Dynamics in the G7 Countries,” Journal of International Money and Finance, Vol. 25, No. 2, 2006, pp. 257-274. http://dx.doi.org/10.1016/j.jimonfin.2005.11.002