Progressive taxation and optimal monetary policy in a two‐country new Keynesian model

• Published date: 01 December 2023
• Author: Daisuke Ida,Kenichi Kaminoyama
• Date: 01 December 2023
• DOI: http://doi.org/10.1111/infi.12428

Received: 14 April 2022

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Accepted: 22 December 2022

DOI: 10.1111/infi.12428

ORIGINAL ARTICLE

Progressive taxation and optimal monetary

policy in a two‐country new Keynesian model

Daisuke Ida

1,2

|Kenichi Kaminoyama

1

1

Faculty of Economics, Momoyama

Gakuin University, Izumi, Japan

2

Graduate School of Economics,

Kobe University, Kobe, Japan

Correspondence

Daisuke Ida, Faculty of Economics,

Momoyama Gakuin University, 1‐1,

Manabino, Izumi, Osaka 594‐1198,

Japan.

Email: ida-dai@andrew.ac.jp

Funding information

Japan Society for the Promotion of

Science

Abstract

This paper examines the effect of tax progressivity on

optimal monetary policy in a two‐country new

Keynesian model. We first address the issue that

coefficients in both structural equations and the central

bank's loss function are crucially affected by a change

in tax progressivity in both countries. Second, we show

that a change in tax progressivity significantly affects

the properties of international monetary policy trans-

mission. Third, we demonstrate that the impact of tax

progressivity on international monetary policy trans-

mission depends on the value of the constant relative

risk‐aversion coefficients.

KEYWORDS

optimal monetary policy, policy coordination, tax progressivity,

two‐country new Keynesian model

JEL CLASSIFICATION

E52, E58, F41

1|INTRODUCTION

The recent rapid progress of globalization and digital transformation has challenged

international taxation systems. The rapid progress of globalization may affect the international

difference in tax rates, such as income or corporate taxes, in advanced countries. For example,

Facundo et al. (2017) reported that the degree of tax progressivity on income has seemed

equalized among advanced countries since the 1980s. Piketty (2014) proposed introducing

international tax progressivity to overcome global issues on income inequality. Moreover,

standard international macroeconomics indicates that as financial and trade globalization

progresses, macroeconomic policies in one country may strongly affect those in other countries

International Finance. 2023;26:260–285.wileyonlinelibrary.com/journal/infi260

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© 2023 John Wiley & Sons Ltd.

through international asset markets and trade (Obstfeld & Rogoff, 1996). Accordingly, these

arguments indicate that tax changes allow us to examine the role of the international

dimensions of monetary and fiscal policies.

This paper examines how a change in tax progressivity on labor income affects the

properties of optimal monetary policy in a two‐country new Keynesian (NK) model. We

explore the role of tax progressivity under international monetary policy coordination

addressed in international macroeconomic policies (Canzoneri & Henderson, 1991;Clarida

et al., 2002;Obstfeld&Rogoff,1996). This paper emphasizes that considering an

international aspect of taxation systems aids in understanding how policymakers should

focus on the interaction of monetary and fiscal policies from a global economic

perspective. Theoretically, if complete asset markets exist internationally, the degree of

tax progressivity that each country's government separately determines might significantly

change the effect of monetary and fiscal policies by changing the terms of trade and

international consumption risk‐sharing. If so, it must be determined whether central

banks should implement their monetary policies in a model with international taxation

systems; however, the standard two‐country NK model lacks the international aspect of

taxation systems. Therefore it may induce a misleading policy prescription for

international macroeconomic policy. To consider this issue, we follow Mattesini and

Rossi (2012) and incorporate the role of tax progressivity on labor income into the two‐

country model developed by Clarida et al. (2002). We then demonstrate how changes in tax

progressivity impact the international spillover effects of structural shocks under an

optimal cooperative policy. To the best of our knowledge, the extant literature has

overlooked the role of tax progressivity from a two‐country NK model.

This paper's main findings are summarized as follows. First, we show that the

coefficients for both structural equations and the central bank's loss function are crucially

affected by home and foreign tax progressivities. Second, we show that a change in tax

progressivity significantly affects the properties of international monetary policy

transmission. In particular, we address the fact that a change in foreign tax progressivity

weakens the impact of the foreign cost‐push shock on home inflation through a change in

the terms of trade. Third, we demonstrate that the impact of tax progressivity on

international monetary policy transmission depends on the value of the constant relative

risk‐aversion (CRRA) coefficients.

The key to understanding the results is focusing on the impact of tax progressivity on

both terms of trade and international risk‐sharing effects. Increased tax progressivity can

generally lower output volatility through taxation on labor income; therefore, increased

foreign tax progressivity may dampen a fluctuation in the terms of trade through an

attenuated response from the foreign output gap. Under international monetary policy

coordination, the home policymakers that know this channel can reduce the impact of the

terms of trade on the home output gap if foreign income taxes become increasingly

progressive. Moreover, the new Keynesian Phillips curve (NKPC) implies that this weaker

output gap change helps reduce home inflation; hence, given the degree of home tax

progressivity, an increased degree of foreign tax progressivity can contribute to reducing the

volatilities of macrovariables in the home country.

The main contribution of this paper is to construct a two‐country NK model with tax

progressivity and to show its effect on monetary policy under international monetary policy

coordination.

1

Mattesini and Rossi (2012) showed that the existence of tax progressivity

significantly affects both inflation dynamics and welfare losses; however, we emphasize that

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