We investigate the dynamic and steady-state effects of a change in
consumption and labor tax rates (« social VAT ») in a two-sector
small open economy with capital accumulation and endogenous
employment. With fixed labor, the substitution of payroll tax on
wage for consumption tax leaving unchanged the government budget
constraint induces solely a rise in wage rate together with a fall
in the marginal utility of wealth, leaving unchanged steady-state
levels of variables. Instead, by extending the two-sector model by
Turnovsky and Sen (1995) to elastic labor, we find that the
fiscal policy crowds-in consumption and investment expenditure
both in the short-run and the long-run and raises employment. The
analytical tractability of the model allows us to characterize the
transitional paths and the factors governing the impact and
long-term effects. Interestingly, while steady-state changes
remain almost qualitatively independent of sectoral capital
intensities, sectoral capital-labor ratios matter in determining
the size of long-run variations. Numerical exercises show that:
[i] beneficial effects on labor-market can be large (depending on
initial tax wedge, sectoral capital-labor ratios and elasticity of
labor supply), and [ii] balanced-budget fiscal multipliers derived
from the change in tax structure fall in the range 0.2-0.4
approximately as the elasticity of labor supply falls in the range
between 0.5-1.