| This study examines the effects of distortionary taxation on the real exchange rate both theoretically and empirically. The theoretical part adopts a Balassa-Samuelson framework in which each country produces both traded and nontraded goods. The traded sector is the capital-intensive sector while the nontraded sector is labor-intensive. The model also assumes balanced budget fiscal policies so that government expenditures are restricted by total tax revenues. In such a framework, I show that an increase in capital interest taxation leads to real exchange rate depreciation. On the other hand, an increase in consumption tax rates lead to real exchange rate appreciation provided that the government spends a larger portion of its budget on the nontradables than private agents do. Similarly, an increase in labor income tax rate leads to a real exchange rate appreciation provided that the fraction of the government consumption spent on the nontradables is greater than the fraction of the GDP produced by the labor. These theoretical findings are complemented by an empirical study of ten member countries of the Organization of Economic Cooperation and Development (OECD), the United States, Canada, Japan, Germany, the United Kingdom, France, Italy, Spain, Sweden and Australia, for the period of 1977--1996. Panel data estimations with fixed effects provide support for all three tax rates with correct signs. The results are also robust to variations such as estimations when Germany is the foreign country rather than the United States, estimations with group-specific autocorrelation coefficients, and estimations on subsamples. Overall, the results provide supportive evidence for the tax theory outlined in this paper and for the Balassa-Samuelson models in general. |
