Fiscal externalities and optimal taxation in an economic community

The Stability and Growth Pact is a continuing source of economic controversy within Europe. The Pact recognizes that individual member states experience divergent business cycle conditions which may lead them to run deficits at certain points in time. However, the pact is designed to encourage member states to adopt fiscal policies that imply zero deficits on average and to limit their deficits to three percent of GDP at any point in time. We study the nature of fiscal externalities within an economic community, such as Europe, which lacks explicit rules for fiscal policy coordination, assuming that each country chooses its tax rates optimally given the fiscal stance of other countries. Allowing for real shifts to country productivity and public expenditure, we find that the fiscal deficit can be a poor indicator of fiscal externalities: countries with different labor and consumption tax rates can exert exactly the same external effect but have very different fiscal deficit behavior. Trade deficits are, by contrast, much more informative about the effects that an individual country has on other members of the community.