DISTORTIONARY TAXATION AND REAL EXCHANGE RATES

Çağay ÇOŞKUNER (Eastern Mediterranean University)

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. Assuming balanced budget fiscal policies, I show that an increase in capital interest taxation leads to real exchange rate depreciation while an increase in labor income and/or consumption tax rates leads to real exchange rate appreciation provided that the government spends a sufficiently large portion of its budget on the nontradables. These theoretical findings are complemented by an empirical study of ten O.E.C.D. countries 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, and estimations with group-specific autocorrelation coefficients. Overall, the results provide supportive evidence for the tax theory outlined in this paper.