Consumption Tax, Nontraded Goods and Welfare

Abstract

This paper studies the welfare effects of a consumption tax rise based on the two-sector small open economy model of Obstfeld and Rogoff (1995) and Lane (1997). The main findings of our analysis are that 1 ) in the case of free trade, the consumption tax rise has no effect on welfare, 2 ) when there is the nontraded goods sector, the consumption tax rise has a negative effect on welfare, and 3 ) the larger the share of nontraded goods in consumption is , the larger the negative welfare effect of consumption tax will be .