Input versus output taxation in an experimental international economy

This paper presents the results of a policy oriented macroeconomic experiment involving an 'international' economy with a relatively small 'home' country and a large 'foreign' country. It compares the economic performance of two alternative tax systems: a wage tax system and a sales-tax-cum-labor-subsidy system. The two systems are applied to the small country, while the wage tax system always obtains in the large country. The main result is that the sales tax system outperforms the wage tax system, using standard economic indicators. Moreover, it turns out that under the sales tax system economic activities appear to be moving toward the 'better' of two theoretical equilibria. It is argued that producers' reluctance to incur costs up-front while being uncertain about product prices can explain these results. Several pieces of evidence are provided to support this claim. The results strongly suggest that behavioral aspects should be taken into account also in applied macroeconomic models.

► We study a macroeconomic experiment that can inform public policy. ► We compare the performance of a wage-tax to a sales-tax system in a small open economy. ► The sales-tax system clearly outperforms the wage-tax system. ► Producers' reluctance to incur costs up-front explains outcomes. ► Behavioral economics aspects are important also in applied macroeconomic models.