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This paper analyzes the role of nominal assets in ranking intertemporal budget policies in a growing open economy. Budget policies are ranked in terms of the public's intertemporal tax liability. In our small open economy model, the constraint for the valuation of private and public financial assets is in terms of the exogenous foreign price level. We show that this limits, under purchasing power parity, the scope of the government to influence the real value of financial assets using fiscal and monetary policy instruments.

An enduring topic of economic policy is the study of the effects of changes in fiscal and monetary instruments on the financial position of the public sector. Indeed, discussions in the political arena often revolve around the question of the response of policy to current fiscal deficits or surpluses. An oft-cited justification of tax cuts is that they pay—at least partially—for themselves, since they also increase the level of economic activity and, consequently, the tax base.2 This issue has been revisited recently as researchers have applied the insights of endogenous growth theory to the relationship between fiscal policy decisions and the dynamic evolution of the government budget.3 The newer research, exemplified by Ireland (1994) and Bruce and Turnovsky (1999), considers the effect of government expenditure and tax policy not only on the growth rate of the economy, but also on the growth rate of the tax base, the path of government debt, and the value of future tax payments required to maintain the intertemporal solvency of the public sector. 4 Bianconi (1999) extends the work of Bruce and Turnovsky (1999) by introducing nominal assets—and hence an inflation tax—into his analysis. He finds that the existence of nominal assets introduces another channel through which changes in fiscal policy can affect the long-term tax liability of the private sector. Through the mechanisms of greater inflation tax revenue and price level effects that lower the burden of the public sector real debt, Bianconi (1999) shows that changes in both government expenditure and tax policy can reduce the long-run tax liability. He supports these analytical results with numerical simulations that suggest that the role of nominal assets in determining future tax liabilities may be of empirical relevance. In this paper we extend this analysis to a small open economy that includes nominal assets. We think this is an useful extension in light of the increasing integration of the world economy and because rules enforcing public sector financial stability are becoming a more important part of multilateral economic agreements, such as the Maastricht criterion for European monetary integration. We develop a single-good, small open economy model in which physical capital accumulation, as in Turnovsky, 1996 and Turnovsky, 1997, is the engine of economic growth. In addition to spending real resources, the government in our model levies lump-sum and income taxes and issues internationally traded bonds and domestic money balances. We consider the following policy experiments: (i) an increase in the share of government expenditure in output; (ii) a cut in the capital tax rate, holding the share of government expenditure constant; (iii) a balanced-budget cut in the capital tax rate in which the share of government expenditure in output falls with the tax rate; and (iv) a change in the rate of growth of nominal balances. We show that an increase in the share of government expenditure—in contrast to Bianconi (1999)—cannot cause a reduction in future tax liabilities, the so-called dynamic scoring result. Indeed, the existence of nominal assets in the small open economy tends to magnify the increase in the private sector's future tax liabilities subsequent to an increase in government expenditure. In this case, dynamic scoring cannot take place because the public sector debt is, by assumption, deflated by the exogenous foreign price level. The latter implies that the value of government assets cannot be eroded through the higher domestic price level that results from a fiscal expansion. In other words, we provide a positive analysis of monetary and fiscal policy in the case of the “dollarization” of government debt. 5 Dynamic scoring does take place in other situations, however. In particular, we derive conditions in which dynamic scoring can occur subsequent to a reduction in capital taxes, both holding the share of government expenditure constant and in the balanced-budget case. As in the case of the government expenditure shock, the response of inflation tax revenues is important in scaling the change in the future tax liability. If the response of inflation tax revenues is sufficiently “large”, it can determine the direction of change in the future tax liability. We show in our simulation exercise that while dynamic scoring does not occur subsequent to a cut in capital taxes, given our choice of parameters, it does take place in the case of a balanced-budget tax cut. In addition, we examine the impact of increasing the rate of growth of nominal money balances. This policy does reduce, through greater inflation tax revenues, the future tax liabilities of individuals, although less than in the closed economy due to the lack of price level effects. The paper is organized as follows. Section 2 describes the private sector, its optimal intertemporal choices and the growth equilibrium of the small open economy. Section 3 shows the effect of fiscal and monetary policy variables on the economy's equilibrium growth rate, the initial levels of consumption and real money balances, and overall welfare. Section 4, containing the major results of the paper, describes the conditions for dynamic scoring. We simulate these results numerically in Section 5. Section 6 briefly concludes.

In this paper we analyze the effects of fiscal and monetary policies on the long-run tax liability of the private sector in a small open economy model with nominal assets. Among our major results, we find that a rise in the fraction of output devoted to government expenditure unambiguously increases the future tax liabilities of the private sector, without any possibility of “dynamic scoring.” In addition, we investigate the conditions in which a tax cut results in dynamic scoring, i.e., a reduction in the long-run tax burden. A key factor in the determination of our theoretical findings is the response of the inflation tax base to the shift in fiscal policy. The existence of nominal assets can either magnify the effect of the change in fiscal policy, as in the case of a government expenditure shock, or, as in the case of a tax cut, it can offset the positive impact of the tax cut on the primary deficit and lead to lower intertemporal tax burdens. Our simulation results suggest that while dynamic scoring does not take place if the capital tax alone is reduced, it can occur in the balanced-budget case. The one component of the long-run tax burden that the policy authorities cannot alter is, however, the real value of public sector debt, which is determined by the exogenous foreign price level under PPP. This factor limits the ability of the government to manipulate intertemporal tax burdens in small open economies. One of our main results, that monetary and fiscal policy cannot alter the real value of government debt, depends upon the assumption that in the small open economy domestic government debt is completely denominated in terms of foreign currency. Consequently, price level effects that alter the real value of public debt in response to monetary and fiscal policy cannot occur. In contrast, we provide a positive analysis of the effects of monetary and fiscal policies when there is, in effect, “dollarization” of government debt. Our results represent, then, a useful benchmark for an analysis of the benefits and costs of dollarization.14 The assumption that government debt is denominated wholly in terms of foreign currency can, of course, be relaxed by specifying that some exogenous proportion of domestic debt is denominated in domestic currency. In this case, monetary and fiscal policy has distinct impacts on the holders of domestic currency denominated debt, [i.e., the price level effects described in Bianconi (1999)], and on the holders of foreign currency denominated debt, as we analyze here. The exogenous constraint on the various denominations of debt holdings implies that arbitrage is unable to eliminate this distinction. A political economy model is, in effect, needed to endogenously determine the extent to which a government can constrain the proportion of debt denominated in foreign currency. We believe this is a fruitful avenue for future research.