Question

The tax code changes so that business firms face higher tax rates on their revenue (offset by other lump-sum tax changes so there's no overall change in tax revenue). What happens to saving, investment, real interest rate and current account balance in a small open economy. Use relevant diagrams to answer. (Assume a closed economy unless stated otherwise)

Answer 1

A higher corporate income tax would result in lower retained earnings and reduced investment demand. Hence in Saving Investment diagram, Investment demand curve shifts leftwards. This brings a new equilibrium where real interest rate has reduced and both investment demanded and saving supplied fall. A fall in the real interest rate leads to capital ouflow and this reduces the demand for home currency. Economy is open so currency depreciates and there is an increase in net exports. Trade surplus occurs and this brings current account surplus.