Tax shocks, firm entry, and productivity in the open economy

Abstract

We examine the role of endogenous firm entry for the domestic effects and international repercussions of tax policy. We present new evidence from proxy-vector autoregressions that exogenous US tax reductions increase hourly labor productivity and firm creation domestically, and induce higher trade deficits and real depreciation with respect to the other G7 countries, with positive spillovers to foreign consumption and investment. We show that the empirical evidence is compatible with a two-country model with endogenous firm entry. The entry channel provides a strong amplification mechanism for the supply effects of tax shocks at home and leads to persistent spillovers to the foreign economies.