Liquidity constraints and tax policy in small open economies

State-contingent tax policy can generate stabilization gains if an economy is subject to occasionally binding financial constraints. The aim of this paper is to assess whether that claim can be supported in a small open economy real business cycle model with liquidity constraints on the consumer side. In the model, the domestic current account deficit is limited by domestic output such that the ability of consumers to self-insure against productivity risks is restricted. The model is calibrated to Argentine data and solved with standard perturbation methods, using a penalty function approach to account for the non-linear current account restriction. The results show that the presence of liquidity constraints leads to volatile and procyclical consumption spending consistent with the data. In this environment, a government can provide some of the missing insurance to consumers by cutting tax rates on labor income in low-productivity states and vice versa. This type of policy raises domestic liquidity through higher output when necessary, which eases the current account restriction and smoothens out consumption.

Keywords: Small open economy models; Real business cycles; Financial frictions;
Liquidity constraints; Limited self-insurance; State-contingent tax policy