Budget-neutral fiscal rules targeting inflation differentials

In light of persistent inflation dispersion and high debt levels in the EMU, this paper investigates the desirability of budget-neutral fiscal policy rules that respond to the domestic inflation differential. The paper employs a two-country DSGE model of a monetary union with traded and non-traded goods. When consumption or labour income taxes respond to the domestic inflation differential while lump-sum taxes balance the budget, a national fiscal authority is able to reduce welfare costs of business cycle fluctuations by 1-4%. When lump-sum taxes are absent, hybrid rules using only distortionary taxes can reduce welfare costs by 6-10% under demand and supply disturbances. Gains in welfare stem from higher mean consumption due to lower price dispersion when the fiscal authority actively compresses the domestic inflation differential and thus domestic inflation.