Capital Control Taxes in an Emerging Market Economy

Abstract

Historically, Emerging Markets (EMs) that own foreign debt and exhibit a high degree of dollarization have demonstrated vulnerability to a range of both real and financial shocks. Governments often use a range of capital control measures, particularly in nations burdened with external debt, with the aim of mitigating sudden swings in both inflows and outflows of capital. These policies are implemented to lessen exchange rate volatility and prevent dollarization. This study employs second moments analysis, impulse response functions and the welfare analysis to investigate the impact of a tax policy that restricts international capital flows on several macroeconomic variables in an emerging economy. A dynamic stochastic general equilibrium (DSGE) model is employed to examine the impact of the tax imposed on foreign borrowing on the economy, including both real shocks such as technology and growth, as well as financial shocks such as country risk premium. The findings of the study indicate that capital control taxes have a diminishing effect on the variability of significant macroeconomic variables, such as investment and consumption, when imposed at lower levels. Conversely, these taxes exhibit a stabilizing impact on the volatility of the trade balance-to-output ratio when implemented at higher levels. Moreover, quantitative evidence reveals that country risk premium shocks exert a substantial influence on variations in both the trade balance-to-output ratio and the level of investment, accounting for around 25% and 50% of the fluctuations, respectively. Finally, the existence of such a taxation enhances the intertemporal utility function at the steady state and reduces its volatility in the case of technology and growth shocks.