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This paper studies an international tax policy design problem by employing a two-country dynamic general equilibrium model with in- complete asset markets. We investigate the possibility of welfare- improving active tax policies, in particular capital and labor income tax, under the non-cooperative Nash equilibrium and the cooperative equilibrium. Unlike the conventional wisdom regarding stabilization policies, optimal tax policies in our economy are procyclical. Relative to the non-cooperative setting, international tax policy cooperation re- quires more active tax policies (about two times) and generates large extra welfare gains (by about a third).

Welfare Effects of Tax Policy in Open Economies: Stabilization and Cooperation