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We are grateful to Teresa Ter-Minassian, Bob Traa, Mark De Broeck, Stephan Danninger, Jorg Decressin, Luc Everaert, seminar participants, and in particular our discussant Robin Boadway, at FAD’s Academic Panel meeting on April 18 in Washington DC, and participants at the conference “Fiscal Policy Challenges in Europe” organized by the German Federal Ministry of Finance and the Center for European Economic Research (ZEW), Berlin, March 22 and 23 for many helpful comments and suggestions. The views expressed in the paper are those of the authors and do not necessarily represent those of the IMF or IMF policy.
The estimated adjustment need is very sensitive to the assumptions regarding the interest rate-growth differential. In the case of the United States, a 1 percent interest rate/growth differential suggests a primary gap of around 7.2 percent, with the age related spending accounting for the bulk of that.
A 1 percent interest rate/growth differential suggests a primary gap of around 5½ percent, with aging costs accounting for around a third of this, and the rest due to the high primary deficit and debt.
These include Argentina, Brazil, China, India, Indonesia, Korea, Mexico, Russia, and Turkey.
See Obstfeld and Rogoff (1995, 1996), Betts and Devereux (2001), Caselli (2001), Corsetti and Pesenti (2001) and Ganelli (2003a). In a recent paper, Erceg, Guerrieri, and Gust (2005) add rule-of-thumb consumers to a model based on the representative agent paradigm and then use the model to study the effects of recent U.S. fiscal deficits on the current account deficit. Not surprisingly, they find much smaller effects than in models that allow for the possibility that permanent increases in government debt can have permanent consequences for the stock of net foreign liabilities and the world real interest rate.
See Frenkel and Razin (1992) for a diagrammatic exposition of a two-country overlapping-generations model without distortionary taxation.
Overall, however, the reforms are likely to achieve a more efficient tax system by shifting from direct to indirect taxation. Over the long run, shifting revenue from direct taxation to less distortionary indirect taxes increases growth through higher employment and investment growth. This is relevant in an aging society where the direct tax base could contract, while the indirect tax base is more stable (see Botman and Danninger, 2007, for a detailed evaluation of these tax policy changes).
There are considerable uncertainties with regard to the eventual cost of the CIT reform, and the intertemporal allocation of consumption and revenues in anticipation of the VAT increase. In addition, the revenue buoyancy may have exceeded unity due to progressive taxation, and would work the other way as growth slows. Finally, as discussed further below, there are substantial risks that the estimates of aging costs may in fact be understated.
The differential effect on real interest rates between large and small economies implies an interesting hypothesis: large economies should have a greater incentive for prudent fiscal polices than small economies. Small economies with integrated capital markets have a smaller incentive to implement a fiscal contraction, as the real interest rate will not decline much relative to larger open economies, or small closed or financially less integrated economies. On the other hand, and abstracting from the role of monetary policy, large open or relatively closed economies have a smaller incentive to use fiscal policy as a demand stabilizing instrument because of the stronger crowding out effects and smaller multipliers.
We use a relatively conservative estimate of the elasticity to reflect that Germany is already closer to the Lisbon objective of 3 percent of GDP spending relative to other euro area countries.
An elasticity of .15 translates into a social rate of return of R&D spending of about 65 percent, which is at the middle level of available estimates—to determine the social rate of return, one needs to adjust the elasticity by the initial R&D stock. Canton and others (2005) conclude that the social rate of return estimates are usually in the range of 30–100 percent; Griffith, Redding, and van Reenen (2000) estimate that for most OECD countries social rates of return on R&D are equal to about 50 percent.
They use price markups of respectively 19 and 39 percent in the tradable and nontradables sector in Belgium, and 21 percent and 41 percent respectively for France. They consider a scenario in which markups in Belgium and France decline to the average level observed for a reference group of countries, consisting of Denmark, Sweden, and the United Kingdom. This implies a sizable reduction in markups, particularly in the nontradables sector, to respectively 14 percent and 24 percent in the tradable and nontradables sector.