Abstract
This Selected Issues paper for Iceland reports that it faces a considerably less favorable inflation-output variability trade-off than do Canada or the United States. A number of measures should be considered that could help minimize the cost of inflation breaching the tolerance band and help to lower the probability of such events occurring. To effectively target inflation, central banks need to be forward looking, responding early to prospective demand pressures. Having housing prices explicitly in the target ensures that the central bank will monitor developments in the housing market closely.
II. Some Illustrative Simulations of the Potential Impact of Income Tax Cuts in Iceland1
A. Introduction
1. The labor income tax cuts commencing in January 2005 in Iceland could contribute notably to the overheating projected over the next two years. This chapter uses some simulations of MULTIMOD, one of the IMF’s multi-country macroeconomic models, to illustrate how the tax cuts could be adding to excess demand pressures, inflation and external imbalances.
2. Although MULTIMOD is a particularly useful tool for examining the impact of announced changes in tax policy, the results should be interpreted qualitatively rather than quantitatively.2 MULTIMOD’s overlapping generations structure means that it affords an important behavioral role for fiscal policy. However, because MULTIMOD has only been estimated for a small group of industrial countries given data limitations, the simulations presented below use the Canada block to proxy what the implication of tax cuts in Iceland might be. Although Canada is also a small open economy, there are no doubt differences in behavioral parameters between Canada and Iceland and, consequently, the results should be interpreted qualitatively rather than quantitatively.
B. The Macroeconomic Impact of Tax Cuts
3. Theory suggests that changes in current and future labor income taxes can stimulate current consumption in two ways. First, in each period, households that don’t have access to capital markets (liquidity-constrained households) simply spend their entire disposable income on consumption. A decline in current tax rates raises disposable income and consumption expenditure rises in step. Second, in addition to using higher disposable income, households that have access to capital markets (unconstrained households) are also able to fund current consumption expenditure by borrowing against their human wealth, the present discounted value of their life-time stream of labor income. When taxes fall permanently, and expectations are that they will decline further in the future, human wealth grows. Somewhat impatient households will borrow against that human wealth to fund current consumption. Because MULTIMOD includes both of these types of households, it incorporates the two channels through which cuts in labor income taxes affect consumption expenditure.
4. If 40 percent of households face liquidity constraints, a tax cut like the one underway in Iceland generates overheating and requires a tightening in monetary policy (Figure 1). In the simulation experiment presented, the labor income tax rate declines by 1 percentage point in 2005, a further 1 percentage point in 2006, and then by an additional 2 percentage points in 2007.3 By 2007 and beyond, labor income taxes are permanently lower by 4 percentage points. To sustain the tax cut in the long run, government expenditure is permanently reduced. The cut in taxes induces households, both constrained and unconstrained, to increase consumption and aggregate demand exceeds supply. In response to the emergence of excess demand and a forecast of rising inflation, the monetary authority raises the policy rate. Through uncovered interest parity, the nominal exchange rate appreciates and this combined with higher domestic inflation leads to an appreciation in the real effective exchange rate. Accelerating domestic demand stimulates imports as does the decline in import prices associated with the appreciating currency. Stronger import demand along with weaker export demand generate a deterioration in the trade balance. These results illustrate how the tax cuts in Iceland, which commenced in January 2005, could be contributing to the growing imbalances in the economy that have been sparked by the new investment projects in the energy and the aluminum-smelting sectors.
Permanent Reductions in Labor Income Taxes
(percent or percentage point deviation from baseline)
Citation: IMF Staff Country Reports 2005, 366; 10.5089/9781451819298.002.A002
Permanent Reductions in Labor Income Taxes
(percent or percentage point deviation from baseline)
Citation: IMF Staff Country Reports 2005, 366; 10.5089/9781451819298.002.A002
Permanent Reductions in Labor Income Taxes
(percent or percentage point deviation from baseline)
Citation: IMF Staff Country Reports 2005, 366; 10.5089/9781451819298.002.A002
5. Developments in the mortgage market could amplify the effects of tax cuts. In August 2004, commercial banks started to compete directly for first mortgages with the publicly guaranteed Housing Financing Fund (HFF). The mortgage products introduced by the banks not only matched HFF loan rates, but in addition, offered higher absolute and loan-to-value limits along with the option to refinance existing loans. In response, planned reforms at the HFF to increase loan limits have been accelerated.4 Taken together, these developments have enabled households to finance a much larger portion of home purchases as well as access built-up home equity to fund consumption expenditures. To proxy the possible effects of these developments, the tax cut experiment is re-simulated with the proportion of liquidity-constrained households reduced from 40 to 10 percent. The results are presented in Figure 2, with the dashed line tracing out the result when 40 percent of households face liquidity constraints and the solid line the outcome when only 10 percent are liquidity constrained. When more households have the ability to borrow against future labor income, the initial impact of the tax cut on aggregate demand is larger, leading to a sharper pickup in inflation and a stronger monetary policy response. In addition, the magnitude of the secondary cycle in real activity required to re-anchor inflation is larger.
Permanent Reductions in Labor Income Taxes
(percent or percentage point deviation from baseline)
Citation: IMF Staff Country Reports 2005, 366; 10.5089/9781451819298.002.A002
Permanent Reductions in Labor Income Taxes
(percent or percentage point deviation from baseline)
Citation: IMF Staff Country Reports 2005, 366; 10.5089/9781451819298.002.A002
Permanent Reductions in Labor Income Taxes
(percent or percentage point deviation from baseline)
Citation: IMF Staff Country Reports 2005, 366; 10.5089/9781451819298.002.A002
6. There are a number of factors that could possibly lead to the tax cuts in Iceland contributing less to overheating that suggested by the these simulation results. First, offsetting cuts in government expenditure could be larger than those assumed here. Although it should be noted that, as yet, no offsetting cuts in government expenditure have been identified. Second, these simulations assume that households fully believe that the future tax cuts will be implemented. However, if households were less certain, their response to the announced future cuts could be more modest than the simulations suggest. Finally, as noted by finance ministry officials in Iceland, the cuts in labor income taxes could increase the labor supply, thereby adding to the economy’s supply capacity sufficiently to accommodate the increase in consumption demand associated with the tax cuts. An additional MULTIMOD simulation that considers this possibility is presented below.
7. If the tax cuts result in a permanent increase of 1 percentage point in the labor force participation rate in Iceland, overheating associated with the tax cuts still appears likely. Ministry officials estimate that the tax cuts will increase the labor supply by 800 people in each of the three years 2005-07. This translates into a increase of roughly 1/3 of a percentage point in the labor force participation rate in each year. To consider the likely impact, such an increase in the participation rate is added to the tax cut simulation in which 10 percent of households face liquidity constraints. Figure 3 contains the resulting paths for GDP, the output gap, consumption and investment when the labor supply also increases (solid line) along with the results from the simulation that does not incorporate the labor supply response (dashed line). The first point to note is that the increase in GDP is now much larger, reflecting the increase in the economy’s supply capacity because of the additional labor input. However, the output gap is similar in both scenarios suggesting little difference in the extent of overheating associated with the tax cuts. This output gap arises because of the response of households and firms. Those entering the labor force use the additional income to demand consumption goods. Given the larger labor supply, firms eventually demand more investment goods to build the capital stock to achieve the profit maximizing capital-to-labor ratio. This increase in investment and consumption demand quickly exhausts the new capacity resulting from the additional labor supply.
Permanent Reductions in Labor Income Taxes
(percent or percentage point deviation from baseline)
Citation: IMF Staff Country Reports 2005, 366; 10.5089/9781451819298.002.A002
Permanent Reductions in Labor Income Taxes
(percent or percentage point deviation from baseline)
Citation: IMF Staff Country Reports 2005, 366; 10.5089/9781451819298.002.A002
Permanent Reductions in Labor Income Taxes
(percent or percentage point deviation from baseline)
Citation: IMF Staff Country Reports 2005, 366; 10.5089/9781451819298.002.A002
C. Conclusions
8. Although past fiscal prudence has enabled the government to be in a position to implement a cut in labor income taxes and announce plans for additional cuts in the future, these tax cuts may be exacerbating the imbalances emerging in the economy. The MULTIMOD simulations presented in this note illustrate how current and planned future tax cuts in Iceland could be stimulating aggregate demand. As a result, the tax cuts may be adding to the overheating in the economy, inflation, the required tightening in monetary policy, the appreciation of the currency and the current account deficit. Further, the reforms at the Housing Financing Fund and the increased competition from banks in the mortgage market may be amplifying the impact of the tax cuts by increasing households’ ability to fund current consumption expenditure by borrowing against the associated increase in their human wealth. A strong labor supply response to lower income taxes is unlikely to reduce the extent of overheating because it will cause both households and firms to also increase demand for goods and services. Looking ahead, to moderate the extent of the projected overheating in Iceland, the government should consider postponing future tax cuts until it is clear that the existing demand pressures in the economy have fully abated. Further, cuts in government expenditure should be implemented as soon as possible to offset the tax cuts that have already been implemented and efforts should be redoubled to identify future expenditure cuts to ensure that once tax cuts proceed, excess demand pressures do not reemerge.
References
Hunt, B., and D. Laxton, 2004, “Some Simulation Properties of the Major Euro Area Economies in MULTIMOD,” Economic Modeling, Vol. 21, pp 759–783.
IMF 2005, “Mortgage Market Developments in Iceland and the Role of the Housing Financing Fund” Iceland: Selected Issues, IMF Country Report No. forthcoming.
Laxton, D., P. Isard, H. Faruqee, E. Prasad, and B. Turtelboom, 1998, “MULTIMOD Mark III: The Core Dynamic and Steady-State Models,” IMF Occasional Paper No. 164.
Prepared by Ben Hunt.
For detailed descriptions of MULTIMOD’s structure and dynamic simulation properties see Laxton et al (1998) and Hunt and Laxton (2004).
The proposed future tax cuts in Iceland also include the elimination of the net wealth tax on individuals and firms in 2006 and cuts in the income surtax from 4 percent to 2 percent in 2006 and zero in 2007.
Details on the mortgage market developments in Iceland are presented in the selected issues chapter, “Mortgage Market Developments in Iceland and the Role of the Housing Financing Fund.”
