The macroeconomic effects of fiscal consolidation are likely to be sensitive to the uncertainty about the behavioral response of consumers and producers to changes in tax policy and government spending. In GFM, these behavioral responses follow from a number of key parameters:
The sensitivity of labor supply to the real wage: The baseline value (0.04) is at the mid-range of values found by micro-economic studies. An alternative simulation assumes a value close to the lower limits of these estimates representing the case of inelastic labor supply.
The elasticity of substitution between labor and capital in the production function: The baseline value is 0.8, with an alternative simulation using a value of 1 (the Cobb-Douglas case).
The elasticity of intertemporal substitution: The baseline value for this parameter that describes the sensitivity of consumption to changes in the real interest rate is 0.33. The parameter value in the alternative simulation (0.2) is consistent with the lower end of microeconomic estimates.
The wedge between the rate of time preference and the yield on government bonds: This parameter—which determines consumers’ degree of impatience—has not been subject to extensive microeconomic analysis. The baseline value of the wedge is set to 10 percent, with an alternative simulation using 1 percent. The baseline value implies an effective planning horizon of ten years, which is obviously much lower than the probability of survival for most of the population, but it is a simple way of introducing a form of myopia into the model.
The fraction of consumers that does not have access to financial markets: In the baseline, 20 percent of the population is assumed to be liquidity constrained and consumes its entire disposable income every period. This fraction is consistent with empirical evidence for the U.K. reported in Al-Eyd and Barrel (2005). To investigate the importance of this assumption, an alternative simulation assumes that all consumers can use financial markets to smooth their consumption over time.
The key factors affecting the timing of consolidation are the planning horizon of consumers and the sensitivity of consumers to change in the real interest rate. The key factor affecting the type of consolidation is the sensitivity of workers to change in the real wages.
A longer planning horizon of consumers reduces the cost of delayed consolidation. If consumers discount the future less—a planning horizon of 100 years instead of 10 years in the scenarios discussed thus far—their intertemporal choices become similar to those in a representative agent model. The crowding out effect of higher government debt is smaller as consumers anticipate that higher government transfers will be followed by higher labor income taxes in the future, leading them to save a higher fraction of the short-term increase in disposable income. Nevertheless, significant benefits of early consolidation through lower transfers or lower government spending remain although consolidating early via higher corporate income taxes now becomes more costly than delaying and adjusting via higher labor income taxes. The reason is that optimizing agents are now more forward-looking and incorporate the fact that the after-tax rate of return will be lower in the future, leading them to substitute towards higher consumption and lower capital accumulation.
Reducing the sensitivity of consumption to changes in the real interest rate increases the benefits of early consolidation. As can be seen from Figure 4 (third panel), a lower intertemporal elasticity of substitution increases the benefits of all early consolidation measures compared to the baseline of delayed consolidation. Delaying consolidation increases net foreign liabilities, alongside the increase in government debt. As a result, the U.K. needs to run trade balance surpluses to service the interest cost on these liabilities. For the trade balance to be in surplus, saving in the U.K. needs to increase. As consumption becomes less responsive, interest rates need to increase by more to provide the incentive to save more. As a result, capital accumulation will decline by more implying that delayed consolidation becomes more costly.
Increasing the sensitivity of workers to changes in the after-tax real wage increases the benefits of consolidating through lower transfers and government spending (Figure 4). As labor supply becomes more elastic, labor income taxation becomes more distortionary as workers reduce labor effort more. In fact, corporate income taxes become less distortionary than labor income taxes in the alternative scenario. By contrast, completely inelastic labor supply would make labor income taxation lump sum, reducing the benefits of alternative types of consolidation measures.
Increasing the access of consumers to financial markets or increasing the substitutability between factors of production has only a marginal effect on the results. Essentially, if all consumers have access to financial markets and are able to smooth their consumption over time, aggregate consumption is determined in a more forward-looking manner. This reduces the crowding out effects of government debt, but not substantially. Conversely, a higher substitutability between capital and labor generally increases the costs of delaying consolidation, while making consolidation through higher corporate income taxation less harmful as it is easier for firms to substitute towards labor.
Tax reform aimed at increasing incentives to save could provide support to fiscal consolidation measures. Specifically, there are potential benefits from revenue neutral tax reform given that taxation of corporate income is more distortionary. To investigate the potential benefits of such tax reform, the paper assumes that corporate income taxes are permanently reduced by 3 percentage points in the context of early consolidation, which is offset by either increasing labor income taxes, or through reducing transfers or government expenditure. Lower taxation of savings produces significant long-term output gains (Figure 5). A reduction in corporate income taxes increases the after-tax marginal product of capital. This in turn stimulates saving and investment in the economy, which, in the long-term increases output. This reflects a move to a more efficient tax system—although less egalitarian. Introducing tax reform alongside fiscal consolidation produces somewhat earlier output gains and makes especially consolidation through lower transfers more effective. Compared to early consolidation without reform, the short-term output losses are somewhat larger as the benefits of lower corporate income taxation accrue over time via higher capital accumulation supported by increased national saving. In net present value terms, tax reform could provide a substantial boost to consolidation efforts.
Bayoumi, T., and D. Botman, 2005, “Jam Today or More Jam Tomorrow? On Cutting Taxes Now Versus Later,” Canada—Selected Issues, IMF Country Report No. 05/116 (Washington: International Monetary Fund).
Bayoumi, T., D. Botman, and M. Kumar, 2005, “Effects of Social Security and Tax Reform in the United States,” United States—Selected Issues, IMF Country Report No. 05/258 (Washington: International Monetary Fund).
Botman, D., D. Laxton, D. Muir, and A. Romanov, 2006, “A New-Open-Economy-Macro Model for Fiscal Policy Evaluation,” (unpublished; Washington: International Monetary Fund).
Botman, D., and D. Laxton, 2004, “The Effects of Tax Cuts in a Global Fiscal Model,” Box 2.2 in World Economic Outlook, April (Washington, International Monetary Fund).
Kumhof, M., D. Laxton, and D. Muir, 2005, “Consequences of Fiscal Consolidation for the U.S. Current Account,” United States---Selected Issues, IMF Country Report No. 05/258 (Washington: International Monetary Fund).
Laxton, D., and P. Pesenti, 2003, “Monetary Rules for Small, Open, Emerging Economies,” Journal of Monetary Economics, Vol. 50, pp. 1109-46.
Prepared by Dennis Botman (FAD) and Keiko Honjo.
The fiscal year runs from April to March.
For applications of the model in the context of fiscal reform in respectively Canada and the United States see Bayoumi and Botman (2005), Bayoumi, Botman and Kumar (2005), Kumhof, Laxton, and Muir (2005), and Botman and Laxton (2004).
In case trade in financial assets is imperfect between the U.K. and the rest of the world, the benefits of an early rather than a delayed consolidation would be larger as higher government debt in the U.K. would imply a larger increase in the real interest rate.
Total after-tax wage income accruing to workers changes the same whether payroll taxes levied on workers or on employers are increased. However, in the former case hours worked declines through a drop in labor supply—increasing the real wage. While in the latter case, hours worked declines (although by less) through a reduction in labor demand causing the real wage to fall as well.
The Appendix also analyses the impact of fiscal adjustment when it is combined with tax reform.