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Prepared by Dennis Botman, Hali Edison, and Papa N’Diaye.
The 2004 reform of the pension system will help contain longer-term pension outlays by streamlining the benefits and gradually increasing the contributions of employees and employers. Most of the demand on the budget will be related to healthcare.
The GFM imposes a fiscal reaction function that re-establishes debt sustainability in the very long run. The simulations in this paper focus on benefits over a shorter policy horizon (about 25 years).
The model has been applied by IMF staff for background work for recent Article IV consultations with Canada, the United Kingdom, and the United States.
Government spending is defined here as all expenditure excluding social transfers and interest payments.
A primary balance for the general government (excluding social security) is the authorities’ goal, but it will not stabilize the debt ratio.
The package includes a reduction in spending of 0.5 percent of GDP during the first two years, followed by a lowering of transfers by 0.5 percent of GDP a year for the next two years, and a 1 percentage point increase in the consumption tax rate in the fifth year.
If consumption were to depend only on current income, then a consumption tax would be equivalent to a payroll tax and an increase will lead to a more pronounced withdrawal of labor effort and a larger supply side impact. The output cost would still be smaller than with a corporate income tax hike.
The model probably understates the sensitivity of investment to taxation as capital is assumed to be not internationally mobile.
This trade-off increases with the shortening of consumers’ planning horizon as future consolidation measures are less discounted. It should also be noted that GFM does not incorporate costs of price adjustment (menu costs), which may provide an additional reason against a gradual increase particularly in the consumption tax rate.
The sensitivity of consumers to changes in interest rates depends on their degree of impatience, captured through the parameterization of the intertemporal elasticity of substitution. With a lower degree of impatience (higher intertemporal elasticity of substitution), consumption would be more sensitive to changes in interest rates, which implies that smaller changes to interest rates will be necessary to re-equilibrate world savings and investment flows.