Gunalp, B. and Dincer, O., 2005, “The Optimal Government Size in Transition Countries,” Department of Economics, Hacettepe University Beytepe, Ankara and Department of Commerce, Massey University, Auckland
Karras, G., 1997, “On the Optimal Government Size in Europe: Theory and Empirical Evidence,” The Manchester School of Economic & Social Studies
Peden, E., 1991, “Productivity in the United States and its relationship to government activity: An analysis of 57 years, 1929–1986.”
Appendix. Model Details1
We consider a small open economy populated by a continuum of heterogeneous households who live indefinitely and face idiosyncratic shocks. All types of households have the same preferences over the consumption of food, cf, manufacturing cm, and services, cs. We assume that services are non-tradable, while manufacturing and food is tradable, and also the numeraire.
There are three fixed types of households in the model: large farmers, rural households, and urban households. Rural households own a small plot of land and have the occupational choice problem of choosing the amount time to devote to producing food (which requires labor and land), and the amount of time working for large farmers for a competitive wage wr. Similarly, urban households have the occupational choice problem of choosing the optimal amount of time to produce services (which use only labor as an input), and how much time to work in manufacturing for a competitive wage w. We assume that households cannot move across rural and urban sectors.
Large farmers own a large plot of land where they can produce food for the domestic market or exports. They hire labor from small farmers and also accumulate capital, both of which are used to produce agricultural goods for export. Large farmers’ capital follows a standard law of motion of capital:
Finally, there are competitive firms that produce manufacturing goods using capital and labor as an input. Manufacturing can also be used indistinctly for investment by large farmers or for consumption. Markets are incomplete, urban and rural households can save at a risk-free interest rate r. Entrepreneurs can borrow at a rate (1 + d)r, where d captures the risk premium in lending. We assume that the capital account is closed and trade balance is always zero.
The government collects value added taxes on food τa and manufacturing goods rm, trade taxes r*, corporate taxes τf, and labor income taxes τw. The government spends part of its resources on manufacturing goods, and gives or collects lump-sum taxes that may be specific to each household type. In the next section we explain the urban households’ problem.
The framework considered here is a continuum of infinitely-lived agents with productivity risk. The model is small open economy with three different agents types: urban households u, farms f, and rural households r. The total mass of agents is normalized to equal 1. All agents maximize the present value of their consumption over three different types of goods: food ca, manufactured goods cm, and services cs.
Prepared by Carlos Janada.
Primary spending fell from 13 percent of GDP in 2010 to 10.7 percent in 2015.
See Annex II of the IMF “Staff Guidance Note for Public Debt Sustainability Analysis in Market Access Countries,” 2013 at https://www.imf.org/external/np/pp/eng/2013/050913.pdf.
Guatemala has one of the lowest revenue-to-GDP ratios in the world (see, for example. “Tax Capacity and Growth: Is There a Tipping Point,” by Vitor Gaspar, Laura Jaramillo and Philippe Wingender; FAD Seminar Series, December 9, 2015.
The years of 2009 and 2010, when the effects of the global financial crisis affected Guatemala most deeply, were excluded. The historical sample was extended by two earlier years to compensate (i.e., the historical average is still based on a 10-year sample).
Commercial bank assets were roughly half of GDP at the end of 2015. Therefore, the contingent liability shock is equivalent to 5 percent of GDP. As a reference, the Troubled Asset Relief Program (TARP) in the U.S. was equivalent to about 5 percent of US GDP when it was announced during the financial crisis of 2008.
Real GDP Growth Shock: GDP growth rate is reduced by 1 standard deviation for 2 consecutive years; level of non-interest expenditures is the same as in the baseline; deterioration in primary balance lead to higher interest rate; decline in growth leads to lower inflation (0.25 percentage points per 1 percentage point decrease in GDP growth). Primary Surplus Shock: Minimum shock equivalent to 50% of planned adjustment (50% implemented), or baseline minus half of the 10-year historical standard deviation, whichever is larger. There is an increase in interest rates of 25bp for every percentage point of GDP worsening in the primary balance.
Interest Rate Shock: Interest rate increases by the difference between average real interest rate level over projection and maximum real historical level, or by 200bp, whichever is larger.
Real Exchange Rate Shock: Estimate of overvaluation or maximum historical movement of the exchange rate, whichever is higher; pass-through to inflation with default elasticity of 0.25 for EMs and 0.03 for AEs.
Preparad by Valentina Flamini, Marina Mendez Tavares, Adrian Peralta-Alva, and Xuan Tam.
Cabrera, M., N. Lustig, and H. Moran, 2014, “Fiscal Policy, Inequality, and the Ethnic Divide in Guatemala”, CEQ Working Paper No. 20.
An empirical study by Acosta-Ormaechea and Yoo (2012) also finds that in low income countries PIT does not significantly affect growth, likely due to the low level of PIT collection in such countries (1.5 percent of GDP on average). This result is relevant for Guatemala where PIT collection is only 0.4 percent of GDP.
This application is part of a research project on macroeconomic policy supported by the U.K.’s Department for International Development (DFID) but should not be reported as representing the views of DFID.