The design of the individual taxes can be adapted, too, in order to reduce the distortionary effects of taxation on growth. For example, Li and Sarte (2004) find that tax progressivity in the personal income tax has a small but non-negligible negative impact on long-run growth, a result which was confirmed by later research (e.g. Johansson et al., 2008, and Heady et al., 2009). Tax progression and high top marginal personal income tax rates reduce productivity growth, especially in industries characterised by high entry rates of new firms. Of course, tax progressivity might be seen as desirable for other reasons, such as reasons of redistribution or because progressivity is linked to higher automatic stabilisation. Recent research, however, suggests that the loss in per capita GDP is too high to justify the relatively small stabilising effect. (133) As regards VAT, a single rate VAT with only
a few exemptions is considered preferable to a more complex structure, as it reduces distortions and facilitates compliance and tax administration. Assistance to low-income households, which is one of the key arguments often brought forward in favour of reduced VAT rates, can be provided at lower budgetary costs outside the VAT
(133) See, e.g., IMF (2009c),
system. (134) In general there is a consensus in the
literature to argue for broad bases and low tax rates. A move to cut inefficient reductions, exceptions or exemptions which are either not economically justified or display incentives not in line with their original aims could be beneficial for many countries and could reduce the size of the tax increases needed as part of the consolidation. However, careful analysis needs to be undertaken to ensure that changes do indeed enhance the operation of the tax system.
Tax reforms after the crisis could not only support growth, but could also address possible deficiencies and distortions of the current systems, some of which have appeared more clearly in the context of the current crisis and although not having caused the crisis, might have contributed to it. Several recent publications address this issue, e.g. IMF (2009a, 2009b), Hemmelgarn and Nicodème (2010), Keen et al. (2010). (135) One
key aspect is that tax systems are often biased towards debt financing which applies to both the corporate and the household sector. In the case of corporations, interest payments can be deducted from the corporate tax base in most Member States whereas the return to equity is not deductible. This
(134) See Heady et al. (2009) and IMF (2010).
(135) European Commission (2010b) will also address this issue in more detail.
creates a tax bias in favour of debt, which is likely to an insufficient capitalisation of companies. As concerns households, several Member States allow for mortgage interest deductibility or even the amortisation of mortgages for owner-occupied housing whereas imputed rents and in many countries capital gains for the principal residence are not taxed. While this favours home-ownership, it can potentially contribute to housing bubbles and promote a high indebtedness of households. Overall, higher indebtedness increases the vulnerability of the private sector to shocks. Solutions to these problems include the introduction of an allowance for corporate equity (ACE) or a comprehensive business income tax (CBIT). (136) In terms of housing taxation, the
taxation of imputed rents and capital gains could be introduced in order to reduce the bias to invest in owner occupied housing, or alternatively the interest deductibility for owner occupied housing could be phased out gradually over a number of years. (137)
(136) The ACE system provides a deductible allowance for corporate equity in the calculation of the taxable profits of corporations, whereas the CBIT allows no deduction of interest payments or the return on equity from taxable corporate earnings. Amongst the EU Member States, Belgium has recently introduced an ACE system (déduction pour les interêts notionnels). See, e.g. de Mooij and Devereux (2009) for an analysis of the effects of potential ACE and CBIT reforms in the EU Member States.
(137) A more detailed discussion of the possible adjustment of the taxation of owner occupied housing can be found in IMF (2009b).
The existing tax structure and the economic situation in the different Member State, will determine which changes in the tax structure and tax design can be expected to have the strongest impact on growth. (138) In planning changes, it is
important to bear in mind the effect that these will have on the revenues of different levels of government as shifts in the tax structure might require adjustments in revenue sharing arrangements. Moreover, another crucial aspect of taxation is the effect it has on income inequality as in many cases there is likely to be a trade-off between growth and equity.
(138) IMF (2010) presents rough estimations for potential revenue increases of different types of taxes in the G-20 countries.
financial crisis, the European Commission called for an EU wide framework of fiscal and structural measures to support aggregate demand and avoid a deeper recession, resulting in the European Economic Recovery Plan (EERP). (139) Despite
earlier scepticism about the general effectiveness of fiscal policy as a stabilisation tool, the specific circumstances of the crisis created a strong case for fiscal stimulus measures. With an increased number of households facing credit constraints and with the zero lower bound on nominal interest rates having been reached, monetary policy was limited in its ability to provide stabilisation and could, instead, accommodate a fiscal stimulus. The presence of both credit constraints and very low interest rates increase the effectiveness of temporary fiscal stimulus measures and justify significant policy interventions.
However, the fiscal stimulus added to the underlying deterioration in fiscal positions which manifested itself when the crisis unfolded. In many countries credit and asset price booms had led to improvements in fiscal positions in recent years. The failure to fully account for the direct and indirect effect of strong asset prices on fiscal positions led to a distorted and overly optimistic picture of the underlying fiscal stance. (140) In
addition, the ongoing negative effects of the financial crisis on potential growth put further pressure on fiscal positions and have led to widespread concern about the long-run sustainability of the public finances. Although the fiscal stimulus packages were not the main reason for the deterioration in the fiscal positions, there have been calls for an early exit from the stimulus measures. This section discusses some of the issues involved. It focuses first on the effects of the withdrawal of fiscal stimulus measures, and, second, on the effects of permanent fiscal consolidations that will be required to put public finances back on a sustainable path.
(139) See also Box I.1.1 describing the EERP and the withdrawal of temporary measures in product and labour markets. (140) See the Report on Public Finances 2009 for an analysis of
the relation between fiscal policy, credit growth and property prices (European Commission (2009)).
Fiscal policy played an important role in supporting growth in the current crisis due to two main factors. (141) First, the financial crisis led to a
significant tightening of credit conditions and increased the share of credit constrained households. Second, with nominal interest rates at or near their zero lower bound, monetary policy was likely to be accommodative of the fiscal stimulus, rather than crowding it out – as would have been the case in normal times – through an increase in interest rates aimed at keeping inflation and inflation expectations in check.(142) However,
while these two factors make fiscal multipliers larger, if they persist they would also make the cost of a withdrawal of the stimulus higher. Table III.6.1 shows the QUEST model multipliers for fiscal stimuli in the EU, for the cases where the EU acts alone, and as part of a global stimulus. The results also represent the expected loss in output stemming from the withdrawal of these measures. As is clear from this table, the GDP effect depends on the instrument used, the presence of credit constraints, monetary accommodation and on whether the stimulus is regional or global.
In general, GDP effects are larger – and so the losses more severe in the case of withdrawal – for public spending measures, such as government consumption and investment, than for tax reductions and transfers to households. Temporarily increasing investment subsidies yields sizeable effects since it leads to a reallocation of investment spending into the period when the purchase of new equipment and structures is subsidised. Government investment yields a somewhat larger GDP multiplier than purchases of goods and services. An increase in government wages has a larger impact on GDP (but a smaller impact on private sector value-added). An increase in government transfers has a smaller multiplier, as it typically implies negative labour supply
(141) Roeger, W. and J. in ’t Veld (2009) , “Fiscal Policy with
Credit Constrained Households”, European Economy
Economic Paper no.357
(142) These two factors also mean that empirical reduced form studies are less relevant to gauge the effects of fiscal policy in the current situation as these studies assess the effects of fiscal stimulus in a normal situation.
incentives. However, transfers targeted to liquidity constrained consumers provide a more powerful stimulus as these consumers have a larger marginal propensity to consume out of current net income. Temporary reductions in value added and labour taxes show smaller multipliers, which are nearly entirely generated by higher spending of the private sector. A temporary reduction in consumption taxes is more effective than a reduction in labour taxes as forward looking households also respond to this change in the intertemporal terms of trade(143). Temporary
reductions in housing tax has little impact for Ricardian households, who smooth their spending, but a non-negligible impact for credit constrained households. Temporary corporate tax reductions would not yield positive short run GDP effects since firms calculate the tax burden from an investment project over its entire life cycle.
The presence of credit-constrained agents raises the multiplier as these agents have a larger marginal propensity to consume out of current net income. The multiplier increases especially for those fiscal measures which increase current income of households directly, such as labour taxes and transfers, while the increase is less strong for government consumption and investment. The reason for this is that credit constrained households not only have a higher marginal propensity to consume out of current
(143) Note that this assumes the VAT reduction is fully passed through into consumer prices. This intertemporal effect will be strongest in the period just before taxes are raised again (in t+1).
income but their spending is also highly sensitive to changes in real interest rates (see Roeger and in 't Veld (2009)). This is because the collateral constraint requires that spending must be adjusted to changes in interest payments. In other words, the interest rate exerts an income effect on spending of credit constrained households. For realistic magnitudes of indebtedness, the interest sensitivity exceeds the interest elasticity of spending of Ricardian households, substantially. An important lesson from this is that it would be better if fiscal exit was only commenced after credit conditions have returned to pre-crisis levels. As long as credit conditions remain tight, and more households face a binding collateral constraint on their borrowing, the costs of a withdrawal of fiscal stimulus remain higher.
Fiscal policy multipliers are also enhanced by monetary accommodation for a fiscal stimulus which is likely to occur when interest rates are at, or close to, their zero lower bound. Under normal circumstances a fiscal stimulus would put upward pressure on inflation and give rise to an increase in interest rates. With monetary accommodation and nominal interest rates being held constant, higher inflation will lead to a decrease in real interest rates and this indirect monetary channel amplifies the GDP impact of the fiscal stimulus (see also Christiano et al. 2009, Erceg and Linde 2009). Under monetary accommodation, both spending and tax multipliers are considerably larger and this effect is amplified in the presence of credit constrained households.
Table III.6.1: Fiscal multipliers for temporary stimulus Without collat.
constr.
With collat. constr.
With collat. constr. + mon. acc.
Without collat. constr.
With collat. constr.
With collat. constr. + mon. acc. investment subsidies 1.52 1.59 2.04 2 2.11 2.63 government investment 0.89 0.91 1.08 1.04 1.08 1.24 government purchases 0.78 0.81 1.03 0.94 1 1.21 government wages 1.11 1.26 1.39 115 1.34 1.46 general transfers 0.2 0.41 0.53 0.24 0.51 0.62
transfers targetted to collateral
constrained hh. - 0.67 0.86 - 0.82 1.01
transfers targetted to liquidity
constrained hh. 0.66 0.69 0.89 0.81 0.86 1.05
labour tax 0.22 0.44 0.55 0.26 0.53 0.64
consumption tax 0.4 0.48 0.65 0.49 0.59 0.76
property tax 0.01 0.12 0.18 0.01 0.16 0.21
corporate income tax 0.02 0.03 0.04 0.03 0.04 0.05
EU stimulus Global stimulus
Note: Effect on EU GDP (% difference from baseline) for a temporary one year fiscal stimulus of 1% of (baseline) GDP.
This also has important implications for the optimal timing of a withdrawal. As long as interest rates remain low, monetary policy is less likely to support a fiscal tightening by reducing interest rates. An early withdrawal of fiscal stimulus, while monetary policy remains at or close to the zero lower bound, risks a much sharper contraction in output than when the exit is delayed till monetary conditions allow room for accommodation. Finally, there are also sizeable positive spill-over effects from fiscal stimuli. The effects of a joint fiscal stimulus (as in the final three columns in table III.6.1) are larger than when acting alone. In the current crisis there has been a global fiscal stimulus with large fiscal packages implemented in all G20 countries. If the fiscal stimuli are withdrawn at the same time, output losses are likely to be larger.
Summarising, these model multipliers show that just as the positive effects of a fiscal stimulus are larger than under normal conditions in the presence of credit constrained households and monetary policy at the zero lower bound, the cost of a withdrawal will also be larger if these conditions still hold. This shows the risks of a too early exit. It indicates that, if a country has sufficient fiscal space, delaying the fiscal exit until credit conditions have returned to normal and monetary policy is no longer constrained by the zero lower bound would importantly support output.
However, there are some additional observations to consider. First, it is important to be aware of the difference between a temporary fiscal stimulus and a permanent fiscal expansion. Unlike temporary fiscal stimuli, a permanent fiscal expansion (or one that is perceived as such) has a smaller multiplier and negative long run GDP effect (see section III.3). Second, a stimulus followed by a spending reversal (144) has a larger impact multiplier and a
more positive medium-run GDP effect. A reversal in later periods has deflationary effects and the implied monetary policy response to this will be
(144) A spending reversal implies that the stimulus is not only withdrawn after a year, but the debt increase is reversed by a further temporary improvement in the budget balance.
felt early on. Also, the tax burden does not change.(145)
Permanent fiscal consolidations
While the previous section suggested that extreme care should be taken when determining the timing of the stimulus withdrawal, it is clear that in the long run significant consolidation is required in most countries to bring the public finances to a sustainable path.
Fiscal consolidations of the magnitude suggested in the previous chapters are likely to have significant effects on output. This section describes some stylised scenarios of fiscal consolidations to illustrate the potential impact of permanent reductions in deficits. In these scenarios the deficit-to-GDP ratio is reduced by 1 percent of GDP. This is achieved through a permanent across-the-board adjustment in spending and taxes, roughly proportionally to their respective shares in government budget. Given the assumptions on the nominal growth rates in the model, this leads to a reduction in the debt-to-GDP ratio of approximately 25 percentage points in the long run. Lower debt implies lower interest payments and the additional fiscal space created by this can be utilised to reduce labour taxes. As this is a long- run scenario, we assume a standard monetary policy response with the central bank targeting inflation and the output gap according to a Taylor type rule. A sovereign risk premium is included in the model, calibrated such that a 1 percentage point reduction in the debt to GDP ratio reduces government bond rates by 3 basis points. In this scenario, with a reduction in the debt-to-GDP ratio converging towards 25 percentage points, long run government bond rates are 75 basis points lower. This is in line with the estimates reported in Laubach (2009), who finds an increase in interest rates on government bonds of between 2 to 6 basis points following a 1 percentage point increase in the government debt to GDP ratio. (146) Note that
(145) Corsetti et al. ("Debt consolidation and fiscal stabilization", AEA Papers and Proceedings, 2010 forthcoming) make a similar point. They also show that with the ZLB constraint binding, the reversal must not come too early on the recovery path, or at least it must be suitably gradual. (146) Note that analysis does not take account of non-linearity in
the relationship between debt levels and risk premia. For very high debt countries, risk premia effects could be much larger. See also the discussion in Section III.3.2 and Box III.3.1.
this risk premium is applied to government bonds and does not affect the general level of interest rates in the economy (147).
Graph III.6.1 and Table III.6.2 illustrate the model's dynamic transition between the short run and the long run for this fiscal consolidation. The composition of the consolidation is divided 50–50 between expenditure and revenue (148). The
reduction in spending and increase in tax immediately lowers output, by approximately 0.4 percent. Both private consumption and investment are negatively affected. But the multiplier is lower than for temporary changes in fiscal instruments, as the permanent nature of the fiscal consolidation is fully credible and leads to anticipation of a lower tax burden in the future. As the government deficit is permanently reduced by 1 percentage point of GDP, the stock of outstanding debt gradually declines, and the costs of servicing this
(147) Some recent evidence for the US suggests that an increase in government debt reduces primarily the spread between government and corporate bonds. Krishnamurthy and Vissing-Jorgensen (2007) show that an increase in Treasury debt held by public leads to a decline in the yield spread of AAA corporate debt over Treasuries. It may well be that for countries which rely heavily on foreign financing of investment, rising government debt could lead to a general increase in the country risk premium and increase interest rates for both government and private bonds. The premium may be particularly large if currency risk is increased.