Download Fundamental Determinants of the Effects of Fiscal Policy

Global Aging Pressures: Impact of Fiscal
Adjustment, Policy Cooperation, and Structural
Reforms
Dennis Botman and Manmohan S. Kumar
Fiscal Policy and Surveillance Division
Fiscal Affairs Department
International Monetary Fund
Prepared for the conference “Fiscal Policy Challenges
in Europe”, organized by the German Federal Ministry
of Finance and the Center for European Economic
Research (ZEW), Berlin, March 22 and 23.
Debt Sustainability Challenges
a.
b.
c.
d.
e.
Demographic pressures in Europe
Current structural deficits, and high initial debt in Europe
Demographic pressures elsewhere: United States, Japan, and
several emerging markets
Globalization: spillover effects of (fiscal) policies increasingly
important
Other Uncertainties
Projected Debt Dynamics in Germany From
“Global” Demographic Pressures...
(Current Policies Scenario)
400
Aging in Germany alone (4 percent aging costs)
Maastricht debt limit
350
Aging in Germany, euro area, and U.S.
300
250
200
150
100
50
0
2007
2018
2029
2040
Projected Debt Dynamics in Germany From Its
Own Demographic Pressures...
(Current Policies Scenario)
400
Baseline: 4 percent of GDP aging costs by 2050
Maastricht debt limit
350
High aging costs (7.75 percent of GDP by 2050)
Low aging costs (2.75 percent by 2050)
300
250
200
150
100
50
0
2007
2018
2029
2040
Policy Options
a.) Fiscal adjustment: revenue/expenditure based—
effects on output, consumption, investment, trade and
financial markets, and debt;
b.) Cooperative action: spillover effects of fiscal
adjustment (trade and financial market channels) in
light of “global” aging pressures; benefits and costs
c.) Lisbon Agenda: complementarities between fiscal
adjustment and structural reform—labor participation,
R&D spending, and product market competition.
Rigorous Modeling Framework: Global Fiscal Model
Absence of Ricardian-equivalence:

Short planning horizons; distortionary taxation (consumptionleisure, investment); heterogeneous consumers
Rich fiscal structure:

Wide menu of taxes/social security contributions;

Government spending and social security transfers.
Interdependence:

Four country blocks/regions: trade and financial market channels.
Other features:

Microfoundations;

Market imperfections (imperfect competition);

Labor or capital augmenting productivity growth;

Wage and price flexibility; capital mobility;

Traded/nontraded goods (“home bias”—government spending).
GFM: Versatile Framework
Fiscal policy analysis:

The effects of revenue and non-revenue neutral tax reform;

The effects of fiscal adjustment through raising taxes or reducing
government expenditure, or a combination of the two;

Evaluating social security reforms;

Addressing long-term fiscal sustainability concerns, including the
pace, timing, sequencing, and size of adjustment;

Analyzing the sensitivity of the results to the behavioral and
structural assumptions;

International spillover effects of fiscal policy.
Other policies and applications:

Effects of structural reforms;

Debt (domestic and external) debt sustainability;

Financial market policies (risk-premium, patience);

Effects of productivity convergence;
Calibration
Macroeconomic and fiscal variables calibrated to actual values for:
(1) Representative large euro area economy (Germany):
- Aging costs (incl. health) by 2050: 4 percent of GDP;
- Higher VAT in 2007, tax reform, initial structural deficit;
(2) Euro area excluding Germany:
- Aging costs (incl. health) by 2050: 4.5 percent of GDP;
(3) United States:
- Aging costs (incl. health) by 2050: 6.0 percent of GDP;
(4) Rest of the World:
- Assumes no adjustment.
Fiscal Adjustment in Germany: Prefunding
1.)
2.)
Achieves structural balance by 2011;
Further adjustment: debt below Maastricht limit until 2050.
Alternative Adjustment measures:
a.)
b.)
c.)
Higher direct taxation: social security contributions
workers/employers (default policy response), CIT, PIT—base
broadening;
Higher indirect taxation: higher VAT—base broadening;
Expenditure measures: government spending, entitlement
reforms;
Authorities’ intention: package of measures, with weight on
expenditure measures/entitlement reforms, avoid higher direct
taxes.
Alternative Adjustment Strategies: Prefunding
Germany: Alternative Fiscal Adjustment Strategies: 2006-17 1/
(In percent unless otherwise indicated)
2006
2007
2011
2017
Indirect taxation
Statutory rate
Effective tax rate
Revenue (in percent of GDP)
16.0
10.1
6.2
19.0
12.0
7.2
24.7
15.6
9.2
26.6
16.8
9.8
Direct taxation
Effective tax rate
Revenue (in percent of GDP)
29.0
8.1
29.0
8.1
34.9
10.1
38.7
11.0
Social security transfers
In the absence of fiscal adjustment (aging effect) 3/
Spending (in percent of GDP)
With fiscal adjustment
Spending (in percent of GDP)
19.7
19.6
19.1
19.8
19.7
19.6
17.1
17.6
Government consumption
Spending (in percent of GDP)
Percentage reduction (relative to 2007)
18.6
18.6
16.6
-10.8
16.4
-11.8
18.6
19.7
...
18.6
19.6
...
18.1
18.0
0.5
18.1
18.0
1.3
10.1
16.0
12.0
19.0
12.6
20.0
12.6
20.0
Package of measures (in percent of GDP)
Spending
Social security transfers
Revenue from income tax base broadening
VAT (in percent)
Effective rate
Statutory rate
Alternative Fiscal Adjustment Strategies
Effects on Real GDP (Germany)
4
4
Adjustment package
Indirect taxation
Direct taxation
3
3
2
2
1
1
0
0
-1
-1
-2
-2
-3
-3
2007
2017
Adjustment package
Spending
Transfers
2027
2037
2047
2007
2017
2027
2037
2047
Prefunding: Effect on Debt Dynamics
400
Debt dynamics with prefunding
350
Maastricht debt limit
Debt dynamics unchanged policies
300
250
200
150
100
50
0
2007
2017
2027
2037
2047
Effects of Adjustment Package
1.) Entitlement reform: higher saving by “optimizing consumers” as
compensation; lower consumption by “rule-of-thumb” consumers;
2.) Higher saving by the government; reduced consumption of
(nontraded) goods;
3.) Base broadening and higher VAT reduce hours worked and
consumption (but, inelastic labor supply);
As a result, consumption declines more than growth, interest rates
decline, investment boom, higher capital-labor ratio, and substantial
improvement in current account balance and net foreign asset
position.
Global Aging: Joint Action?
Assumptions:
1.) Germany maintains debt below Maastricht limit until 2050 through
package of measures;
2.) Euro area implements its own package to maintain debt below 60
percent of GDP;
3.) U.S. package includes further increasing indirect taxation given
starting structural deficit and higher costs from aging; maintains debt
somewhat below current level until 2050.
Choice between early adjustment or delaying (assume 10 year
delay) for each country/region.
The Benefits of Joint Action I (GDP effects)
Germany early, euro area and U.S. delay 10 years
Early cooperated adjustment
10
10 year delay Germany, euro area and U.S. early
10 year delay Germany, euro area, and U.S.
6
2
-2
2007
2017
2027
2037
2047
The Benefits of Joint Action II (NPV of GDP effects)
Sensitivity Analysis
Parameter values based on empirical estimates from micro
studies/selected to match the national accounts of a country.
However, uncertainty about consumers and firms responses to macro
policies remains. The benefits of joint action are robust to alternative
parameter estimates. But .they are smaller if consumers are more
“Ricardian”:



The planning horizon of consumers is very long;
Labor supply is not sensitive to changes in the after-tax real wage;
If all consumers have access to financial markets;
Or if consumption is not sensitive to changes in the real interest rate.
Other factors matter as well, such as: a firms’ flexibility to substitute
between capital and labor; how costly it is to change the capital stock;
degree of monopolistic competition; bias towards domestically
produced tradables; bias towards nontradables; or economic size.
Effects of Joint Action
Early Joint Action relative to delayed action, while entailing some
output and consumption losses in the near-term, has significant
benefits over the medium and longer run.
Financial market effects dominate spillover effects through
international trade channels—decline in the world real interest
rate more than offsets declining exports following a fiscal
consolidation.
Nevertheless, output and consumption (especially of “rule-of
thumb” consumers) still decline over the next decade: can
structural reforms help to offset the contraction?
Lisbon Objectives: Germany
I: Increase Labor Participation to 70 percent by 2010 (from 65 percent):
 Higher labor demand: due to tax reform;
 Higher labor supply: reducing incentives for non participation, and
reduction of tax distortions.
II: Higher R&D spending, raising productivity growth:
 Increase in R&D spending to GDP from 2.5 to 3 percent by 2010;
TFP elasticity to R&D spending in the middle of existing estimates.
III: Higher product market competition:
 Gradual reduction in markups by 2015 by one quarter.
Analyze the contribution of each of these objectives, and as a package,
in complimenting fiscal adjustment.
Lisbon I: Higher Labor Participation (Germany)
Significant increase in output and consumption; rule-of-thumb
consumption increases later (as real wage declines)
Consumption (percent)
Real GDP
20.0
16.0
Cooperation and labor market reform
14.0
Cooperation
15.0
12.0
10.0
10.0
8.0
6.0
5.0
4.0
2.0
0.0
0.0
-2.0
-5.0
2007
2017
2027
2037
2047
2007
2017
2027
2037
2047
Lisbon II: Higher R&D Spending (Germany)
Significant increase in output, smaller increase in consumption (real
exchange rate depreciates)
Consumption (percent)
Real GDP
18.0
20.0
Cooperation and higher R&D spending
16.0
Cooperation
14.0
15.0
12.0
10.0
10.0
8.0
6.0
5.0
4.0
2.0
0.0
0.0
-2.0
-5.0
2007
2017
2027
2037
2047
2007
2017
2027
2037
2047
Lisbon III: More Competition
(Germany)
Significant increase in output and consumption, especially of rule-ofthumb consumers (as prices and equity values decline)
Consumption (percent)
Real GDP
15.0
14.0
Cooperation and product market
reform
Cooperation
12.0
10.0
10.0
8.0
5.0
6.0
4.0
0.0
2.0
0.0
-5.0
-2.0
-4.0
-10.0
2007
2017
2027
2037
2047
2007
2017
2027
2037
2047
Implementing the Overall Lisbon Agenda
Consumption (percent)
Real GDP
30.0
30.0
Germany implements full Lisbon Agenda
Cooperation only
Euro area implements full Lisbon Agenda
25.0
(Germany)
25.0
20.0
20.0
15.0
15.0
10.0
10.0
5.0
5.0
0.0
0.0
-5.0
-5.0
-10.0
2007
2017
2027
2037
2007
2047
Consumption by optimizing consumers (percent)
2017
2027
2037
2047
Consumption by rule-of-thumb consumers (percent)
30.0
35.0
25.0
30.0
20.0
25.0
20.0
15.0
15.0
10.0
10.0
5.0
5.0
0.0
0.0
-5.0
-5.0
-10.0
-10.0
2007
2017
2027
2037
2047
2007
2017
Capital stock (percent)
2027
2037
2047
2037
2047
Labor effort (percent)
40.0
7.0
35.0
6.0
30.0
5.0
25.0
4.0
20.0
3.0
15.0
2.0
10.0
1.0
5.0
0.0
0.0
-1.0
-5.0
-2.0
2007
2017
2027
2037
2047
2007
2017
2027
Effects of Implementing the Overall Lisbon Agenda



Significant increase in output and consumption, offsets the
contractionary effects of fiscal adjustment;
Spillovers of structural reform mainly through international trade
channels, and both consumer types (“constituencies”) benefit;
Effects of euro area as a whole achieving the Lisbon objectives even
more positive as average starting position weaker, for some of the
objectives:


(i) labor participation from 62.5 to 70 percent;
(ii) R&D spending from 2.1 to 3 percent (and further international R&D
spillovers);
Effects of Delayed and Partial Attainment of
the Overall Lisbon Objectives (Germany)
Still substantial benefits, but cannot offset short-term adjustment costs of
prefunding future aging costs
Real GDP
Consumption (percent)
30.0
30.0
Full implementation
26.0
25.0
Partial and delayed implementation
22.0
20.0
18.0
15.0
14.0
10.0
10.0
5.0
6.0
2.0
0.0
-2.0
-5.0
2007
2017
2027
2037
2047
2007
2017
2027
2037
2047
Conclusions: Debt Sustainability

(i) There is little doubt that debt is unsustainable under current
policies in the euro area as well as in the United States.

(ii a) Debt in any particular country or region is seen to be even
more unsustainable if the trading partners are also aging. The
spillover effects of global aging occur through both financial and
trade channels, with the former dominating.

(ii b) There is very substantial uncertainty about the costs of
aging. But even with low estimates of higher costs of health care
and pensions, debt will be on an unsustainable path.

(ii c) Substantial fiscal adjustment inevitable.
Conclusions: Fiscal Adjustment

(iii) Fiscal adjustment that combines both revenue and
expenditure measures is the only feasible and relatively
efficient method to maintain debt sustainability. Such a package
should aim for a modest surplus in the primary balance over the next
decade, to prefund future aging costs, and maintain
intergenerational equity.

(iv a.) The short-term contractionary consequences of Germany
implementing such an early fiscal reform by itself can be
substantial.

(iv b.) Early Joint Action relative to delayed action has
significant benefits over the medium and longer run. Financial
market effects dominate spillover effects through international trade
channels. If all countries that face aging pressures delay adjustment,
the consequences for each and collectively would be highly
adverse.
Conclusions: Structural Reforms

(v) Achieving the Lisbon objectives in Germany and the euro
area is likely to overcome the adverse short-term effects on real
GDP and consumption of the fiscal response.

(vi) There are significant benefits for all constituents of
pursuing the Lisbon Agenda as a package. Each of the
components imply different timing of the benefits, and differential
effects across income groups.

(vii) A partial and delayed attainment of the Lisbon objectives
has the negative consequence that the short-term output and
consumption losses from prefunding of future aging costs
cannot be mitigated.

(viii) Regardless of actions by other countries, it is in each
country’s own interest to take early resolute measures both in
terms of fiscal adjustment and structural reforms.