Explaining Sudden Stop, Growth Collapse, and BOP Crisis: The Case of Distortionary Output Taxes

Abstract

The paper discusses a model in which growth is a negative function of fiscal burden. Moreover, growth discontinuously switches from high to low as fiscal burden reaches a critical level Growth collapse is associated with a sudden stop of capital inflows, real depreciation and a drop in output (driven by a fall in the output of nontradables)–all of which have occurred during recent financial crises in emerging markets. The monetary version of the model is employed to show that balance of payments (BOP) crises could be a result of fiscal distortions. In particular, it is further argued that BOP crisis could be a justifiable central bank response to growth collapse, although realistic circumstances may make this response highly ineffective. An important policy implication of the model is that in order to avoid sudden stop crises, policymakers should aim at improving fiscal institutions. Lowering the fiscal deficit is highly effective in the medium term, but could be counterproductive in the short run if it relies on higher taxes.