Simulating Tax Effects on Economic Activities in Sierra Leone: A DSGE Framework

Abstract

"In order to analyse the macroeconomic effects of changes in the marginal tax rate on cyclical fluctuations in Sierra Leone, we created a DSGE model that evaluates the macroeconomic impact of three tax instruments (i.e., consumption, income, and capital). The model is calibrated with parameter values that reflect the peculiarities and representative tax structure of the Sierra Leone economy. We found that; a 5% increase in consumption tax rate causes a distortionary effect on output, consumption, and investment (in the short-run), while in the long-run output contract by 3.1%, with a permanent decline in consumption and investment. Whilst, fiscal revenues increase in the dynamic short run, 15%, higher than it previous steady-state value. On the other hand, a simulation of a 5% reduction in consumption tax, labour income tax, and capital income tax from the current rates shows a positive impact on consumption and investment as such output grows permanently by 8.45%, but fiscal revenues decrease marginally by 1.7%. The key point in the analysis is that in Sierra Leone tax changes have distortionary effects on the decisions of individuals and firms, affecting output, investment, consumption, and fiscal revenues. As such tax policy can alter economic behaviour in profound ways. We observed that fluctuations in tax rates produce large substitution effects that alter investment & consumption decisions and have distortionary effect on the behaviour of economic agents. The results suggest that the authorities should synchronize policies to manage the trade-off between the desire for more welfare gains, output growth, and the need for more fiscal revenue mobilization."