Fiscal Distortions Research Articles

Optimal fiscal policy with low interest rates for government debt

This paper analyzes optimal fiscal policy when the rate at which governments can borrow changes persistently. To analyze trade-offs, we allow for fiscal distortions and productive government spending and characterize the optimal mix between spending and revenue measures in a low rate environment. We find that low interest rates on government bonds can be welfare-enhancing if used by the government for fiscal measures that reduce the level of distortion, notably the labor tax, permanently. In the case of a general "flight-to-quality”, where households ask for a premium for holding physical (private) capital, the optimal policy is to increase the public-to-private capital ratio for as long as the shock persists. The associated financing needs should be met by a small increase in government debt and a temporary capital tax.

How effective is an incremental ACE in addressing the debt bias? Evidence from corporate tax returns

The Allowance for Corporate Equity (ACE) introduced in Italy in 2011 has decreased the fiscal distortion between the costs of equity and debt by introducing the deductibility from taxable income of a notional return on capital increases. In this paper, we estimate the impact of the ACE on the leverage ratio of Italian manufacturing firms. Using a novel instrumental variable approach to identify the causal effect, we find that the introduction of the incremental ACE has substantially reduced the leverage ratio of its beneficiaries. We find that the effect is larger for smaller enterprises and for mature firms. In addition, the impact of the ACE is higher for vulnerable and risky firms than for sound firms. These results suggest that an incremental ACE may be an effective policy tool to reduce the leverage ratio of European firms.

Populism, Financial Inequality and Central Bank Independence: A Political Economics Approach

This paper examines myopic, populist policies that guarantee short-term financial protection of the people from the elite without regard for long-term fiscal or monetary distortions. Assuming that citizens are financially heterogeneous, this paper shows that inefficient outcomes can arise when the majority of citizens are bank stakeholders. Populist policies promote politically controlled central banks.

Tax Incentives and Financial Stability

The Allowance for Corporate Equity (ACE) introduced in Italy in 2011 has decreased the fiscal distortion between the costs of equity and debt by introducing the deductibility from taxable income of a notional return on capital increases. In this paper we estimate the impact of the ACE on the leverage ratio of Italian manufacturing firms. Using a novel instrumental variable approach to identify the causal effect, we find that the introduction of the incremental ACE has substantially reduced the leverage ratio of its beneficiaries. The effect of the reform increases with age and decreases with the size of the enterprise. These results suggest that an incremental ACE may be an effective policy tool to reduce the leverage ratio of European firms.

An Assessment of the Linkage between Financial Reporting and Taxation in Tunisia

The relationship between tax and financial reporting has deferred widely over time. The connection between accounting and taxation can provide negative effects; such as earnings management for fiscal purposes and value relevance distortion. This leads to an optimal and efficient looking on the nature of the relation that should bring them together. Few studies have focused on this relationship in some countries, but no research has been applied in the context of Tunisia using an empirical model. In this paper, we analyze within this framework the Tunisian case. We specified a longitudinal dimension of tax and financial reporting association through the separation of two periods of evolution. We collected information about the different accounting and fiscal treatments of seventeen substantial accounting topics from 1968 to 2013, and we assessed them using five cases of connection or disconnection. The results show that even in the case of the lack of accounting standards, there is a total disconnection between accounting and taxation in Tunisia. We also found that the relationship between accounting and taxation in this country was a typical of continental European countries before accounting normalization. After the Tunisian accounting system implementation, the nature of this relationship has changed to the Anglo-Saxon system.

Convergence of inflation with a common cycle: estimating and modelling Spanish historical inflation from the 16th to the 18th centuries

The aim of this paper is twofold. First, to obtain inflation rates for the four regions of Spain analysed for the period 1501–1800 by modelling Hamilton’s (American treasure and the price revolution in Spain, 1934; War and prices in Spain, 1947) price index series by means of an unobserved component model with a common cyclical factor. And second, to prove their long-term convergence process. Therefore, convergence concerns both the cyclical variation of inflation rates common to the four regions, and trend inflation. A complete convergence of the trend inflation occurred once the monetary reforms of Charles II of Spain were introduced in order to redress the previous monetary instability known as inflation of the vellón. The predominance of the vellón in small change and the concentration of the influx of silver when inflation was comparatively lower (second half of the sixteenth century and the seventeenth century) complicate to reach simple conclusions on the monetary origin of inflation exclusively based on precious metals, but, on the contrary, suggest a monetary origin based on copper coin and fiscal distortions. So, monetary stability proved to be a necessary condition for inflation convergence and the fulfilment of the purchasing power parity condition along the eighteen century.

Green Tradable Certificates versus Feed-In Tariffs in the Promotion of Renewable Energy Shares

The paper analyzes the relationship between CO2 mitigation policy and promotion policies designed to deploy renewable energy sources for electricity production (RES-E). If an emission cap is the only policy target, an optimal mix consisting of high and low carbon use of fossil fuels, deployment of RES-E, and energy savings can best be achieved by either setting a uniform carbon tax or by implementing a cap-and-trade system covering all CO2 sources. An additional RES-E share target causes higher costs in achieving the cap. Conversely, a more ambitious emission target automatically increases the RES-E share. In a second step we investigate different policies for inducing an RES-E quota. Such a quota can be efficiently achieved either by a system of tradable green certificates or by a budget-balancing premium system. A budget-balancing FIT system, by contrast, is not efficient, since it generates excessive fiscal distortion. We also show that differentiated, technology-specific FITs are even more inefficient.

Estimating the Costs and Benefits of a Common Currency for the Second West African Monetary Zone (WAMZ)

This paper, estimates the costs and benefits of a common currency in WAMZ. Behavioral models capturing the elements of costs (asymmetric shocks, loss of monetary policy autonomy, and fiscal policy distortion), and benefits (trade creation, financial integration effects and policy coordination gains) were estimated using the Vector Auto-regression (VAR) procedure and panel estimation technique.VAR impulse response and forecast error method was used to determine the countries’ response to shocks while panel regression technique was used to estimate other behavioral equations. Fiscal policy distortion and loss of monetary policy autonomy are the main cost of monetary union in the zone while the potential trade creation gain is marginal. High disposition to money reserve and weak revenue base are the core determinants of fiscal policy distortion in the zone. Overall, the paper concludes that fiscal policy distortion constitutes serious policy challenge to monetary union in the zone. Dealing with this challenge may require short-run systematic macroeconomic adjustments to enhance the convergence of macroeconomic policy indicators in the zone.

Ricardian equivalence and fiscal distortions in the Dominican Republic

This paper tests the Ricardian equivalence hypothesis in the context of the Dominican Republic (DR). The results rejected the Ricardian theorem but a weaker version is shown to have significant implications for the DR. If the government borrows to increase spending, private consumption is crowded out and the economy will suffer in the long run. The outcome is worst if the government borrows to deliver a tax cut. In particular, for every RD$ 1.00 of additional debt incurred to finance government primary spending, private consumption and gross domestic product (GDP) fall by a meaningful RD$ 2.15 and RD$ 1.15 respectively. If the debt is used to finance the tax cut, the fall is RD$ 2.15 in both consumption and output. Interestingly, if the government uses taxes to cover a budget deficit, the effect is neutral and consistent with Ricardian equivalence. The paper argues that fiscal distortions are in part responsible for these multipliers. Distortions are estimated to be 21 % coming from different sources including taxes evasion and fiscal drainage. These findings suggest that the DR could benefit from either reducing the level of fiscal distortions or the size and scope of the Dominican government. If, however, the government continues to pursue an active fiscal role under the current environment, it will generate an unnecessary burden to consumption and economic growth.

House Purchase Versus Rental in Spain

One of the most salient feature of the Spanish housing market, compared to other European economies, is its relatively low rental share. This may be partly attributed to the existence of fiscal distortions in Spain favoring ownership. In this paper, we simulate the potential efects of different policy measures aimed at homogenizing the fiscal treatment of ownership and renting and improving the efficiency of the rental market. We do so in the context of a DSGE model featuring a market for owner-occupied and rented housing, as well as collateral constraints in loan markets. We find that eliminating the existing subsidy to house purchases, introducing a comparable subsidy to rental payments or increasing the efficiency in the production of housing rental services raise the rental share by a similar amount. However, their implications in terms of the construction sector differ.

FDI and Growth: What Cross-Country Industry Data Say

We simulate the macroeconomic and welfare implications of different fiscal consolidation scenarios in Italy using a medium scale two-areas dynamic general equilibrium currency-union model. Differently from similar models, ours is rich in the terms of fiscal features. We assume distortionary taxes (on labor income, capital income and consumption) and welfare-enhancing public expenditure. We distinguish between public spending on final goods and services, public employment and transfers to households. The scenarios that we consider envisage a decreases in the public debt to GDP ratio of 10 percentage points in 5 years. Based on our simulations we find that: first, fiscal distortions are quantitatively significant; second, a consolidation strategy that reduces expenditure and simultaneously lowers tax rates has a positive effect on long-run GDP of 5% to 7% and on welfare of 4% to 7% of the initial levels, depending on the composition of the adjustment; third, consumption and investment are stable or grow on impact and along the path to the new steady state; finally, spillovers to the rest of the euro area are expansionary and sizeable both in the long run and along the transition.

Optimal monetary and audit policy with imperfect taxation

We study optimal monetary and fiscal policy in the presence of informal activities and tax evasion in a cash-and-credit model where identical households are audited to determine their compliance with the tax code. Taxation of informal labor is imperfect, but the government has tools to deal with informal activities and can choose them optimally to reduce fiscal distortions. We characterize both the optimal monetary (optimal interest rate) and fiscal policy (optimal income tax, evasion penalty and audit probability). When auditing is costless, a nominal interest rate equal to zero is optimal and attained when all agents are audited and both types of labor are taxed at the same rate. In the presence of auditing costs, the optimal audit policy does not follow the Friedman rule, and we report the welfare costs of implementing this monetary policy prescription. We derive conditions under which the Friedman rule can be recovered in an economy with informal activities.

The Macroeconomics of Fiscal Consolidations in a Monetary Union: The Case of Italy

We simulate the macroeconomic and welfare implications of different fiscal consolidation scenarios in Italy using a medium scale two-areas dynamic general equilibrium currency-union model. Differently from similar models, ours is rich in the terms of fiscal features. We assume distortionary taxes (on labor income, capital income and consumption) and welfare-enhancing public expenditure. We distinguish between public spending on final goods and services, public employment and transfers to households. The scenarios that we consider envisage a decreases in the public debt to GDP ratio of 10 percentage points in 5 years. Based on our simulations we find that: first, fiscal distortions are quantitatively significant; second, a consolidation strategy that reduces expenditure and simultaneously lowers tax rates has a positive effect on long-run GDP of 5% to 7% and on welfare of 4% to 7% of the initial levels, depending on the composition of the adjustment; third, consumption and investment are stable or grow on impact and along the path to the new steady state; finally, spillovers to the rest of the Euro area are expansionary and sizeable both in the long run and along the transition.

Tax buyouts

The paper studies a fiscal policy instrument that can reduce fiscal distortions without affecting revenues, in a politically viable way. The instrument is a private contract (tax buyout), offered by the government to each citizen, whereby the citizen can choose to pay a fixed price in exchange for a given reduction in her tax rate for a period of time. We introduce the tax buyout in a dynamic overlapping generations economy, calibrated to match several features of the US income, taxes and wealth distribution. Under simple pricing, the introduction of the buyout is revenue neutral but, by reducing distortions, benefits a significant fraction of the population and leads to sizable increases in aggregate labor supply, income and consumption.

The Governance of Migration Policy

In this paper, I examine high‐income country motives for restricting immigration. Abundant evidence suggests that allowing labor to move from low‐income to high‐income countries would yield substantial gains in global income. Yet, most high‐income countries impose strict limits on labor inflows and set their admission policies unilaterally. Making immigration more attractive would require creating mechanisms that limit the negative impacts of labor inflows on natives. Fiscal distortions create an incentive for receiving countries to screen immigrants according to their perceived economic impact. For high‐skilled immigrants, screening can be based on educational degrees and professional credentials, which are relatively easy to observe. For low‐skilled immigrants, illegal immigration represents an imperfect but increasingly common screening device. For policy‐makers in labor‐importing nations, the modest benefits freer immigration brings may simply not be worth the political hassle. To induce high‐income countries to lower border barriers, they need to get more out of the bargain.

Uncertainty and Fiscal Policy in an Asymmetric Monetary Union

We examine monetary and fiscal interactions in a monetary union model with uncertainty due to imperfect central bank transparency. It is first shown that monetary uncertainty discourages excessive taxation and may thus reduce average inflation and output distortions. However, as countries enter the monetary union, this tax-restraining effect of uncertainty is mitigated. The monetary union may hence lead to higher fiscal distortions in some member countries, depending on governments’ spending targets and on the change in the degree of uncertainty implied by common monetary policy.

Is migration a good substitute for education subsidies?

Assuming a given educational policy, the recent brain drain literature reveals that skilled migration can boost the average level of schooling in developing countries. In this paper, we introduce educational subsidies determined by governments concerned by the number of skilled workers remaining in the country. Our theoretical analysis shows that developing countries can benefit from skilled emigration when educational subsidies entail high fiscal distortions. However when taxes are not too distortionary, it is desirable to impede emigration and subsidize education. We then investigate the empirical relationship between educational subsidies and migration prospects, obtaining a negative relationship for 105 countries. Based on this result, we revisit the country specific effects of skilled migration upon human capital. We show that the endogeneity of public subsidies reduces the number of winners and increases the magnitude of the losses.

Money and Capital

We revisit classic questions concerning the effects of money on investment in a new framework: a two-sector model where some trade occurs in centralized and some in decentralized markets, as in recent monetary theory, but extended to include capital. This allows us to incorporate novel elements from the microfoundations literature on trading with frictions, including stochastic exchange opportunities, alternative pricing mechanisms, etc. We calibrate models with bargaining and with price taking in the decentralized market. With bargaining, inflation has little impact on investment, but a sizable impact on welfare: going from 10 percent inflation to the Friedman rule e.g. barely affects capital, but is worth 3 percent of consumption. With price taking, this policy increases capital between 3 percent and 5 percent, and is worth 1.5 percent of consumption across steady states or 1 percent with transition. Fiscal distortions are also big. So is the impact of holdup problems from bargaining, even if the decentralized market accounts for only 5 percent of output. Many of these numbers are quite different from previous studies. Our two-sector specification is a key to the results.

Some considerations on capital mobility in the European Union: mechanisms to avoid the fiscal distortions

The increase of economic internationalisation has caused the increase of international direct inversions. This has caused an increase in international double tax problems. For this reason, states and organisations have developed mechanisms of tax coordination to elude the distortions in the investment that have originated through the tax variable. The main objective of this paper is to analyse the developments in the European Union international organisms to avoid double taxation of income capital and in international direct investments. Using these instruments it is possible to avoid double taxation and improve investment efficiency at international level.

Aid versus Trade Revisited: Donor and Recipient Policies in the Presence of Learning‐by‐Doing

We examine the (non) equivalence of aid and trade preferences as alternative forms of donor assistance in the presence of learning‐by‐doing externalities in recipient‐country export production. Using a model based on van Wijnbergen (1985), we show that switching donor support on the margin from aid to trade preferences can increase recipient‐country welfare. Simulations in which the productivity externality also interacts with private capital accumulation and fiscal distortions illustrate the potential growth and welfare gains from a revenue neutral re‐orientation of donor assistance. We conclude by considering why these potential dynamic gains remain unexploited by both donors and recipients.