Fiscal Reform and Government Debt in Japan: A Neoclassical - - PowerPoint PPT Presentation

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

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Fiscal Reform and Government Debt in Japan: A Neoclassical Perspective

Gary Hansen (UCLA) and Selo ˙ Imrohoro˘ glu (USC) May 10, 2013

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Table of Contents

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1

Introduction . . .

2

Model Economy . . .

3

Calibration . . .

4

Quantitative Experiments . . .

5

Conclusion

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Basic Issue

Two significant challenges faced by Japan

High debt to output ratio (close to 150%). Projected increase in government expenditures due to aging population.

Spending to output projected to rise by 7% due to increases in pension and health spending.

We explore size and consequences of fiscal responses to this problem.

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

High Debt

1985 1990 1995 2000 2005 2010 0.2 0.4 0.6 0.8 1

Figure : Net Debt to GNP Ratio

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Aging Population

2010 2020 2030 2040 2050 2060 2070 2080 2090 2100 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 65+ to 21−64 70+ to 20−69

Figure : Dependency Ratios

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Implications of Aging Population

Fukawa and Sato (2009)

1990 2000 2010 2020 2030 2040 2050 2060 2070 2080 0.1 0.15 0.2 0.25 G/Y 1990 2000 2010 2020 2030 2040 2050 2060 2070 2080 0.1 0.15 0.2 0.25 TR/Y

Figure : Government Expenditures to GNP Ratios

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

What We Do

Formulate and calibrate neoclassical growth model of Japan. Calculate effects of alternative fiscal policies designed to achieve fiscal balance. How large must tax rates on labor and/or consumption be to achieve this goal? First consider reducing transfers (lump taxes) and then consider distorting taxes.

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

What We Do

Hayashi and Prescott (2002) and Chen, ˙ Imrohoro˘ glu and ˙ Imrohoro˘ glu (2006). Economic agents have perfect foresight. Characterize how model performs from 1981-2010.

Take as exogenous TFP, tax rates, government consumption, transfers and population. Use observed values 1981-2010.

Use model to forecast from 2011 and beyond.

Government projections for population to 2050. Forecasts of Fukawa and Sato (2009) of G/Y and TR/Y to 2050.

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Features of Model

Government debt is introduced with bond price (interest rate) endogenous.

Government bonds enter utility function ⇒ rate of return dominance.

Endogenous labor choice ⇒ consumption and labor income taxes are distorting. “Fiscal Sustainability Rule” insures that intertemporal government budget constraint is satisfied.

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Related Literature

˙ Imrohoro˘ glu and Sudo, “Productivity and Fiscal Policy in Japan: Short Term Forecasts from the Standard Growth Model”

Experiment with policies to eliminate budget deficit in near future by increasing consumption tax.

˙ Imrohoro˘ glu and Sudo, “Will a Growth Miracle Reduce Debt in Japan”

Assess possibility that high TFP growth could eliminate government debt.

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Model: Government Budget

Gt + TR∗

t + Bt

=

ηtqtBt+1 + τc,tCt + τh,tWtht

+τk,t(rt − δ)Kt + τb,t(1 − qt−1)Bt.

ιt = { 1 if Bs/Ys ≥ bmax for some s ≤ t,

• therwise

Dt = κιt(Bt − Bt), TR∗

t = TRt − Dt

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Model: Household’s Problem

max

∞

∑

t=0

βtNt[log Ct − α h1+1/ψ

t

1 + 1/ψ + φ log(µt + Bt+1)] subject to

(1 + τc,t)Ct + ηtKt+1 + qtηtBt+1 = (1 − τh,t)Wtht + [(1 + (1 − τk,t)(rt − δ)] Kt +[1 − (1 − qt−1)τb,t]Bt + TRt,

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Model: Firm’s Problem

NtYt

=

At(NtKt)θ(Ntht)1−θ Nt+1Kt+1

= (1 − δ)NtKt + NtXt

At+1

=

γtAt

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Stationary Equilibrium Conditions

Given a per capita variable Zt we obtain its detrended counterpart zt = Zt A1/(1−θ)

t

. First order conditions and market clearing conditions combine to give 10 equations in 10 unknowns

{ct, xt, ht, yt, kt+1, bt+1, dt, qt, wt, rt} for each period t.

Computation Objective: Find value for k1 such that sequence converges to steady state.

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Population and Labor Input

Nt = working age population between the ages of 20 and 69 Use actual values for 1981-2010 Use official projections for 2011-2050 Population constant after 2050 ht is employment per working age population multiplied by average weekly hours worked divided by 98 (discretionary hours available per week).

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

National Accounts: Hayashi and Prescott (2002)

Table : Adjustments to National Account Measurements

C = Private Consumption Expenditures I = Private Gross Investment + Change in Inventories + Net Exports + Net Factor Payments from Abroad G = Government Final Consumption Expenditures + General Government Gross Capital Formation + Government Net Land Purchases

− Book Value Depreciation of Government Capital

Y = C + I + G

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Government Accounts

Public health expenditures in Japan are included in Gt. TRt, includes social benefits (other than those in kind, which are in Gt,) that are mostly public pensions, plus

• ther current net transfers minus net indirect taxes.

8.1% of output is added to TRt since modeling of flat tax rates ignores deductions and exemptions.

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Tax Rates

τh,t, are average marginal labor income tax rates estimated by Gunji and Miyazaki (2011). Last value is 0.324 for 2007 and we assume that this remains constant thereafter. τk,t, is constructed following methodology in Hayashi and Prescott (2002). Last value is 0.3557 for 2010 and we assume that this remains constant thereafter.

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Tax Rates, continued

Tax Rate on Consumption, τc,t

0% 1981-1988 3% 1989-1996 5% 1997-2013 8% 2014 10% 2015 and beyond.

Tax Rate on Bond Interest, τb, 20% for all time periods.

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Tax Rates, continued

1985 1990 1995 2000 2005 2010 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 Consumption Tax Rate Labor Income Tax Rate Capital Income Tax Rate

Figure : Tax Rates

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Technology Parameters

At = Yt/(K θ

t h1−θ t

).

θ = 0.378, which is the average value from 1981-2010. γt = At+1/At, comes from the actual data between 1981 and 2010. γt = 1.0151−θ. for 2011 and beyond. δ = 0.0842, which is the average value from 1981-2010.

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Preference Parameters

Five preference parameters, β, α, ψ, φ, and µ. µ = µt/A1/(1−θ)

t

= 1.1.

ψ = 0.5, the Frisch elasticity of labor supply estimated by Chetty et al (2012).

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Preference Parameters, continued

For β, α, and φ, use equilibrium conditions to obtain a value for each year, and then average over the sample: βt =

(1 + τc,t+1)γ1/(1−θ)

t

ct+1

(1 + τc,t)ct

[ 1 + (1 − τk,t+1) ( θ yt+1

kt+1 − δ

)] αt = h−1/ψ

t

(1 − τh,t)(1 − θ)yt (1 + τc,t)ctht

φt = ηt(µ + bt+1) [ qtγ1/(1−θ)

t

(1 + τc,t)ct − βt [1 − (1 − qt)τb,t+1] (1 + τc,t+1)ct+1

] .

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Bond Price

Need empirical counterpart to qt : qt = Bt+1/Ft

(Bt+1 + Pt+1)/Ft+1

. Bt is beginning of period debt. Pt is interest payments made in period t. Ft is the GNP deflator.

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Bond Price, continued

1985 1990 1995 2000 2005 2010 0.9 0.91 0.92 0.93 0.94 0.95 0.96 0.97 0.98 0.99 1 q from model q with φ = 0 q from data

Figure : Bond Prices

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Bond Price, continued

1980 1985 1990 1995 2000 2005 2010 0.05 0.1 0.15 0.2 Before Tax Rate of Return on Bonds Before Tax Rate of Return on Capital 1980 1985 1990 1995 2000 2005 2010 0.02 0.04 0.06 0.08 After Tax Rate of Return on Bonds After Tax Rate of Return on Capital

Figure : Returns on Capital and Bonds

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Structural Parameters

Table : Calibration of Structural Parameters

Parameter Value θ 0.3783 Data Average δ 0.0842 Data Average β 0.9677 FOC, 1981-2010 α 22.6331 FOC, 1981-2010 ψ 0.5 Chetty et al (2012) φ 0.063 FOC, 1981-2010 µ 1.1 fit qt for 1981-2010

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Fiscal Sustainability

dt = κιt(bt − b y), ιt = { 1 if Bs/Ys ≥ bmax for some s ≤ t,

• therwise

b = 0.6 Consider bmax = 200%, 250% and 300%. Japan already near 150%. Different value of κ for each bmax.

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Fiscal Sustainability

1990 2000 2010 2020 2030 2040 2050 2060 2070 2080 2 4

Debt to GNP Ratio, bmax = 2.5

1990 2000 2010 2020 2030 2040 2050 2060 2070 2080 0.2 0.4 0.6 Consumption Tax Equivalent Revenue Requirement, bmax = 2.5 κ = 0.05 κ = 0.1 κ = 0.15

Figure : Revenue Requirement in the Benchmark Economy

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Fiscal Sustainability

1990 2000 2010 2020 2030 2040 2050 2060 2070 2080 0.5 1 1.5 2 2.5 3 3.5

bmax = 2.0, κ = 0.12 bmax = 2.5, κ = 0.1 bmax = 3.0, κ = 0.087

Figure : Bond to Output Ratio for Alternative Maximum Debt to GNP Ratios

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Fiscal Sustainability

1990 2000 2010 2020 2030 2040 2050 2060 2070 2080 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45

bmax = 2.0, κ = 0.12 bmax = 2.5, κ = 0.1 bmax = 3.0, κ = 0.087

Figure : Revenue Requirement for Alternative Maximum Debt to GNP Ratios

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Comparison of Benchmark with Data

1980 1985 1990 1995 2000 2005 2010 0.25 0.3 0.35 0.4 Hours Worked Data Model 1980 1985 1990 1995 2000 2005 2010 0.5 1 1.5 x 10

6

Capital Stock 1980 1985 1990 1995 2000 2005 2010 2 3 4 5 6 x 10

5

GNP

Figure : Labor, Capital, and Output

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Comparison of Benchmark with Data

1980 1985 1990 1995 2000 2005 2010 1.5 2 2.5 3 3.5 x 10

5

Consumption Data Model 1980 1985 1990 1995 2000 2005 2010 0.5 1 1.5 2 x 10

5

Investment 1980 1985 1990 1995 2000 2005 2010 1.5 2 2.5 3 Capital Output Ratio

Figure : Consumption, Investment, and Capital-Output Ratio

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Comparison of Benchmark with Data

1980 1985 1990 1995 2000 2005 2010 0.2 0.4 0.6 0.8 1 1.2 1.4

Figure : Bond to Output Ratio

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Government Finance in Steady State

Consumption Tax

0.2 0.4 0.6 0.8 1 0.25 0.3 0.35 0.4 0.45 0.5 0.55 0.6 0.65 revenue/output consumption tax rate

G + TR divided by benchmark output Revenue divided by benchmark output

Figure : Consumption Tax Laffer Curve

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Government Finance in Steady State

Labor Tax

0.2 0.4 0.6 0.8 1 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 revenue/output labor income tax rate

Revenue divided by benchmark output G + TR divided by benchmark output

Figure : Labor Income Tax Laffer Curve

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Tax Wedge

From first order condition for labor, can define 1 − τt ≡ 1−τh,t

1+τc,t

⇒ τt = τc,t+τh,t

1+τc,t

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Government Finance in Steady State

Combination of Taxes

0.2 0.4 0.6 0.8 1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 labor income tax rate consumption tax rate

Effective tax rate Consumption tax rate

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Implementation of Tax Increases

τx,t =    τx,last if Bs/Ys ≤ bmax for all s ≤ t τx + π if Bs/Ys > bmax for some s ≤ t and Bt/Yt > b τx if Bt/Yt ≤ b. where x = c or h and t ≥ 2015. π is chosen as the smallest increment that leads to the activation of the second trigger (convergence to steady state).

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Increase Consumption Tax Only

1980 2000 2020 2040 2060 2080 2100 0.1 0.2 0.3 0.4 0.5 0.6 0.7 Consumption Tax Experiment 1

labor income tax rate consumption tax rate

Figure : Consumption Tax Experiment 1

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Increase Both Consumption and Labor Tax

Use Consumption Tax to Retire Debt, Increase Labor Tax to 45%.

1980 2000 2020 2040 2060 2080 2100 0.1 0.2 0.3 0.4 0.5 0.6 0.7 Consumption Tax Experiment 2

consumption tax rate labor income tax rate

Figure : Consumption Tax Experiment 2

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Increase Both Consumption and Labor Tax

Use Labor Tax to Retire Debt, Increase Consumption Tax to 40%.

1980 2000 2020 2040 2060 2080 2100 0.1 0.2 0.3 0.4 0.5 0.6 0.7

Labor Income Tax Rate Experiment labor income tax rate consumption tax rate

Figure : Labor Income Tax Rate

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Transition Paths for Various Experiments

1980 2000 2020 2040 2060 2080 2100 0.2 0.25 0.3 0.35 0.4 Labor Input 1980 2000 2020 2040 2060 2080 2100 1 2 3 x 10

6

Capital Stock 1980 2000 2020 2040 2060 2080 2100 5 10 15 x 10

5

Output lumpsum tc1 tc2 th

Figure : Labor, Capital, and Output

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Transition Paths for Various Experiments

1980 2000 2020 2040 2060 2080 2100 1 2 3 4 5 6 x 10

5

Consumption 1980 2000 2020 2040 2060 2080 2100 0.5 1 1.5 2 2.5 3 x 10

5

Investment lumpsum tc1 tc2 th

Figure : Consumption and Investment

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Transition Paths for Various Experiments

1980 2000 2020 2040 2060 2080 2100 0.5 1 1.5 2 2.5 3 lumpsum tc1 tc2 th

Figure : Debt to GNP Ratio

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Effective Tax Distortion

1980 2000 2020 2040 2060 2080 2100 0.25 0.3 0.35 0.4 0.45 0.5 0.55 0.6 0.65 0.7 0.75 lumpsum tc1 tc2 th

Figure : Effective Tax Rate

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Conclusion

Soaring debt to GNP ratio implies fiscal “day of reckoning” is soon–around 2020. Costs of aging population require large nearly permanent increases in tax rates:

Consumption tax: permanent increase to 48% with additional 12% during transition. Both consumption and labor tax: permanent increase to 40%, smaller additional increase during transition.

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Introduction Model Economy Calibration Quantitative Experiments Conclusion

Conclusion

Other options to explore:

Broaden tax base: 8.1% of GNP potential. Social security and health insurance reform. Increase fertility and/or allow immigration. Encourage female labor force participation. Reduce spending.