FISCAL POLICY IN SOUTH AFRICA: AN INTERTEMPORAL CGE ANALYSIS Margaret Chitiga, Ramos Mabugu, Hélène Maisonnave and Véronique Robichaud For an Equitable Sharing of National Revenue

O UTLINE OF THE P RESENTATION Aims and Objectives Methodology Results Conclusion 2 Workshop Name Date 2011

A IMS AND O BJECTIVES New Growth Plan involves accelerated investment program in social and economic infrastructure and general government spending These expansionary fiscal strategies raise a number of critical policy questions: – composition of spending – financing strategies (taxation or increased debt) How would these policies and their financing affect the South African economy in the short, medium and long run? CGE analysis in a forward-looking perspective 3 Workshop Name Date 2011

M ETHODOLOGY - J USTIFICATION CGE analysis that allows taking into account all the linkages between productive sectors, demand, international trade and macroeconomic constraints As measures are known in advance, a forward- looking behaviour (for firms and households) is more suitable Impact of infrastructure on economic growth is taken into account 4 Workshop Name Date 2011

M ETHODOLOGY - O VERVIEW Multi-sector analysis (19 industries and commodities) Intertemporal framework: all current and future prices are known and affect firms investment decision and households consumption pattern Taxation options: many tax instruments are explicitly modelled to allow for a wide variety of policy responses 5 Workshop Name Date 2011

M ETHODOLOGY - F IRMS Representative firm in each industry that combines labour, capital and intermediate inputs to produce composite commodities that can be sold either locally or exported. Constant returns to scale technology Competitive environment in the good markets, as well as in factor markets. 6 Workshop Name Date 2011

M ETHODOLOGY - F IRMS Nested structure: 7 Workshop Name Date 2011 Total output Value added Total intermediate cons. Capital Labour Int. cons. by commodity Leontief CES

M ETHODOLOGY - F IRMS Nested structure: 8 Workshop Name Date 2011 Total output Value added Total intermediate cons. Capital Labour Int. cons. by commodity

M ETHODOLOGY - F IRMS 9 Workshop Name Date 2011 Public infrastructure:

M ETHODOLOGY - F IRMS 10 Workshop Name Date 2011 Public infrastructure:

M ETHODOLOGY - F IRMS Standard static optimization problem yields the first order conditions: 11 Workshop Name Date 2011

M ETHODOLOGY - F IRMS Intertemporal optimization: the representative forward-looking firm maximizes the actualized value of profits net of investment expenditures: subject to: – Profits 12 Workshop Name Date 2011

M ETHODOLOGY - F IRMS – Capital stock accumulation: – Adjustment cost function (Hayashi 1982): 13 Workshop Name Date 2011

M ETHODOLOGY - F IRMS From the first order conditions, we find: – Optimum level of investment: – Desired future capital stock: 14 Workshop Name Date 2011

M ETHODOLOGY - H OUSEHOLDS Finite number of infinitely-lived households The representative household makes consumption and savings decisions It derives its current income from wages and profits paid by firms, and pays income tax. It maximizes an intertemporal utility function subject to a sequence of budget constraints and an intertemporal solvency constraint. 15 Workshop Name Date 2011

M ETHODOLOGY - H OUSEHOLDS The intertemporal utility function is additively separable, features a constant rate of time preference and an instantaneous logarithmic utility function that is weakly separable and defined over aggregate consumption CTH. from which we derive the trade-off between consumption in two consecutive periods (Euler equation): 16 Workshop Name Date 2011

M ETHODOLOGY - H OUSEHOLDS Based on the optimal path for aggregate consumption consumption expenditures, the representative household allocates in each period these expenditures among the available commodities (C i ). A Linear Expenditure System (LES) function is used as the aggregator function to specify the relation between aggregate consumption and the quantities of various commodities consumed by the representative household. 17 Workshop Name Date 2011

M ETHODOLOGY - G OVERNMENT The government collects various direct and indirect taxes: – Income taxes (firms and households) – Taxes on production and on factors of production – Import duties and export taxes – Taxes on commodities It receives and pays transfers, and consumes goods and services (current and investment). It also pays interest on the public domestic and foreign debt for which interests rates can differ and are exogenous 18 Workshop Name Date 2011

M ETHODOLOGY - G OVERNMENT The government finances the excess of its current and investment expenditures over its revenue by issuing bonds (SG). A positive balance implies that the government would reimburse part of its debt, whereas a negative balance would increase it. 19 Workshop Name Date 2011

M ETHODOLOGY - C LOSURES Small open economy hypothesis (world prices are given) Constant current account balance Fixed repartition between domestic and foreign debt Nominal exchange rate is the numéraire 20 Workshop Name Date 2011

R ESULTS -S IMULATIONS Two simulations: – Increased current public spending 10% in 2011 and % in 2013,2014 and 2015 back to BAU in 2016 – Increased public investment 10% in 2011 and % in 2013,2014 and 2015 back to BAU in Workshop Name Date 2011

R ESULTS -S IMULATIONS Under three financing mechanisms: – Increased income tax rate on households’ income – Increased indirect tax rate on commodities – Increased debt Caveats: – Public investment in infrastructure is assumed to increase total factor productivity – But public current spending does not affect productivity (period of increased spending is assumed too short to significantly impact productivity) 22 Workshop Name Date 2011

R ESULTS -S IMULATION 1 Increased public expenditures has little impact on GDP, regardless of the timeframe. 23 Workshop Name Date 2011 Direct tax financingIndirect tax financingDebt financing GDP1.18%0.07%-0.10%-0.54%-0.42%-0.23%1.14%0.04%-0.12% GDP deflator1.19%0.38%0.11%-0.56%0.15%0.16%1.15%0.35%0.10% Real GDP-0.01%-0.31%-0.20%0.02%-0.57%-0.39%-0.01%-0.32%-0.21% Real consumption-1.07%-0.71%-0.24%-1.65%-0.81%-0.40%-1.09%-0.74%-0.27% Real investment-5.56%-0.77%-0.05%-2.54%-1.27%-0.28%-5.69%-0.81%-0.07% Debt0.00% 1.97%2.08% Gov. expenditures5.92%1.22%0.03%6.23%1.36%0.07%5.91%1.43%0.25% Increase in tax rate2.65%0.63%0.06%1.01%0.26%0.04%n.a.

R ESULTS -S IMULATION 1 Affects negatively real investment, especially in the short run and under direct tax and debt financing. 24 Workshop Name Date 2011 Direct tax financingIndirect tax financingDebt financing GDP1.18%0.07%-0.10%-0.54%-0.42%-0.23%1.14%0.04%-0.12% GDP deflator1.19%0.38%0.11%-0.56%0.15%0.16%1.15%0.35%0.10% Real GDP-0.01%-0.31%-0.20%0.02%-0.57%-0.39%-0.01%-0.32%-0.21% Real consumption-1.07%-0.71%-0.24%-1.65%-0.81%-0.40%-1.09%-0.74%-0.27% Real investment-5.56%-0.77%-0.05%-2.54%-1.27%-0.28%-5.69%-0.81%-0.07% Debt0.00% 1.97%2.08% Gov. expenditures5.92%1.22%0.03%6.23%1.36%0.07%5.91%1.43%0.25% Increase in tax rate2.65%0.63%0.06%1.01%0.26%0.04%n.a.

R ESULTS -S IMULATION 1 Implies increased income tax rates by 2.65 or increased indirect tax rates by 1 (temporary tax) 25 Workshop Name Date 2011 Direct tax financingIndirect tax financingDebt financing GDP1.18%0.07%-0.10%-0.54%-0.42%-0.23%1.14%0.04%-0.12% GDP deflator1.19%0.38%0.11%-0.56%0.15%0.16%1.15%0.35%0.10% Real GDP-0.01%-0.31%-0.20%0.02%-0.57%-0.39%-0.01%-0.32%-0.21% Real consumption-1.07%-0.71%-0.24%-1.65%-0.81%-0.40%-1.09%-0.74%-0.27% Real investment-5.56%-0.77%-0.05%-2.54%-1.27%-0.28%-5.69%-0.81%-0.07% Debt0.00% 1.97%2.08% Gov. expenditures5.92%1.22%0.03%6.23%1.36%0.07%5.91%1.43%0.25% Increase in tax rate2.65%0.63%0.06%1.01%0.26%0.04%n.a.

R ESULTS -S IMULATION 1 Debt financing mechanism implies greater debt-to GDP ratio, even in the very long run 26 Workshop Name Date 2011

Direct tax financingIndirect tax financingDebt financing GDP0.02%0.15%0.17%-0.22%0.16%0.26%0.02%0.15%0.17% GDP deflator0.02%-0.34%-0.27%-0.22%-0.33%-0.25%0.02%-0.34%-0.27% Real GDP0.00%0.49%0.44%0.00%0.49%0.51%0.00%0.49%0.44% Real consumption0.07%0.30%0.37%-0.09%0.23%0.37%0.07%0.30%0.38% Real investment-0.21%0.89%0.51%0.46%1.12%0.79%-0.25%0.88%0.51% Debt0.00% 0.17%-0.15% Gov. expenditures0.73%0.07%-0.07%0.76%0.06%-0.10%0.73%0.08%-0.08% Increase in tax rate0.34%-0.03%-0.11%0.13%-0.01%-0.04%n.a. R ESULTS -S IMULATION 2 Increased public investment has greater impact on GDP, especially in the long run (TFP effect) 27 Workshop Name Date 2011

Direct tax financingIndirect tax financingDebt financing GDP0.02%0.15%0.17%-0.22%0.16%0.26%0.02%0.15%0.17% GDP deflator0.02%-0.34%-0.27%-0.22%-0.33%-0.25%0.02%-0.34%-0.27% Real GDP0.00%0.49%0.44%0.00%0.49%0.51%0.00%0.49%0.44% Real consumption0.07%0.30%0.37%-0.09%0.23%0.37%0.07%0.30%0.38% Real investment-0.21%0.89%0.51%0.46%1.12%0.79%-0.25%0.88%0.51% Debt0.00% 0.17%-0.15% Gov. expenditures0.73%0.07%-0.07%0.76%0.06%-0.10%0.73%0.08%-0.08% Increase in tax rate0.34%-0.03%-0.11%0.13%-0.01%-0.04%n.a. R ESULTS -S IMULATION 2 Stimulates real consumption (especially in the longer run) 28 Workshop Name Date 2011

Direct tax financingIndirect tax financingDebt financing GDP0.02%0.15%0.17%-0.22%0.16%0.26%0.02%0.15%0.17% GDP deflator0.02%-0.34%-0.27%-0.22%-0.33%-0.25%0.02%-0.34%-0.27% Real GDP0.00%0.49%0.44%0.00%0.49%0.51%0.00%0.49%0.44% Real consumption0.07%0.30%0.37%-0.09%0.23%0.37%0.07%0.30%0.38% Real investment-0.21%0.89%0.51%0.46%1.12%0.79%-0.25%0.88%0.51% Debt0.00% 0.17%-0.15% Gov. expenditures0.73%0.07%-0.07%0.76%0.06%-0.10%0.73%0.08%-0.08% Increase in tax rate0.34%-0.03%-0.11%0.13%-0.01%-0.04%n.a. R ESULTS -S IMULATION 2 Affects real investment negatively in the short run, but positively in the medium and long run 29 Workshop Name Date 2011

Direct tax financingIndirect tax financingDebt financing GDP0.02%0.15%0.17%-0.22%0.16%0.26%0.02%0.15%0.17% GDP deflator0.02%-0.34%-0.27%-0.22%-0.33%-0.25%0.02%-0.34%-0.27% Real GDP0.00%0.49%0.44%0.00%0.49%0.51%0.00%0.49%0.44% Real consumption0.07%0.30%0.37%-0.09%0.23%0.37%0.07%0.30%0.38% Real investment-0.21%0.89%0.51%0.46%1.12%0.79%-0.25%0.88%0.51% Debt0.00% 0.17%-0.15% Gov. expenditures0.73%0.07%-0.07%0.76%0.06%-0.10%0.73%0.08%-0.08% Increase in tax rate0.34%-0.03%-0.11%0.13%-0.01%-0.04%n.a. R ESULTS -S IMULATION 2 Would require small tax increase in the short run but translate into tax reduction in the longer term 30 Workshop Name Date 2011

R ESULTS -S IMULATION 2 Although the debt-to-GDP ratio is above that of BAU in the short term, it would be below in the long run because of economic growth 31 Workshop Name Date 2011

R ESULTS -S IMULATION 2 Different values of elasticity would change the amplitude of the impact on GDP by less than 1%. 32 Workshop Name Date 2011

R ESULTS -S IMULATION 2 Similar conclusion for the debt-to-GDP ratio 33 Workshop Name Date 2011

C ONCLUSIONS Current expenditures: – Increase in current expenditures has little impact on the economy – Including TFP impact would significantly change the results. (Would a 5-year increase be sufficient to impact TFP?) – Debt financing would require future intervention in order to go back to the initial debt-to-GDP ratio. 34 Workshop Name Date 2011

C ONCLUSIONS Investment expenditures: – Short term public investment in infrastructure would affect TFP – Positive impact on macroeconomic impacts, especially in the medium run – Reduces the debt-to-GDP ratio, regardless of the financing mechanism (economic growth). 35 Workshop Name Date 2011