The evaluation of fiscal consolidation strategies

Although noticeable improvements have been made in the aftermath of the global economic crisis and recession of the late 2000s, many countries still face considerable budget deficits and growing public debts. In response to these undesirable developments, most governments in the advanced economies have already introduced extensive strategies to achieve fiscal consolidation to alter this unsustainable development. An important issue related to fiscal consolidation, or in broader sense any reform related to public financing, is how different reform strategies will affect future economic performance of the country.

The analysis of short- and long-run effects of fiscal consolidations has attracted a lot of attention in the academic literature and this topic is a crucial issue also for policy makers. Most of the academic papers look at the aggregate economic implications, like the overall impact on employment or output growth, but usually do not take into account implied distributional effects or the influence on income inequality. Several these studies present evidence that spending based adjustments, like cuts in government spending or transfers to households (including pensions and social benefits), are less detrimental to future economic activity than increasing taxes. A survey of this strand of literature can be found in Alesina and Ardagna (2010). More evidence reinforcing and supporting these ideas can be found in Leigh, Devries, Freedman, Guajardo, Laxton, & Pescatori (2010) or Alesina and Ardagna (2012). On the other hand, Figari, Paulus, and Sutherland (2015) use static microsimulations to show the importance of the interactions between various consolidation strategies and the income distribution. Inappropriately, this aspect has been often overlooked in the macroeconomic literature. They find that as an immediate effect of the consolidation, richer households tend to bear greater burden when taxes are increased, while low- income households are more affected by spending cuts. As an alternative approach, Cournede, Goujard, and Pina (2013) present a qualitative framework designed to rank fiscal consolidation instruments. The ranking reflects some kind of compromise between adverse side-effects of consolidation on growth (short- and long-term), income inequality as well as on external imbalances.

In this paper, we present results of a quantitative evaluation of fiscal consolidation strategies in the context of Slovakia. Strategies are assessed within the framework of a behavioural general equilibrium model. This approach utilizes microsimulation techniques that allow to simulate the Slovak tax and benefit system changes in fine detail (see our related paper by Siebertova, Svarda, & Valachyova, 2016) and to quantify their impact on individual and household income distribution.

The model is behavioural, so changes in individual attitudes conditional on applied fiscal consolidation instruments (within tax and transfer system) are taken into account. Modelling the labour supply at the extensive margin is detailed in our related analysis by Senaj, Siebertova, Svarda, and Valachyova (2016). Based on the macro part of the model, described in Horvath, Senaj, Siebertova, Svarda, and Valachyova (2018), the long-run effects on the aggregate economy can be evaluated (in particular, the impact on output growth or employment).

The consolidation instruments that we consider in this paper are policies that are intended to affect governments’ primary revenues and spending. More specifically, we examine how changes in direct and indirect taxation and in social transfers to households affect the aggregate economic performance, as well as income distribution and inequality. This is the practical advantage of combining empirical micro and theoretical macro blocks of our model, as it allows to evaluate these impacts in a unified framework. We provide an assessment of two sets of policies.

First, we define the benchmark scenarios to demonstrate how our simulation model works and through which specific channels the results are obtained. These consolidation strategies involve altering single parameter of the tax and transfer system. We identified marked heterogeneity in terms of magnitude, composition as well as short- and long-run effects of fiscal consolidation. The approach that we are using allows us to consider the interactions between the setup of consolidation instruments and households’ distribution of income. We show that increase in labour taxes is less detrimental to output growth than increase in consumption taxes. Due to the statutory settings of the Slovak tax system, lower-income households tend to bear greater burden when income tax allowances are reduced, while richer households are more affected by tax rates increases. Spending cuts reduce directly households’ disposable income and thus are more likely to influence the lower part of the income distribution. Considerable labour supply reaction at the extensive margin increases employment in the long-run, and we show that spending cuts strategies do not destruct output growth.

We address an important question of how to provide an appropriate assessment of the simulation results. This we understand as a fundamental issue, if the presented approach should be used as an analytical tool in the actual practice of policy makers or analysts in general. Therefore, to evaluate fiscal and economy wide impacts of reform strategies in monetary amounts (euros), we use scaling factors that provide an adjustment of the differences between simulated outcome from the model and the official statistics.

The structure of the paper is the following. In Section 2, methodology is summarized and the valuation of the simulation results is discussed. Section 3 provides an evaluation of the consolidation scenarios. In particular, we discuss their setup, common features, distributional and economic implications. Finally, Section 4 concludes.

In this paper consolidation scenarios, designed as a tax and transfer system reforms, are evaluated in the framework of the general equilibrium behavioural microsimulation model. The approach taken allows us to provide an assessment of different impacts of the selected fiscal instruments. First, immediate fiscal effects are evaluated by using the static microsimulation model of the Slovak tax and transfer system SIMTASK. The behavioural reaction, after individuals have adjusted their behaviour to the new environment after the reform scenario has been implemented, is simulated using a labour supply model. Finally, the long-run effects are assessed using the micro-macro simulation model what-if that is estimated and calibrated for Slovakia. Long-run in our model stands for an appropriate time frame that permits the effects of the policy measures fully to work themselves through the economy. Further details on the Slovak tax and transfer system, the labour supply model and on what-if macro model is provided in Appendix A.

In the framework of the general-equilibrium model, we provide an assessment of the impact of selected consolidation instruments on short- and long-term fiscal stance, long-term growth and income inequality. The microsimulation approach allows us to evaluate changes in measures such as average and marginal effective tax rates (AETR and METR, respectively) or disposable income at an individual and households’ level. We discuss how to provide a credible valuation and interpretation of the simulation results based on the outcomes from the model. As a baseline year for our analysis, the statutory settings of the tax and transfer system in Slovakia valid from 2018 are fixed.

In the analysis, we consider benchmark scenarios, which are defined as consolidation strategies altering only one parameter of a tax and transfer system. They demonstrate how our simulation model works and through which specific channels are the results obtained. We evaluate the strategies of fiscal consolidation both on the revenue as well as the expenditure sides of the budget. On the revenue side, we consider consolidation through increasing different direct and indirect taxes: the personal income tax, the corporate income tax and the value added tax. Also, changes in health insurance contributions paid by employees and employers are assessed. On the expenditure side, child tax credits along with a reduction of family related transfers are evaluated as well as a decrease in material need benefits.

The what-if model is utilized to provide an assessment of the proposed consolidation strategies. First, we look at static or the “day-after” effect of the applied fiscal instruments. In particular, change in individual tax burden and aggregate fiscal effect is assessed under the assumption that people do not change their behaviour. However, the size of the fiscal effect is influenced by the behavioural adjustment to the changes induced after the consolidation measures are applied. This implies that consolidation instruments might affect the motivation to work, which translates into labour supply changes. By behavioural response we denote the effects including the reaction of labour supply to reform scenarios. In the long term, employers adjust gross wages as a reaction to labour supply changes as well as to the changes in their labour (employers’ SIC and HIC), capital and hiring costs. Thus, the new economy wide equilibrium wage level is determinative to long-term fiscal revenues. As a result, the new equilibrium level of labour and capital is determinative to the long-term growth of GDP.

The detailed results of short-run, behavioural and long-run effects are summarized in Tables B.1–1 to B.1–3 in the Appendix, where the direct output from the model is introduced. In addition, Tables B.2–1 to B.2–3 in the Appendix present the re-scaled monetary effects of changes.

The next set of consolidation scenarios concern taxing consumption instead of labour income. We consider 1 p.p. increase in the standard rate of value added tax and the abolition of reduced rate of value added tax (the setup of scenarios is detailed in Table 2). In order to study the effects on households’ budget, we define similarly like Pestel and Sommer (2017) a quantity called post-VAT income that equals to household disposable income minus paid VAT. It can be understood as the virtual monetary amount left for the consumption after VAT has been paid. Both, increase in income and consumption taxes lead to a drop in post-VAT income of households. While income tax rate growth reduces net wage, the consumption tax reduces real value of net earnings and social transfers. Summing up, the motivation to work of individuals is reduced by both forms of taxation. On the demand side, the firms react to decline in employment by raising wages, their labour costs increase and the overall output decreases.The microsimulation approach allows us to consider in detail the effects of different forms of taxation on different population subgroups. Income tax system in Slovakia with two tax rates and a gradual phase-out of tax allowances is a progressive system. On the contrary, value added tax, when measured as a percentage of disposable income, exhibits a clearly regressive pattern (see Table 2.1 in OECD, 2014). When the behavioural reaction of individuals in the two scenarios of 1 p.p. increase is compared, in the scenario with income tax rate increase, mainly higher-income groups react and reduce their motivation to work. On the other hand, when value added tax is increased, the motivation to work of low-income groups decreases more (see Table B3 in the Appendix). Our empirical results confirm progressive pattern of income tax system and a regressive pattern of value added tax. The overall small magnitude of estimated changes depends on the statutory settings of the Slovak tax system.

Comparing the long-run effects of the two sets of scenarios, labour as well as output face greater decrease when income tax is raised (detailed in Table B4 in the Appendix). The results gained from our model thus confirm an indication often discussed in the economic literature that capital/corporate and labour taxes are most detrimental to output growth, while consumption and property taxes belong to less damaging instruments for consolidation. For the discussion and useful references, see European Commission (2015b).

The next topic we discuss is the distribution of the tax burden between employers and employees. We define two consolidation scenarios increasing the rate of health insurance contributions (HIC) by 1 p.p. either at the side of employees or employers. HIC should be understood as a form of labour taxation as they are the compulsory payments, guaranteeing an access to the full utilization of public healthcare. Since statutory tax incidence is in the former scenario born by employees and in the latter by employers, it is interesting to see the resulting economic incidence.

The immediate, or “the day-after” effect on the total revenues from HIC is of the same magnitude in both scenarios. However, the total fiscal impact is different. In the case of scenario increasing HIC for employees it is offset by the drop-out in the revenues from personal income tax and value added tax. Since the work incentives of employees are reduced, the immediate behavioural reaction of labour supply is present in this scenario (see Table B3 in the Appendix). Again, the firms react to reduced labour supply by increasing the wages.

On the other hand, in the case of scenario increasing HIC for employers, the total fiscal impact is offset by the drop-out in the revenues from corporate income tax. In this scenario labour supply in the short-run does not react. In the long-run, the firms, facing higher statutory labour costs, maximize their after-tax profits. Therefore, firms significantly reduce wages keeping their unit labour costs unchanged. This implies the switch of the tax burden, statutorily laid on employers, to employees. Overall, the employment and effective labour falls, which leads to the decline in output.

Classical models of labour market assume, that the side of the market, on which a tax is levied, does not affect its economic incidence. This implies that irrespective of which side of the market is tax levied on, the costs of the employer and the net wages received by the employees would adjust in the same way. However, there is no consensus of empirical works whether the “invariance of incidence proposition” holds (for the discussion and useful references see European Commission, 2015a). Our results show, for both analysed scenarios in the long-run a decline of net wages of employees and an increase in unit labour costs. Thus, confirming the adjustment process in the same direction. However, the magnitude differs, the impact on economy being larger in the scenario when the burden is statutorily increased for the employees.

The economic incidence, or, in other words the extent to which workers or employers bear the burden of labour taxation, is a function of labour supply and demand elasticities. Thus, in the long- run, relative size of elasticities of labour supply and labour demand determine the economic incidence. In our model, the elasticity of labour supply is estimated directly from microdata, while the degree of responsiveness of labour demand stems from the way how the macro-part is modelled and calibrated (e.g. involuntary unemployment). The results of analysed scenarios imply that 1 p.p. increase in the tax burden translates into the drop in net wages of employees by 0.4 – 0.5 %. This holds, irrespective of the instruments applied (personal income tax rate or health insurance contributions either at the side of employees or employers). In both scenarios, the output of the economy decreases and net profits of firms decline, which confirms sharing the tax burden between the two sides.

In the previous scenario, tax burden of employers was increased through the increase in labour costs. In the next scenario, we consider 1 p.p. increase in the corporate income tax (CIT) rate, which would decrease after-tax profits of the firms.

As a common feature, both scenarios show positive total fiscal effect, although the revenues from increase of HIC are higher than those from increase of CIT. In both cases, the statutory incidence is on the employers’ side, thus initiating no immediate behavioural reaction of the labour supply. However, in the long-run, employers react differently and the tax burden is distributed. In the case of scenario increasing HIC, the employers aiming to reduce labour costs decrease gross wages. It turns out, that the employers shift the tax burden to employees (lower net wages). In case of the scenario increasing CIT rate, the employers decrease wages only marginally, but they significantly reduce capital. Consequently, the firms bear the increase in tax burden via lower net profits. Despite the different reaction on the employers’ side, the model predicts very similar decline of output. The decline in net profit is more pronounced in the case of tax rate increase.

Moving from consolidation strategies at the revenue side to those on the expenditure side, a scenario reducing family related transfers and credits and a scenario reducing material need benefits is analysed. These expenditures cutting scenarios are described in detail in Table 3 bellow. The first scenario has much larger effect compared to the latter one. Fiscal effect stems from the decline in social transfers, and on top of that, in the former scenario, from abolishing the tax credit for dependent children for high income individuals. In both scenarios, households face decline in their disposable income, which translates into a decline in the government revenue from value added tax.

The two scenarios differ considerably with respect to the behavioural reaction of labour supply. In the scenario when the transfers are withdrawn from high earners, the labour supply hardly reacts. Therefore, also the long-run effects are negligible.

On the contrary, the reduction of material need benefits affects those with the lowest income, thus invoking significant labour supply reaction as they have higher labour supply elasticities. In the long-run, following high labour supply response, the employment rises and firms react by decreasing wages. This results into the decrease of unit labour costs. Consequently, the output of the economy and profit of the firms rises. The government revenues from corporate income tax rises as well. A note on the interpretation of this result need to be made at this point. A significant reaction of the extensive margin followed by an employment rise should be considered as an upper bound of the effect. We argue that the decision of the inactive individuals to enter the labour market is not always driven only by financial motivation, modelled in our framework, but also by other factors that are not captured in our model. Therefore, in reality, it can be expected that the reaction would be lower. To sum up, in opposition to the strategies on the revenue side, the analysed spending cuts strategies are not detrimental or even promote the long-run economic growth. This result is in line with literature findings, see the summary assessment of growth effects of fiscal consolidation instruments reported by Cournede et al., 2013 (in Table 2).

The fiscal challenges, that many advanced economies face, require adjusting abroad range of tax and spending cuts instruments. The question of their appropriate mix is still open and the practise varies across countries. There is a growing consensus in the literature that no one-size-fits-all approach exists (Cournede et al, 2013) and that economic and social situation of countries should be considered by adjusting the usage of consolidation objectives. When tax and spending cuts policies are designed, the impact of fiscal adjustments on the aggregate macroeconomic performance is of great relevance, as well as a balance between distributional and efficiency objectives. This analysis provides an evaluation of the effect of selected benchmark consolidation measures on fiscal stance, economic growth and income inequality in Slovakia. Our approach combines the microsimulation analysis that allows to evaluate the impact of the individual policy instruments separately and their incidence along the households’ income distribution, to simulate the behavioural reaction on the labour market and finally to provide an assessment of the long-run general equilibrium effects. We find a considerable variation in terms of magnitude and implied effects of the tested instruments. The amount of the deficit reduction naturally varies depending on instruments chosen. Our empirical results confirm that taxing labour and consumption has both a negative effect on individuals’ motivation to work, but in the long-run increasing labour taxes is more detrimental to employment and output growth than taxing consumption. We analyse the distribution of the tax burden between employers and employees when the consolidation is driven by an increase in employers’ and employees’ health insurance contributions rates. The empirical evidence confirms that the adjustment process works in the same direction, however, the output declines more in case when the statutory tax incidence is levied on employees. On the other hand, the two spending cuts strategies are not detrimental to output growth. Cuts of transfers to households enforce positive reaction of the labour supply and in the long-run employment grows.

We consider presented empirical results as a starting point that may serve for further analysis. Our methodology can be used as a tool that can practically examine different tax and transfer system reform packages that are currently discussed in Slovakia — in terms of their efficiency and political workability. An important topic might be to test such reform packages that are revenue neutral, but not detrimental to income inequality. Finally, we have not considered the consequences of the measures from the perspective of the intertemporal consumption decision of households. At the same time, we have assumed,through an appropriate functional form for welfare, that policy decisions have no wealth effect on the labour supply. This allowed us to solve for the labour market dynamics independently of the household's consumption decision. Anticipated changes in the net income may have significant wealth effects. The full implications of these should be taken into account when evaluating the overall effects, including budgetary impacts, of the measures. This is an important extension of our framework which will be addressed in our future work.

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Author details

1. Matus Senaj

   Council for Budget Responsibility, Slovakia

   For correspondence

   senaj@rrz.sk

2. Zuzana Siebertova

   Council for Budget Responsibility, Slovakia

   For correspondence

   siebertova@rrz.sk

3. Norbert Svarda

   Council for Budget Responsibility, Slovakia

   For correspondence

   svarda@rrz.sk

4. Jana Valachyova

   Council for Budget Responsibility, Slovakia

   For correspondence

   valachyova@rrz.sk