FISCAL POLICY IN SOUTH AFRICA: AN INTERTEMPORAL CGE ANALYSIS

1. 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

2. Outline of the Presentation Workshop Name Date 2011 • Aims and Objectives • Methodology • Results • Conclusion

3. Aims and Objectives Workshop Name Date 2011 • 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

4. Methodology - Justification Workshop Name Date 2011 • 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

5. Methodology - Overview Workshop Name Date 2011 • 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

6. Methodology - Firms Workshop Name Date 2011 • 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.

7. Methodology - Firms Total output Leontief Value added Total intermediate cons. Leontief CES Capital Labour Int. cons. by commodity Workshop Name Date 2011 • Nested structure:

8. Methodology - Firms Total output Value added Total intermediate cons. Capital Labour Int. cons. by commodity Workshop Name Date 2011 • Nested structure:

9. Methodology - Firms Public infrastructure: Workshop Name Date 2011

10. Methodology - Firms Public infrastructure: Workshop Name Date 2011

11. Methodology - Firms Workshop Name Date 2011 • Standard static optimization problem yields the first order conditions:

12. Methodology - Firms Workshop Name Date 2011 • Intertemporal optimization: the representative forward-looking firm maximizes the actualized value of profits net of investment expenditures: subject to: • Profits

13. Methodology - Firms Workshop Name Date 2011 • Capital stock accumulation: • Adjustment cost function (Hayashi 1982):

14. Methodology - Firms Workshop Name Date 2011 From the first order conditions, we find: • Optimum level of investment: • Desired future capital stock:

15. Methodology - Households Workshop Name Date 2011 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.

16. Methodology - Households Workshop Name Date 2011 • 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):

17. Methodology - Households Workshop Name Date 2011 Based on the optimal path for aggregate consumption consumption expenditures,the representative household allocates in each period these expenditures among the available commodities (Ci). 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.

18. Methodology - Government Workshop Name Date 2011 • 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

19. Methodology - Government Workshop Name Date 2011 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.

20. Methodology - Closures Workshop Name Date 2011 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

21. Results-Simulations Workshop Name Date 2011 • Two simulations: • Increased current public spending • 10% in 2011 and 2012 • 2% in 2013,2014 and 2015 • back to BAU in 2016 • Increased public investment • 10% in 2011 and 2012 • 2% in 2013,2014 and 2015 • back to BAU in 2016

22. Results-Simulations Workshop Name Date 2011 • 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)

23. Results-Simulation 1 Workshop Name Date 2011 • Increased public expenditures has little impact on GDP, regardless of the timeframe.

24. Results-Simulation 1 Workshop Name Date 2011 • Affects negatively real investment, especially in the short run and under direct tax and debt financing.

25. Results-Simulation 1 Workshop Name Date 2011 • Implies increased income tax rates by 2.65 or increased indirect tax rates by 1 (temporary tax)

26. Results-Simulation 1 Workshop Name Date 2011 • Debt financing mechanism implies greater debt-to GDP ratio, even in the very long run

27. Results-Simulation 2 Workshop Name Date 2011 • Increased public investment has greater impact on GDP, especially in the long run (TFP effect)

28. Results-Simulation 2 Workshop Name Date 2011 • Stimulates real consumption (especially in the longer run)

29. Results-Simulation 2 Workshop Name Date 2011 • Affects real investment negatively in the short run, but positively in the medium and long run

30. Results-Simulation 2 Workshop Name Date 2011 • Would require small tax increase in the short run but translate into tax reduction in the longer term

31. Results-Simulation 2 Workshop Name Date 2011 • 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

32. Results-Simulation 2 Workshop Name Date 2011 • Different values of elasticity would change the amplitude of the impact on GDP by less than 1%.

33. Results-Simulation 2 Workshop Name Date 2011 • Similar conclusion for the debt-to-GDP ratio

34. Conclusions Workshop Name Date 2011 • 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.

35. Conclusions Workshop Name Date 2011 • 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).