On the Implications of Taxation for Investment, Savings and Growth:

Transcription

1 IDB WORKING PAPER SERIES No. IDB-WP-560 On he Implicaions of Taxaion for Invesmen, Savings and Growh: Evidence from Brazil, Chile and Mexico Emilio Espino Marín González-Rozada April 205 Iner-American Developmen Bank Deparmen of Research and Chief Economis

2 On he Implicaions of Taxaion for Invesmen, Savings and Growh: Evidence from Brazil, Chile and Mexico Emilio Espino Marín González-Rozada Universidad Torcuao Di Tella Iner-American Developmen Bank 205

3 Caaloging-in-Publicaion daa provided by he Iner-American Developmen Bank Felipe Herrera Library Espino, Emilio. On he implicaions of axaion for invesmen, savings and growh: evidence from Brazil, Chile and Mexico / Emilio Espino, Marín González-Rozada. p. cm. (IDB Working Paper Series ; 560) Includes bibliographic references.. Taxaion Brazil. 2. Taxaion Chile. 3. Taxaion Mexico. 4. Spendings ax Brazil. 5. Spendings ax Chile. 6. Spendings ax Mexico. I. González Rozada, Marín. II. Iner-American Developmen Bank. Deparmen of Research and Chief Economis. III. Tile. IV. Series. IDB-WP-560 hp:// Copyrigh 205 Iner-American Developmen Bank. This work is licensed under a Creaive Commons IGO 3.0 Aribuion-NonCommercial-NoDerivaives (CC-IGO BY-NC-ND 3.0 IGO) license (hp://creaivecommons.org/licenses/by-nc-nd/3.0/igo/legalcode) and may be reproduced wih aribuion o he IDB and for any non-commercial purpose. No derivaive work is allowed. Any dispue relaed o he use of he works of he IDB ha canno be seled amicably shall be submied o arbiraion pursuan o he UNCITRAL rules. The use of he IDB s name for any purpose oher han for aribuion, and he use of IDB s logo shall be subjec o a separae wrien license agreemen beween he IDB and he user and is no auhorized as par of his CC-IGO license. Following a peer review process, and wih previous wrien consen by he Iner-American Developmen Bank (IDB), a revised version of his work may also be reproduced in any academic journal, including hose indexed by he American Economic Associaion s EconLi, provided ha he IDB is credied and ha he auhor(s) receive no income from he publicaion. Therefore, he resricion o receive income from such publicaion shall only exend o he publicaion s auhor(s). Wih regard o such resricion, in case of any inconsisency beween he Creaive Commons IGO 3.0 Aribuion-NonCommercial-NoDerivaives license and hese saemens, he laer shall prevail. Noe ha link provided above includes addiional erms and condiions of he license. The opinions expressed in his publicaion are hose of he auhors and do no necessarily reflec he views of he Iner-American Developmen Bank, is Board of Direcors, or he counries hey represen.

4 Absrac This paper explores he qualiaive and quaniaive implicaions of axaion for growh and savings in hree Lain American counries: Brazil, Chile and Mexico, sudying a small open economy in he conex of an endogenous growh model where he domesic ineres rae depends on he level of domesic deb. The model s parameers are calibraed o he Brazilian, Chilean and Mexican economies. The ndings sugges ha, in order o implemen he opimal ax regime, Brazil mus ax capial a a considerably lower rae han a presen. Consumpion should be heavily axed in Brazil and Mexico and opimal labor axes should be lower han acual axes in Brazil and Chile. However, while sub-opimal axes seem o imply lower long-run growh in hese hree counries, low saving raes do no seem o be a direc consequence of sub-opimal axaion. JEL Classi caion: E6, E62, H2 Keywords: Opimal scal policy, endogenous economic growh, savings. The auhors graefully acknowledge he nancial suppor of he Iner-American Developmen Bank (IDB). The auhors are hankful o Agusina Harick, Giselle Monama and Erneso Pienika, who provided excellen research assisance.

5 Inroducion Despie successful sabilizaion programs and reforms during he las decades, Lain America saving raes have remained relaively sagnan, especially in comparison wih he Eas Asian "miracle" economies. As Figure illusraes, naional saving in Lain America has averaged, during he pas decade, less han 20 percen of GDP, in comparison wih over 30 percen in six rapidly growing Eas Asian economies. Each economy of Lain America and he Caribbean (LAC) had a saving rae subsanially below ha recorded in he Asian "miracle" economies, and in several LAC economies saving raes were only abou one-hird of he Asian "miracle" average. This is far oo sriking. Does his indicae some sor of misallocaion? If so, wha are heir main deerminans of hese di erences? Figure. Counries Naional Savings as a Percenage of GDP in Eas Asia and LAC Source: Auhors calculaions using he World Bank WDI daabase. These quesions lead o key policy issues, as one of he dominan views in he lieraure highlighs ha Lain America s low rae of saving condemns he region o an ine cien allocaion of resources ha delivers low invesmen and consequenly low susainable growh raes (see Gavin, Hausmann and Talvi, 997). 2

6 As saving raes are jus endogenous variables reacing opimally o incenives, policies should concenrae on removing impedimens o growh raher han rying o esablish programs aimed direcly a promoing saving ha are likely o be of dubious e eciveness and may involve economic ine ciencies. As a maer of fac, policy should aim o esablish an environmen conducive o high and susainable growh, rusing saving o follow in response o he incenives ha such an environmen provides. While policies aimed a increasing saving may exhibi a subsanial overlap wih hose aimed a removing impedimens o growh, he shif of emphasis in he policy objecive from saving o growh is non-rivial. Figure 2 below shows ha axes in Lain America are subsanially higher han axes in Eas Asia and he Paci c. Average ax revenues in Lain America have been almos 3 percen of GDP beween 99 and 2007, while in Eas Asia and he Paci c his gure amouns o only 9 percen. Consequenly, we sudy he role played by scal policies, more precisely axes, on economic growh and heir implicaions for domesic savings (see Aanasio and Wake eld, 200). More precisely, his paper aims o answer he following quesions: Wha are he implicaions of sub-opimal axaion for susainable growh? How much of he relaively low levels of saving raes is a consequence of hese sub-opimal policies? The answers o hese quesions are no sraighforward, as many e ciency-raising, growh-promoing policies are likely o have an adverse e ec on savings ha, alhough emporary, may las for many years (see Gavin, Hausmann and Talvi, 997). In order o answer hese quesions, we sudy he e ec of opimal axaion on growh and savings under full commimen o nance an exogenous pah of public expendiures in a small open economy in he conex of an endogenous growh model. The model economy for analyzing hese issues includes some non-sandard assumpions o capure paricular feaures of Lain American developing counries. The informal secor in hese counries produces beween 25 o 76 percen of gross domesic produc or GDP (Schneider and Ense, 2000). Therefore, he design of public policies mus especially consider his peculiar feaure: a large share of labor marke relaionships canno be moniored by governmens. So, in he model economy here are wo secors, radable and non-radable, ha can hire labor in he formal or in he informal labor marke. There is a neoclassical echnology o produce commodiies and non-radable goods ha displays consan reurns o scale. Addiionally, he domesic ineres rae has an exra componen deermined by he level of domesic deb. We quanify he behavior of his economy along he compeiive equilibrium balanced growh pah o undersand how changes in axes a ec variables in he long run. Then, using he characerizaion of he compeiive equilibrium, we sudy he design of opimal ax policy. Tha is, we solve a dynamic opimal axaion problem o provide a quaniaive analysis in a calibraed economy in which we rs we characerize and compue he opimal allocaions, 3

7 Figure 2. Tax Revenue as a Percenage of GDP in Eas Asia and LAC Counries, Source: Auhors calculaions using he World Bank WDI daabase. 4

8 ha are decenralized as compeiive equilibrium, and he corresponding opimal axes, and hen we compue he compeiive equilibrium allocaions semming from acual (poenially subopimal) ax sysems and compare hese economies. In his way i is possible o quanify he negaive impac on welfare and susainable levels of growh, as well as consequen implicaions for domesic savings. As shown by Espino and González-Rozada (203) in a similar seing, he negaive impac migh no be rivial, and herefore is quani caion migh be of ineres on several frons. 2 The quaniaive resuls obained ouline no only he opimal design of scal policies bu also he challenges governmens face in implemening hem. The ndings poin ou he coss in erms of growh, savings and welfare of deviaing from hese opimal policies in hree Lain American counries: Brazil, Chile and Mexico. In order o do so, we compare his opimal design wih non-opimal ax schemes, including he saus quo and a counerfacual ax scheme, given by he ax srucure of one of he Eas Asia miracle counries: Thailand. The res of he paper is organized as follows. Secion 2 presens a review of he relaed lieraure. Secion 3 provides a deailed descripion of he model, a small open economy wih endogenous growh, and wo secors, radable and non-radable, ha can hire no only formal bu also informal labor. Commodiies and non-radable goods are produced wih a consan reurns o scale neoclassical echnology, and he domesic ineres rae depends on he level of domesic deb. Secion 4 formalizes he compeiive equilibrium, characerizes he corresponding balanced growh pah and provides deailed compued examples o sudy he impac of axes on alernaive equilibrium variables. The evidence found in his secion suggess ha he inroducion of an informal secor ino he economy has a negaive impac on he long-run growh rae bu does no a ec privae savings in he hree counries analyzed. Increasing labor axes induces a reducion in he long-run growh rae, and an increase in he capial ax rae produces a fall in privae savings along he balanced growh pah. Addiionally, and as expeced, increasing labor axes reduces he ime devoed o work in he formal secor and increases he ime allocaed o work in he informal secor of he economy. However, he reducion in working ime in he formal secor of he hree counries is larger han he increase in working ime in he informal secor, resuling in a decline in oal ime allocaed o work. Increasing consumpion axes has similar e ecs, as does increasing labor axes. Tha is, an incremen in he consumpion ax rae slows down he economy bu does no a ec privae savings along he balanced growh pah. Finally, increasing governmen expendiures induces an increase in boh he growh rae and privae savings in he hree 2 The soluions ha we obain are ime-inconsisen, a common characerisic of models of his ype. This is no unreasonable, since his is a normaive analysis. These models do no seek o develop esable implicaions bu raher o provide quaniaive guidelines for opimal decision-making by governmens, which is he main purpose of his sudy. 5

9 counries. Secion 5 inroduces he concep of opimal scal policy, describes in deail he Ramsey allocaion problem and provides a deailed characerizaion of he corresponding balanced growh pah. The main objecive of his secion is wofold: rs, o measure how much he ax raes observed in Brazil, Chile and Mexico should change o decenralize he Ramsey allocaion problem, ha is, o swich o he opimal ax policy and second, o assess he coss in erms of growh and savings of using he acual ax scheme insead of he ax srucure of one of he Eas Asia miracle economies: Thailand. The empirical evidence in his secion indicaes ha sub-opimal axes seem o imply lower long-run growh in he hree Lain American counries. However, i seems ha he low levels of saving raes are no a direc consequence of sub-opimal axaion, as opimal axes imply a case, Brazil, where privae savings are lower han he acual siuaion; a case, Chile, where opimaliy induces larger privae savings and a case, Mexico, where he opimal ax srucure does no a ec privae savings. In he hree counries, opimal axes reallocae labor from he informal o he formal secor. The policy recommendaions semming from Secion 6 sugges ha in Brazil, capial, which, based on sandard neoclassical growh models, should no be axed, has o be axed, albei a a considerably lower rae han he rae observed. Consumpion should be heavily axed in Brazil and Mexico, and opimal labor axes should be lower han acual axes in Brazil and Chile. Finally, Secion 7 concludes he paper. 2 Lieraure Review There is a vas heoreical lieraure ha sudies opimal scal policy in some version of he neoclassical growh model. 3 Chamley (986) showed ha he long-run ax rae on capial should be zero. This nding was exended o an endogenous growh model by Lucas (990) and Jones, Manuelli and Rossi (993). The basic inuiion behind his resul is ha a capial income ax disors he invesmen decision and herefore should, in he long run, be replaced enirely by an income ax. This is an imporan resul since he opimal ax srucure ha i describes is signi canly di eren from wha is observed in pracice. As such, he model on which i is based requires furher consideraion. In paricular, a siuaion in which he zero ax will no apply is he following. Correia (996) sudies a small open economy and assumes ha here are one or more facors of producion ha he governmen canno ax (or canno ax opimally). Then he ax on capial income will be dependen on he relaionship beween capial and non-axable facors. Given hese heoreical resuls, acual ax sysems are apparenly far from hese prescripions. This raises he possibiliy ha reforms in hese sysems can raise he rae of 3 A comprehensive survey of his area can be found in Chari, Chrisiano and Kehoe (998). 6

10 growh and he level of welfare. This leads o a purely quaniaive quesion of wheher a policy reform can be jusi ed ha considers a budge-balanced replacemen of he capial ax by axes on consumpion or labor. The rs major conribuion in his respec was by Lucas (990), who analyzed an endogenous growh model wih invesmen in human capial driving growh in a represenaive agen seing ha eliminaes disribuional issues o focus enirely upon e ciency. Using daa from he U.S. economy, he measures wha would have happened if he ax on capial had been se o zero in 985, wih revenue-neuraliy ensured by increasing he ax on labor. The policy change resuls in a signi can level e ec bu an insigni can growh e ec. These ndings can be explained as follows. Since ime is he only inpu ino he producion of human capial, he cos (and reurn) is jus he forgone wage. This leaves he human capial choice una eced by axaion and, since i is his ha drives growh, here is no growh e ec. The level e ec arises simply because of he replacemen of a disorionary ax by a non-disorionary one. The analysis of Lucas is exended by King and Rebelo (990), who consider boh an open economy and a closed economy. The model di ers from Lucas s hrough having physical capial as an inpu ino he producion of human capial. In addiion, King and Rebelo also permi depreciaion of boh capial inpus. In heir benchmark case, where he share of physical capial in human capial producion is a hird, increases in he capial ax and he labor ax from 20 percen o 30 percen reduce he growh rae by.52 percen from is iniial level of.02 o 0.5 percen. The level e ec is a 62.7 percen decrease in welfare. A 0 percen increase in he capial ax alone reduces growh o 0.5 per cen. When he share of physical capial in human capial producion is decreased o 0.20, 0.52 percen falls o 0. percen. In he open economy version of he model, which is characerized by an ineres rae xed a he world level, he fall in growh is even greaer: a 0 percen increase in he capial ax reduces growh by 8.6 percen. Jones, Manuelli and Rossi (993) provide he mos general and ambiious quaniaive exercises in a seing ha combines elemens of hose of Lucas and of King and Rebelo (in paricular, human capial requires ime and goods o be produced). Where i di ers signi canly from he Lucas model is in he parameers of uiliy. Lucas ineremporal marginal rae of subsiuion, =, is 0.5 and he elasiciy of labor supply, in heir noaion, is 0.5. In conras, Jones e al. calibrae wih he daa and so, when = 2, he corresponding is 4:99; i.e., labor supply is much more elasic, implying in urn ha axaion will have a greaer disorionary e ec. For = 2, Jones e al. nd ha he eliminaion of all axes (so disorions are compleely removed) raises he growh rae from 2 percen o 5 percen wih a welfare gain of 5 percen (e.g.,.5 is he 7

11 facor by which he consumpion pah mus be raised in order o bring uiliy under he curren sysem up o he level aained in he Ramsey soluion). For lower values of, and hence greaer values of, he e ec is even more dramaic. 4 Summarizing hese conribuions, Lucas nds no growh e ec bu a signi can level e ec. In conras, King and Rebelo and Jones e al. nd very srong growh and level e ecs. King and Rebelo use a much lower share of human capial in heir own producion han Lucas and a depreciaion rae of 0 percen. For human capial especially, his rae would seem excessive. For Jones e al., i is he higher degree of elasiciy of labor supply ha leads o he divergence wih Lucas. 5 Naional saving maers for growh as high raes of saving are highly correlaed wih high raes of growh. Di eren sudies of he deerminans of saving raes (see Gavin, Hausmann and Talvi, 997 and Guiérrez, 2007, and he references herein) sugges ha he long-run behavior of savings is closely relaed o boh he rae of growh and per capia income levels. However, close correlaion does no ranslae ino causaion, and his is a crucial elemen in he design of policies. Saring wih Carroll and Weil (993), he lieraure has sudied he relaionship beween saving and economic growh in samples covering a large number of counries over several decades, and i has found ha pas growh predics fuure saving raes, while pas saving raes do no predic fuure growh. Therefore, he fac ha increased growh ends o precede increased saving raes suggess ha saving may be, o an imporan exen, caused by economic growh. The paern of srong increases in saving raes afer an acceleraion of growh is illusraed by he experience of he Asian "miracle" economies. Gavin, Hausmann and Talvi (997) shows ha saving raes increased subsanially in hese economies, while hey had remained sagnan in Lain America since he early 970s. The Asian economies have displayed during recen years a much higher rae of saving han LAC counries. Bu his is a relaively recen phenomenon, resuling from a long and gradual increase in Asian saving from raes ha were, in he 970s, generally below hose recorded in Lain America. Only in he lae 970s and early 980s, afer he acceleraion of growh in Asia, did Asian saving raes rise consisenly and subsanially above Lain American raes. In Lain America, Chile is an example where srong increases in saving followed he acceleraion of growh. Chile s economic recovery began in 984, when domesic saving was sill quie depressed, and he economy was as a resul heavily relian upon capial in ows o nance domesic invesmen. I was only in he lae 980s, afer 4 If = : while he corresponding is calibraed o be 7:09, he increase in growh raes is abou 8 percen. The reason for his increase in growh can be seen in he response of labor supply o he ax changes. 5 The role played by each ingredien o explain he divergence beween he resuls is sudied in Sokey and Rebelo (995), who use a model ha encompasses he previous hree. 8

12 several years of susained economic growh, ha Chilean saving raes approached he high levels now observed. See Guiérrez (2007) and Aanasio and Székely (2000) for deailed discussions. The mos relaed work is Espino and González-Rozada (203), which no only encompasses Jones, Manuelli and Rossi (993) and Correia (996) bu also adds some key ingrediens o sudy developing economies. The auhors explore he qualiaive and quaniaive implicaions of opimal axaion in a developing economy when economic growh is endogenously deermined. This class of economies di ereniaes from developed economies in wo aspecs: i) he informal secor is quaniaively signi can and ii) ax-collecing echnologies are more rudimenary. The model is calibraed o he Chilean economy and heir resuls sugges ha capial should sill be axed bu considerably less han acual axes (ha is, 0.78 percen versus 8.5 percen). Labor should be subsidized (o simulae accumulaion of human capial), while consumpion axes should be increased by approximaely 50 percen (from 9 percen o 28 percen). As expeced, he beer collecing echnologies, he higher he corresponding axes. In his conex, he resuling growh rae increases only slighly along he balanced growh pah. In his paper we sudy he e ec of opimal axaion on growh and savings under full commimen o nance an exogenous pah of public expendiures in a small open economy in he conex of an endogenous growh model in hree Lain American counries: Brazil, Chile and Mexico. The nex secion provides a deailed descripion of he heoreical model. 3 A Theoreical Framework In his secion we describe he physical seing, he asse marke srucure and he role played by he governmen. 3. Technology and Households There are wo secors ha produce goods in his economy. The rs is an inermediae commodiy (denoed T ) ha is inernaionally raded, and he second is a non-radable consumpion good (N). Le P N commodiy. denoe he prices of non-radable goods in erms of he There is a neoclassical echnology o produce he commodiy ha displays consan reurns o scale. Commodiies are produced using e ecive unis of labor and domesic capial. This echnology is represened by 9

13 Y T = F T (K T ; L T ) = A T K T T L T ( T ) L T = L T;F + ( ) L T;I where A T is a echnology parameer, T 2 (0; ); 2 (0:5; ] and 0: The disribuion parameer re ecs inensiy in unis of e ecive formal labor while T is he paricipaion of capial. is he elasiciy of subsiuion beween e ecive informal, L I, and e ecive formal,, labor while he elasiciy of subsiuion beween capial and composie labor L F is. Noe ha when here is sric complemenariy ( < ), oher hings equal, a rise in L F leads in equilibrium o an increase in informal labor, and conversely, when here is sric subsiuabiliy ( > ), a rise in L F induces a decrease in informal labor. If =, his echnology reduces o he sandard Cobb-Douglas producion funcion. Non-radable goods are also produced using e ecive unis of labor and domesic capial. The corresponding echnology is represened by Y N = F N (K N ; L N ) = A N K N L N = L N;F + ( ) N L N;I L N ( N ) Parameers have he same inerpreaion. This echnology also displays consan reurns o scale. Toal facor produciviy parameers, namely A T and A N, are consan. Observe ha rms can hire labor eiher in he formal labor marke or in he informal labor marke. Informaliy ranslaes ino less produciviy, ( > 0:5), and labor hired in he informal marke does no pay labor axes. A dae, rms face compeiive facor markes. They pay wages w F and w I per uni of e ecive formal and informal labor, respecively, in unis of commodiy goods. commodiy, is denoed r. The renal price of capial a dae, also in unis of he We model informaliy under he assumpion ha here is a represenaive rm ha operaes in boh labor markes, creaing boh formal and informal jobs. possible. This assumpion is made o simplify he analysis, bu broader inerpreaions are To see his, noice rs ha consan reurns o scale and compeiive facor markes imply ha he equilibrium number of rms is undeermined. There is an alernaive inerpreaion which can be summarized as follows. In each secor here are wo ypes of represenaive rms. One ype of rms hires capial and formal labor and uses he echnology corresponding o more producive labor. The oher ype, on he oher hand, hires capial and informal labor while using he less producive echnology. We emphasize ha we do no 0

14 aim o explain he emergence of informal labor markes, bu we ake heir exisence as given o sudy he implicaions of axaion. Agens value non-radable consumpion and leisure. A dae, le C and x denoe privae consumpion of he non-radable good and leisure, respecively. 6 Represenaive household preferences are described by ime-separable, discouned uiliy where fc ; x g =0 is valued X =0 C (x ) where 2 (0; ), > 0 and 0. is he discoun rae and is he ineremporal elasiciy of subsiuion. 7 The represenaive household is endowed wih a uni of ime every period which mus be allocaed across hree ypes of aciviies and leisure. E ecive unis of formal and informal labor are, L F = u H L I = v H where u and v is he dae respecively. H is he dae fracion of ime working in he formal and informal secor, sock of human capial ha evolves according o H + = A H e H + ( H ) H where e H is inerpreed as he e ecive unis of labor allocaed o he human capial secor a dae, A H > 0 is a human capial echnology parameer and H 2 (0; ) denoes human capial depreciaion rae. The e ecive amoun of leisure ha he represenaive household consumes is given by x = ( du v e ). We assume ha d > as an ari cial device so ha formal wages are lower han ne formal wages. 3.2 Facor Mobiliy, Asse Marke Srucure and he Governmen Le G denoe public consumpion of he non-radable good a dae. We consider a benevolen governmen ha provides public goods, G, nanced levying linear axes on labor, 6 Leisure in his model should be inerpreed in a broad sense, ha is, including any non-marke aciviy like home goods producion. 7 I is imporan o menion ha, similar o Lucas (990), if agens do no value leisure ( = 0) hen axes have no impac on growh raes.

15 capial and consumpion as well as issuing deb. We assume ha G = gy N g 2 (0; ) is he raio of governmen spending o non-radable oupu. for all, where There is no inernaional labor mobiliy and physical capial is domesic. Producion of new capial is domesic, bu invesmen is impored from abroad a he (exogenous) price P. Le K denoe he domesic sock of capial a dae. The linear echnology o produce new capial is sandard and renders he law of moion for capial given by K + = I + ( K ) K where K 2 (0; ) denoes he depreciaion rae I denoes invesmen a dae. The governmen can levy a ax of k 2 [0; K ] on he he ne reurn on capial, (r K ) K, where r denoes he domesic renal price of capial before axes. 8 Think of k as a ax on corporae pro s ha is levied on rms operaing in he counry. The governmen can also ax consumpion a he rae c and he formal secor a he rae w. As sressed above, he informal secor does no pay axes. There is a one-period bond o rade inernaionally a he price q = =R, where R denoes he gross ineres rae, which will be deermined endogenously. The governmen and households have access o he credi marke. Le B p and B g denoe privae and governmen deb holdings, respecively and B = B p + B g. The governmen s budge consrain is ( + R ) B g + P N G = c P N C + w w F L F + k r K k K K + B g + where B g + is furher resriced by a no-ponzi condiion speci ed laer. We denoe =0 = c ; w ; k ; G ; B g + as a scal policy. =0 The domesic ineres rae depends posiively on he domesic deb-radable oupu raio as follows where R 0 > 0: B R = R Y T Domesic agens ake his rae as given; i.e., hey do no inernalize he impac of alernaive deb choices. The marke clearing condiions for he marke of non-radable goods, domesic capial and domesic formal and informal labor are C + G = Y N 8 Following he convenion in he lieraure we assume ha reurn on capial afer depreciaion is axed. 2

16 K = K T + K N u H = L T;F + L N;F v H = L T;I + L N;I for all. 4 Compeiive Equilibrium Analysis In his secion, we formalize he corresponding compeiive equilibrium concep (Subsecion 4.), and hen we quanify he behavior of he economy along he balanced growh pah (BGP, Subsecion 4.2). The goal of his secion is wofold. Firs, we nd i useful o undersand how changes in axes a ec he variables in he long run. Second, we use he characerizaion of he compeiive equilibrium o sudy he design of he opimal ax policy discussed in Secion Fiscal Policy and Compeiive Equilibrium Given a scal policy = c ; w ; k ; R ; L ; G and prices r =0 ; w F ; w I ; P ; P N represenaive household solves =0, he subjec o max fc ;x ;u ;v ;e ;H + ;K + ;B p + g X =0 C (x ), ( + c )P N C + P I + ( + R ) B p () = (( w ) w F u H + w I v H ) + ( k )r + k K K + B p + H + = A H e H + ( H ) H (2) K + = I + ( K ) K (3) lim TY T! j=0 B p T ( + R j ) 0 (4) where (K 0 ; H 0 ; B p 0 = 0) are given and x = ( du v e ). Noice ha consumpion as well as labor and capial axes are paid by households. In equilibrium, i is indisinc if facor axes are paid eiher by rms or workers. 3

17 Firms in he radable and non-radable secors ake prices as given and, respecively, solve he saic problems (L T;F max ;L T;I ;K T )0 n F T (K T ; L T;F ; L T;I ) w F L T;F w I L T;I r K T o and (L N;F max ;L N;I ;K N )0 n P N F N (K N ; L N;F ; L N;I ) w F L N;F w I L N;I r K N Given a scal policy and a price sysem R ; w F ; w I ; r ; P N ; P =0, denoe o fc (); x (); u (); v (); e ()K + (); H + (); B p +(); L T;F (); L T;I (); K T (); L N;F (); L N;I (); K T ; K N ()g =0 as he corresponding soluions o he represenaive household s problem and he rms problem in he radable and non-radable secor. We say ha a scal policy is feasible if ( + R ) B g () + P N G = c C () + w w F u () H () + B g +() + k r K () k K K (); for all ; ha is, a scal policy is feasible if i sais es he governmen budge consrain evaluaed a he allocaion ha is a soluion. We resric ourselves o feasible scal policies wihou any furher reference. De niion. Given a scal policy = c ; w ; k ; G ; B g + and invesmen prices =0 fp g =0, a compeiive equilibrium (CE) is an allocaion fc ; x ; u ; v ; K + ; H + ; B p +; L T;F ; L T;I ; K T ; L N;F ; L N;I ; K T ; K N g =0 and a price sysem R ; w F ; w I ; r ; P N ; such ha he following condiions are sais ed: =0 CE.. Given and P ; R ; w F ; w I ; r, he allocaion =0 fc (); x (); u (); v (); e ()K + (); H + (); B+()g p =0 solves he represenaive household s problem. CE.2. Given and P ; R ; w F ; w I ; r fl T;F (); L T;I (); K T (); L N;F (); L N;I (); K T ; K N ()g =0 solves he rms saic problems in he radable and non-radable secor, respecively. =0, CE.3. Fiscal policy = c ; w ; k ; G ; B g + =0 is feasible. 4

18 CE.4. There is consisency of he domesic ineres rae; ha is, for all R = R B =Y T. Noice ha, as we couple he governmen s and he domesic agen s budge consrains, we obain he las equilibrium condiion (B p + B g ) ( + R ) + P I = F T (K T ; L T ) + B p + + B g Balanced Growh Compeiive Equilibrium: Quaniaive Implicaions We are paricularly ineresed in sudying he balanced growh pah in his seing ha displays some novel feaures. Firs, he growh rae is endogenously deermined by he fac ha he ineres rae depends on a measure of relaive indebedness. This fricion will be criical for closing he model for he developing economies we sudy. Second, he degree of informaliy in he economy is deermined endogenously and i depends, among oher hings, on he design of he scal policy. In wha follows, we analyze he quaniaive implicaions of alernaive ax srucures for hree Lain American counries, Brazil, Chile and Mexico. We are paricularly ineresed in sudying he BGP Only Formal Secor The rs exercise consiss of removing he informal secor of he economy ( = ) o see how K and w a ec he BGP. Figure 3 shows how capial and labor axes a ec he economy s growh rae in his scenario. As Figure 3 illusraes, in he hree counries, increasing he labor ax raes reduces he growh rae along he BGP. Wihou capial and labor axes he growh rae is around 3.7 percen in Chile, 4.3 percen in Mexico and 5.4 percen in Brazil. Increasing he labor ax rae by 20 percen reduces growh around half a percenage poin in he hree counries. This is expeced, since disorionary ax raes should slow down he economy. The e ec of increasing he capial ax rae on growh goes in he same direcion as increasing labor axes, bu he magniude is much lower, almos impercepible in he gure. When looking a privae savings he picure is he opposie. Figure 4 shows he impac of capial and labor axes on wha we called privae savings as a percenage of oal income. Privae savings are de ned as oal income, radable and non-radable, minus non-radable consumpion as a fracion of oal income. Tha is, in his 5

19 Figure 3. Growh Rae along he BGP, Formal Secor Only (in percen) Source: Auhors esimaions. de niion privae savings include invesmen and bond savings. As is clear from he gure, while increasing capial axes reduces privae savings in he hree counries, an increase in he labor ax rae does no seems o a ec savings along he BGP. Increasing he capial ax rae o around 20 percen reduces privae savings from around 35 o 33 percen in Chile, from 29 o 26 percen in Mexico and from 48 o 45 percen in Brazil. Consumpion axes play a similar role as labor axes. Increasing he consumpion ax rae induces a reducion in growh along he BGP and does no a ec privae savings in he hree counries, as can be seen in Figures 5 and 6. Figures 7 and 8 show he impac of changes in capial and labor axes on he disaggregaed componens of privae savings (invesmen and bond savings). As can be seen in Figure 7, increasing he capial ax rae induces a fall in invesmen measured as a percenage of oal income in he hree counries. This e ec is larger for Chile and Brazil, where an increase of capial ax rae from zero o 0.8 reduces invesmen by around 6 percen along he BGP. Labor axes do no seem o a ec invesmen in any of he hree counries. Figure 8 shows ha, when here is no informal secor, here is no bond savings in he hree counries, and a rise in he capial ax rae induces an increase in deb along he BGP. Again, Chile and Brazil are he counries where he impac on deb of increasing 6

20 Figure 4. Income) Privae Savings along he BGP, Formal Secor Only (in % of Toal Source: Auhors esimaions. 7

21 Figure 5. Growh Rae along he BGP, Formal Secor Only (in percen) Source: Auhors esimaions. capial axes is larger. In boh counries, increasing he capial ax rae from zero o 0.8 induces an incremen in deb along he BGP of approximaely 20 percen. The impac of increasing consumpion axes on invesmen and bond savings is similar o he impac of increasing labor axes and so hey are no shown here. Figure 9 shows he impac of an increase in governmen expendiure (de ned as a percenage of he non-radable oupu) over growh along he BGP. As can be seen in he gure, as governmen increases is expendiures here is an increase in growh in he hree counries analyzed here. The growh rae when here is no capial ax and he governmen expendiure is zero is around 2.6 percen in Chile, 3.7 percen in Mexico and 3 percen in Brazil. Increasing governmen expendiures by 20 percen induces an increase in growh of around 9 percen in Chile, percen in Mexico and 7 percen in Brazil. Increasing governmen expendiures also induces an increase in privae savings along he BGP in he hree counries as illusraed in Figure 0. Figure shows he e ec of increasing capial and labor axes on he ime devoed o work in he formal secor of he economy. As labor axes increase, he ime devoed o work decreases, while an increase in he capial ax rae does no seem o a ec he ime devoed o work, in he hree counries. 8

22 Figure 6. Income) Privae Savings along he BGP, Formal Secor Only (in % of Toal Source: Auhors esimaions. 9

23 Figure 7. Invesmen along he BGP, Formal Secor Only (in % of Toal Income) Source: Auhors esimaions. Overall, he inuiion behind hese resuls is ha increasing labor axes leads o a decrease in he ime devoed o human capial accumulaion. The reducion in he ime devoed o human capial accumulaion induces a reducion in he growh rae along he BGP. A similar e ec can be obained when increasing consumpion axes. The same mechanism operaes wih he capial ax rae, alhough much more smoohly. Increasing capial axes induces a mild reducion in he ime devoed o accumulae human capial, and his laer reducion implies a sligh fall (almos impercepible in he gures) in he long-run growh rae. In he case of labor and consumpion axes, increases in boh ax raes reduce he ime devoed o work in he formal secor of he economy, implying a non-rivial increase in he ime devoed o non-marke aciviies, i.e., leisure. I is imporan o inerpre leisure in a broad sense, as modeled, and hus i mus include non-marke producion goods. In oher words, an agen who devoes less ime accumulaing human capial is no necessarily a home doing nohing; raher, he or she could be engaged in non-marke aciviies (i.e., producing goods). Increasing capial axes also has a posiive e ec on ime devoed o leisure. Since increasing labor axes increase he ime allocaed o non-marke aciviies, reducing he ime devoed o accumulaing human capial and he oal ime allocaed o work here is an inra-emporal subsiuion beween work and leisure and privae consumpion does no 20

24 Figure 8. Income) Bond Savings along he BGP, Formal Secor Only (in % of Toal Source: Auhors esimaions. 2

25 Figure 9. Growh Rae along he BGP, Formal Secor Only (in percen) Source: Auhors esimaions. change or changes slighly. A he same ime, he increase in domesic capial compensaes he fall in unis of labor and he produc does no change or changes slighly. Boh e ecs, no impac on consumpion and no impac on producion, imply ha here is no change in privae savings Formal and Informal Secor The second exercise inroduces he informal secor ino he economy. Here, we exend our analysis o sudy he impac of capial and labor axes as well as he impac of capial and consumpion axes. Figure 2 shows he impac of changes in he capial and labor ax raes on he growh rae along he BGP in an economy wih boh formal and informal secors. As he gure shows, an increase in he labor ax rae has a negaive e ec on he growh rae, while increases in he capial ax rae does no seem o a ec growh. Overall, he average growh rae in an economy wih an informal secor is lower han he average growh rae wihou one. A comparison of Figures 3 and 2 suggess ha he inroducion of an informal secor ino he economy diminishes growh; in paricular, even if here is no change in he ax raes, 22

26 Figure 0. Privae Savings along he BGP, Formal Secor Only (in % of Toal Income) Source: Auhors esimaions. Figure. Toal Time Devoed o Work, Formal Secor Only (in percen) Source: Auhors esimaions. 23

27 Figure 2. Growh Rae along he BGP, Formal and Informal Secors Source: Auhors esimaions. he growh rae decreases from 3.7 o 3.4 percen in Chile, from 4.3 o 4. percen in Mexico and from 5.4 o 4.9 percen in Brazil. Figure 3 presens he e ecs of changes in he capial and labor ax raes on privae savings along he BGP when he economy has an informal secor. The gure shows ha when he capial ax rae increases privae savings fall along he BGP. When comparing wih 4 one noices ha inroducing he informal secor seems no o a ec privae savings. Figures 4 and 5 show he impac of capial and labor axes on invesmen and bond savings. The inroducion of an informal secor ino he economy does no a ec invesmen, bu i does have a large e ec on bond savings. Wih only a formal secor and neiher capial nor labor axes here is no bond savings in he hree counries, while he inroducion of informaliy induces posiive bond savings in Chile and Mexico and a reducion in deb in Brazil. As can be observed in Figure 4, an increase in he capial ax rae reduces invesmen along he BGP in he hree counries. The magniude of his reducion is very similar o he case wih no informal secor. Figure 5 shows he impac of capial and labor axes on bond savings. I is clear from he gure ha increasing he capial and labor ax raes induces a rise in bond savings along he BGP in he hree counries analyzed here. In paricular, raising capial axes from zero o 0.8 induces an increase in bond savings from 6 o 4 percen in 24

28 axes. 9 Figure 6 shows he impacs of capial and consumpion axes on he growh rae Figure 3. Privae Savings along he BGP, Formal and Informal Secors Source: Auhors esimaions. Chile, from 2 o 8 percen in Mexico and from -4 o almos 3 percen in Brazil. Increasing consumpion axes has he same e ec on invesmen and bond savings as increasing labor along he BGP. Consumpion axes negaively a ec he long-run growh rae, due o addiional disorions. When boh axes are zero, he growh rae is 3.5 percen in Chile, 4.2 percen in Mexico and 4.5 percen in Brazil. If he consumpion ax rae is increased o 20 percen, he growh rae is only 3. percen in Chile, 3.9 percen in Mexico and 4. percen in Brazil. Again, his is expeced, since disorionary axes end o slow down he economy. The nex wo gures show he impac of increasing governmen expendiures on he growh rae and he impac of privae savings on he BGP. Figures 7 and 8 sugges ha increasing governmen expendiures induces an increase in boh he growh rae and privae savings in alll hree counries. Figures 9, 20 and 2 illusrae for he hree counries ha, when he labor ax rae increases, ime devoed o working in he formal secor decreases, while ime devoed o working in he informal secor increases, which are he expeced resuls of his model. 9 Figures for he impac of consumpion axes are available from he auhors upon reques. 25

29 Figure 4. Invesmen along he BGP, Formal and Informal Secors Source: Auhors esimaions. Figure 5. BondSavings along he BGP, Formal and Informal Secors Source: Auhors esimaions. 26

30 Figure 6. Impac of Capial and Consumpion Taxes on he Growh Rae along he BGP (in percen) Source: Auhors esimaions. 27

31 Figure 7. Growh Rae along he BGP (in percen) Source: Auhors esimaions. Figure 8. Privae Savings along he BGP (in % of Toal Income) Source: Auhors esimaions. 28

32 Figure 9. Brazil: Time Devoed o Work, Formal and Informal Secors (in percen) Source: Auhors esimaions. However, he gure also suggess ha he oal ime devoed o work decreases wih his ax rae, implying ha he disincenive o work in he formal secor is, on average, greaer han he incenive o work in he informal secor. Increasing he capial ax rae does no have an impac on he ime devoed o work in boh secors. As before, he e ec of he consumpion ax rae is very similar o he labor ax rae, ha is, increasing he consumpion ax rae reduces he ime devoed o working in he formal secor and increases he ime devoed o work in he informal secor of he economy. The inroducion of informaliy reduces he oal ime devoed o work compared wih he economy wihou an informal secor. 29

33 Figure 20. Chile: Time Devoed o Work, Formal and Informal Secors (in percen) Source: Auhors esimaions. Overall, he evidence found in his secion suggess ha he inroducion of an informal secor ino he economy and increasing labor and consumpion axes have a negaive impac on he long-run growh rae. This las e ec is expeced, since disorionary axes should slow down he economy. Increasing capial axes reduces privae savings in he hree counries analyzed here. Addiionally, and again as expeced, an increase in labor axes reduces he ime devoed o work in he formal secor and increases he ime devoed o work in he informal secor. However, he reducion in he formal secor is greaer han he increase in he informal secor, resuling in a decline in oal ime allocaed o work. An increase in capial axes seems no a ec he ime devoed o work boh in he formal and informal secors. A rise in consumpion ax raes reduces he ime devoed o work in boh secors, formal and informal. Therefore, increasing labor or consumpion axes increases he ime devoed o leisure and diminishes he ime devoed o human capial accumulaion, and his mechanism induces a fall in he growh rae along he BGP. In he nex secion, we sudy he behavior of his ype of economy along he BGP when he governmen ses opimal ax raes. 30

34 Figure 2. percen) Mexico: Time Devoed o Work, Formal and Informal Secors (in Source: Auhors esimaions. 5 Opimal Fiscal Policies This secion describes he Ramsey approach o opimal axaion in regard o he problem faced by a benevolen governmen ha chooses opimal axes and ransfers given ha only disorionary ax insrumens are available. The governmen ses axes ha i has available so ha, wihin he se of compeiive equilibria, he uiliy of he represenaive agen is maximized. In oher words, he governmen choose he opimal ax scheme ha ensures nancing an exogenous pah of public expendiures and, a he same ime, maximizes he represenaive agen s uiliy. More precisely, he formal de niion is he following. De niion 2. Given a scal policy = c ; w ; k ; G ; B g +, le =0 fc(); x(); u(); v(); K(); H(); B p (); L T;F (); L T;I (); K T (); L N;F (); L N;I (); K T (); K N ()g be he corresponding compeiive equilibrium allocaion. The opimal scal policy is de- ned as he soluion o max X =0 C () (x ()) Solving his problem direcly migh be a nonrivial ask. There are wo common approaches o solving Ramsey problems. The rs is he primal approach, which characerizes 3,

35 a se of allocaions ha can be implemened as a compeiive equilibrium wih axes. By implemenaion we mean he following: for a se of axes, nd a se of (consumpion and labor) allocaions and equilibrium prices such ha hese allocaions are a compeiive equilibrium given axes. Conversely, a se of (consumpion and labor) allocaions is implemenable if i is possible o nd axes and equilibrium prices such ha hese allocaions are a compeiive equilibrium given hese prices and axes. Implemenaion ofen makes i possible o simplify a Ramsey problem by reformulaing a problem of nding opimal axes as he problem of nding implemenable allocaions. This reformulaion of he problem is referred o as a primal approach o Ramsey axaion, and is applicaion in his seing is discussed in deail in he Technical Appendix. 5. Opimal Fiscal Policies: Quaniaive Implicaions In his secion we compue he opimal ax srucure and compare is implicaions on growh and labor marke paricipaion wih he CE allocaion semming from he acual ax sysems. In addiion, we perform a counerfacual exercise in which we quanify he implicaions of imposing he ax in one of he fas-growing Asian economies (Thailand in our examples). Tables, 2 and 3 repor he resuls for Brazil, Chile and Mexico, respecively. The rs row in each able shows he resul of he compeiive equilibrium when he economy has a formal and informal secor. The second row in each able repors he opimal ax srucure compued from he Ramsey problem, and he las row repors a counerfacual exercise imposing on he economy he acual ax srucure of Thailand and compuing he compeiive equilibrium. As menioned, Appendix A deails he calibraion. Consider rs he case of he Brazilian economy. Table shows ha opimaliy dicaes ha labor and capial should be axed subsanially less han observed while consumpion should be heavily axed insead. The impac on growh is large, an increase of more han 30 percen, while here is a non-rivial reallocaion of labor from he informal secor o he formal secor. On he oher hand, opimal axaion reduces he savings rae around 4 percen wih respec o he compeiive equilibrium. If he acual ax sysem were replaced wih he ax srucure of a fas-growing Eas Asian economy he growh rae along he BGP would increase by almos 20 percen, while he savings rae should also increase by 3 percen. Table 2 shows he resuls for Chile. Acual axes imply a growh rae along he BGP of 3 percen and privae savings of around 33 percen of oal income. The second row of he able shows he opimal axes. As can be seen, he governmen should ax consumpion less and ax capial and labor subsanially less o obain an increase of 30 percen in he 32

36 Table. Brazil: quaniaive implicaions c w k u v Savings Compeiive equilibrium Ramsey allocaion Comp. equil. (Thailand) Source: Auhors elaboraion. growh rae and 6 percen in privae savings along he BGP. Opimal axes also sugges a reallocaion of labor from he informal o he formal secor of he economy. Tax srucure in Thailand is similar o he opimal case, where capial, consumpion and labor axes are lower han acual axes in Chile. This siuaion produces higher growh and privae savings along he BGP han he compeiive equilibrium. Table 2. Chile: quaniaive implicaions c w k u v Savings Compeiive equilibrium Ramsey allocaion Comp. equil. (Thailand) Source: Auhors elaboraion. Finally, Table 3 shows he resuls for Mexico. In his case opimaliy suggess axing consumpion more heavily and axing capial subsanially less o obain a slighly higher growh rae. The able also shows ha opimal ax srucure does no a ec compeiive equilibrium privae savings. In conras wih he oher wo counries, in Mexico labor in he informal secor is larger han in he formal one. Opimal axes imply a lile reallocaion of labor from he informal o he formal secor. Thailand axes labor subsanially less han he acual and opimal siuaions and axes consumpion more han he acual siuaion bu less han he opimal case. This counerfacual siuaion produces values for he growh rae, privae savings and allocaion of labor in he formal and informal secor very similar o he compeiive equilibrium siuaion. Table 3. Mexico: quaniaive implicaions c w k u v Savings Compeiive equilibrium Ramsey allocaion Comp. equil. (Thailand) Source: Auhors elaboraion. 33

37 Overall, he evidence found in his secion suggess ha sub-opimal axes imply lower long-run growh in he hree counries analyzed here. However, i seems ha he low levels of saving raes are no a direc consequence of sub-opimal axaion, as opimal axes imply a case, Brazil, where privae savings are lower han he acual siuaion; a case, Chile, where opimaliy induces larger privae savings and a case, Mexico, where he opimal ax srucure does no a ec privae savings. In he hree counries, opimal axes reallocae labor from he informal o he formal secor. 6 Policy Recommendaions The ndings in he las secions provide some policy implicaions for Brazil, Chile and Mexico. Firs, we measured how much he acual ax srucure should be modi ed o reach he opimal ax scheme and second, we esimaed he impac of hese changes along he BGP on he long-run growh rae, privae savings and he allocaion of ime beween he formal and informal labor marke. In he case of Brazil, implemening he opimal ax regime would imply a signi can change in he acual ax raes. Labor axes should be reduced almos 47 percen and consumpion axes increased more han 70 percen, while he capial ax rae should decrease more han 30 percen. This las nding is imporan because, unlike conclusions in previous sudies, capial should be axed in he long run and, as a maer of fac, a a relaively high rae. The opimal ax sysem ranslaes ino a signi can reallocaion of ime beween formal and informal work. Time devoed o work in he informal secor declines around 26 percen while ime devoed o work in he formal secor increases by around he same magniude when implemening he opimal ax srucure. Noice ha in he case of Brazil, opimaliy will imply a higher growh rae bu lower privae savings along he BGP. Comparing opimal ax raes o hose observed in he Chilean economy sugges, similar o he Brazilian case, ha he ax rae changes needed o decenralize he Ramsey allocaions are signi can. In his case, capial should be axed minimally as he opimal ax rae on capial is almos zero,and here labor should be axed subsanially less as he opimal ax rae on labor is only.78 percen compared o he acual 7.00 percen. Implemening he opimal ax regime will induce an increase in boh he growh rae and privae savings along he BGP. Opimal axaion will addiionally reallocae labor from he informal o he formal secor as in he case of Brazil. However, hese changes are no as large as in Brazil. Opimaliy in Mexico suggess ha, in comparison o hose acual axes observed, consumpion should be more heavily axed and capial should be axed subsanially less. 34