LATVIA'S FIRST CGE MODEL WITH FISCAL SECTOR

Konstantīns Beņkovskis

Eduards Goluzins

Oļegs Tkačevs

June 21, 2016

MOTIVATION

• CGE models can quantify various effects of economic policies and other shocks on o individual industries o regions o socioeconomic groups

• This type of models perfectly fit for answering the policy questions that require going beneath the aggregate macroeconomic surface o which makes it especially useful for structural and fiscal policy

questions

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MODEL’S BASIC ASSUMPTIONS

• Perfect competition assumption: o unit cost of production = unit price of commodity

o zero economic profits

• Current input-output data represent equilibrium point of

economy

• Labour is perfectly mobile across industries

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DATABASE: INPUT-OUTPUT DATA

National Supply-Use table from www.wiod.org

o 35 domestic industries (reduced to 32 in the model) o 59 + 59 domestic and imported commodities (reduced to 55 + 55

in the model) o 35 + 5 users (modified to 32 + 7 in the model);

• industries • private consumption • VAT taxable government consumption, VAT exempt government consumption • government investments, private investments, housing investments • exports

Year 2011 is used for simulation purposes (latest available in

WIOD)

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Source: http://www.wiod.org/new_site/database/nat_suts.htm

DATABASE: SOCIO ECONOMIC ACCOUNTS (SEA) AND FISCAL DATA

• Data on employment, labour compensation and capital

compensation was taken from WIOD SEA

• Data on VAT, excise tax and labour tax revenues were obtained

from State Revenue Service

• Data on government expenditure were obtained from the

Statistical Office

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INPUT DATA: USE TABLE (MODIFIED)

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INPUT DATA: SUPPLY TABLE

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MODEL COMPLEXITY

• Latvia's CGE model with fiscal sector includes 11'358

variables.

• The number of equations varies depending on the fiscal

rule: o model with endogenous fiscal policy contains 11'010 equations

o model with exogenous fiscal policy contains 10'843 equations.

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DESCRIPTION OF THE MODEL: STRUCTURE OF PRODUCTION

1. Factors of production are

demanded in direct

proportion to output

2. Domestic/import shares of

factors of production depend

on relative prices

3. Oil (Refined petroleum

products) may only be

imported

4. Two primary factors are used

in production. Shares depend

on relative prices

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1

3

2 2 4

DESCRIPTION OF THE MODEL: REPRESENTITIVE HOUSEHOLD

1. Initial fraction of household

budget is used to purchase

subsistence goods

2. Rest of the budget is distributed

according to CES structure (shares

of budget devoted to particular

good remain constant)

3. Domestic/import shares of goods

depend on relative prices

4. Consumers choose between

different suppliers of the same

commodity based on supplier

relative prices

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1., 2

4

3 3

4

DESCRIPTION OF THE MODEL: GOVERNMENT CONSUMPTION

1. Shares of budget devoted to

particular good are constant

2. Domestic/import shares of factors

of production depend on relative

prices

11

1

2 2

DESCRIPTION OF THE MODEL: INVESTMENT (PRIVATE NON-HOUSING AND GOVERNMENT) DEMAND STRUCTURE

1. Factors of production of capital

are demanded in direct

proportion to output

2. Investment is determined in a way

to keep the desired aggregate real

capital level unchanged

(=depreciation rate)

3. Domestic/import shares of factors

of production depend on relative

prices

12

1

2

3 3

DESCRIPTION OF THE MODEL: EXPORT DEMAND STRUCTURE

1. Non-residents choose between domestic and

foreign commodities,

2. Demand for domestic good depends on a)

exogenous growth of foreign demand for a

particular good; b) relative price of domestic

good

3. Given changes in the relative prices between

domestic and non-domestic good of the same

type there is an increase or decrease in exports

of that good

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3

DESCRIPTION OF THE MODEL: LABOUR MARKET

• Labour is perfectly mobile across industries • Changes in gross wage are the same across industries • Changes in employment lead to real wage adjustment:

• Employment above or below it’s natural level forces adjustment in real wage (γ > 0)

14

0

011

E

EE

w

ww t

r

t

r

t

r

t

gross real wage growth

deviation of employment from

natural level

GOVERNMENT REVENUES AND EXPENDITURES

Revenues Expenditures

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VAT revenues

SSC revenues

PIT revenues

Excise tax revenues

Other revenues

Gov. consumption

Gov. investment

Social transfers

Interest payments

Other expenditures

LABOUR TAXES AND ENVELOPE WAGES

• Unit cost of labour is comprised of gross wage and employer's social

contributions

• Some firms evade paying labour taxes and the share of enterprises

paying labour taxes is industry specific

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Social security payments of employer

LABSSCERGROSSGROSSLAB stWWP

Share of labour tax payers

Gross wage

LABOUR TAXES AND ENVELOPE WAGES

• All workers in a particular industry receive equal salaries

• Non-taxable minimum is assumed to be constant for all workers

in all industries

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PITLABSSCEEGROSSLABSSCEEGROSSGROSSNET tNTMstWstWWW 1

Social security payments of employee

Personal income tax payments

Non-taxable minimum

Net wage

EXCISE TAX

• All users except exports are subject to excise tax

• Excise tax differs by commodity

• We assume that excise tax is a specific tax (proportional to

volume of use)

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EXC

basprod tPP

Producer prices

Basic prices

VALUE ADDED TAX AND NON-PAYMENT OF VAT

• Three categories of final use are subject to the VAT payments: o private consumption

o part of government consumption

o housing investments

• VAT rate differs by commodity

• It is assumed that only a fraction of agents pays VAT

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)1( stPP VAT

prodpur

Purchaser prices Producer prices

SHADOW ECONOMY PARTIAL ENDOGENIZATION

• Envelope wage rate depends on

o Level of labour taxes o Level of industry value added

• Rate of payment of VAT depends on

o Level of VAT tax o Level of real GDP

• Coefficients α and β were calibrated

based on Schneider (2010)

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exoe

ShYX

1

1

SIMULATIONS

TWO TYPES OF SIMULATIONS ARE POSSIBLE BASED ON EXOGENIZED OR ENDOGENIZED GOVERNMENT EXPENDITURE

• Constant ratio of budget balance to nominal GDP

• Government consumption and investments move in same proportion to maintain budget balance-to-GDP ratio

• Social transfers depend on real wage and CPI

• Interest payments depend on interest rate and government debt

• Nominal government expenditures

(exc. transfers and interest

payments) are exogenous

• Social transfers depend on real

wage and CPI

• Interest payments depend on

interest rate and government debt

Endogenized gov. exp. Exogenized gov. exp.

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EXOGENOUS VARIABLE LIST

• Import prices o by commodity

• Productivity o by industry

• Export demand shift o by commodity

• Social security tax, employer and employee

• Personal income tax • Non-taxable minimum • Value added tax

o by commodity • Excise tax

o by commodity • Government investment

o by commodity • Government consumption

o by commodity • Government pensions • Envelope wage share

o by industry • Shares of VAT paying enterprises

o by commodity

Other Fiscal sector related

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RUSSIA'S EMBARGO ON FOOD IMPORTS

In August 2014, the Government of Russian

Federation announced an embargo on imports

of various beef, pork, poultry meat, fish, cheese,

milk, vegetables and fruit products from the US

and the EU countries. For Latvia it meant a drop

of around 13% in exports of fish products and a

7.5% decrease in exports of food products

(mainly dairy products).

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RUSSIA'S EMBARGO ON FOOD IMPORTS

Exogenous fiscal policy case

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RUSSIA'S EMBARGO ON FOOD IMPORTS

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Industry specific response in 2015

AN INCREASE IN VAT RATE

This scenario assesses the effect of a permanent VAT rate increase

by 1 percentage point. The simulation is implemented by

assuming that the government raises both standard and reduced

rate of VAT and the pass-through into prices is full

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AN INCREASE IN VAT RATE Exogenous fiscal policy case

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AN INCREASE IN VAT RATE

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Exogenous fiscal policy case

AN INCREASE IN VAT RATE Endogenous fiscal policy case

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DECREASE IN PERSONAL INCOME TAX RATE

This scenario assesses the effect of a permanent decrease in PIT

rate by 1 percentage point. The tax reform helps boosting

households' real disposable income and therefore provides an

incentive to spend more

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DECREASE IN PERSONAL INCOME TAX RATE

Exogenous fiscal policy case

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DECREASE IN PERSONAL INCOME TAX RATE

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Exogenous fiscal policy case

DECREASE IN PERSONAL INCOME TAX RATE

Endogenous fiscal policy case

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POSSIBLE WAYS FORWARD

• Better modelling of the labour market o disaggregating into high/medium/low skilled workers

o imperfect mobility of labour

o overlapping generations

• Expanding to global model

• Incorporation of profit margins (corporate income tax)

• Strategically – introducing elements of agent-based

model o using micro level data for Latvia

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