Can we rely upon fiscal policy estimates in countries with a tax evasion of 15% of GDP?

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1 Can we rely upon fiscal policy estimates in countries with a tax evasion of 15% of GDP? Raffaella Basile, Ministry of Economy and Finance, Dept. of Treasury Bruno Chiarini, University of Naples Parthenope, Dept. of Economics S. Vinci Elisabetta Marzano, University of Naples Parthenope, Dept. of Economics S. Vinci and CESIfo

2 Outline of the presentation Goal of the paper Motivation and literature Evidence about underground economy and tax evasion in Italy Model specification Estimation strategy Impulse response analysis Policy implications

3 Goal of the paper To investigate the effects of fiscal policy in Italy during the sample period , by using: Quarterly public finance variables, recorded under the accrual criterion A quarterly time series estimate of tax evasion based upon Vat evasion Two different, and alternative, specifications for the GDP: Private (GDP net of public spending) Regular (GDP net of public spending and underground production)

4 The literature about the estimation of fiscal multipliers Large amount of studies for the US, and an increasing number of paper for European countries Identification issues: Structural Var s Structural restrictions following Blanchard and Perotti, 2001, 2002 Choleski decomposition (Fatas and Mihov, 2001) The approach by Mountford and Uhlig (2009) The narrative approach Endogenous variables: G, T, Y (BP2001); G, T, Y, i, π; in addition the level of public debt (Favero and Giavazzi, 2007)

5 The theoretical controversy Conflicting expectations about consumption in DSGE models: Real Business Cycle: generally predicts a decline in private consumption in response to a rise in government spending. With infinitely-lived Ricardian households, an increase in government spending lowers the present value of after-tax income, and thus generates a negative wealth effect on consumption. It also induces a rise in the quantity of labor supplied at any given wage, leading to a lower real wage, and higher employment and output. New Keynesian: In contrast, when consumers behave in a non - Ricardian fashion, their consumption is a function of their current disposable income. According to Galì et al. (JEEA 2007) the hypothesis of sticky prices, along with the presence of rule-of-thumb consumers, is able to reconcile positive effects of spending shocks on consumption with a DSGE framework. This obliges to include in the empirical analysis additional variables: Labor market: wages, hours/employment Aggregate demand: consumption, investment

6 Some empirical results: US and Europe The estimates for the fiscal multiplier are quite variegated, though the most of them are Positive for public spending Negative for taxation There is a controversy about the sign of the reaction in consumption and investment Crowding out?

7 Some empirical results: Italy Giordano et al. (EJPE, 2007): an exogenous 1% (in terms of private GDP) to government purchases of goods and services increases private real GDP by 0.6% after 3 quarters Shocks to net revenue have positive and statistically significant effect on GDP, though transitory and extremely small Afonso e Sousa (ECB WP2009): Spending shock display a very small positive effect in the first quarters, after that GDP falls, suggesting a crowding-out effect. The impulse-response function to a shock in government revenue show a negative effect on GDP, although not persistent. Basile (2009): very weak response of the economy to a spending shocks, but a different role for current expenditure and investment ; as regards as the tax multiplier, there seems to emerge non- Keynesian results

8 Why adding tax evasion and unreported production? They are stylized facts for the Italian economy, but not negligible in several advanced economies Busato and Chiarini (2004) and Busato et al. (2008) show that underground economy can have counter cyclical properties and offer income/consumption smoothing opportunities Chiarini and Marzano (2007) show that underground labor input is importantly tied to the business cycle in general and to the regular cycle in particular

9 Underground employment (private sector, 000, source: Istat) 3, , , , , , , , ,000.0 UNDERGROUND REGULAR 1, , , ,

10 Underground employment ratio (private sector, source: Istat)

11 Underground economy (% of total Value added, Istat)

12 Our approach We abstract form the theoretical controversy about the effect of fiscal policy on aggregate demand components We aim to check whether fiscal stimulus may have different effects on the two components of the private supply side: Regular Underground In addition: Which interaction between tax evasion and regular production? Tax and spending or spending and tax?

13 Undeclared VAT base and VAT evasion Base Evasa (destra) Evasione IVA (sinistra)

14 Private and regular GDP (real, millions)

15 Direct public expenditure (consumption +investment)

16 Average (apparent) tax rate (net revenues/total GDP)

17 The empirical strategy 4 variables: GDP, Tax Evasion, Public Spending, Average Tax Rate Univariate Analysis : structural breaks and stationarity Multivariate analysis: cointegration tests Vector Error Correction Model: 1. there is little guidance, theoretical or empirical, on how to identify the structural shocks. 2. we like to achieve information on the underling equilibrium tendency among a set of variables, but we also like to know the short run dynamics and the adjustment coefficients. 3. a situation of special interest arises if several variables are driven by one or more stochastic trends, in which case they have a particularly strong link that may be of interest in economic terms

18 The Cointegration Space The deterministic variables included in the Johansen test are: one mean-shift dummy describing a regime shift starting in 1992:3. This dummy is restricted to lie in the Cointegration space. 1 dummy describing a transitory shock: 2003: dummy describing a transitory shock: 2005:4; impulse dummies (describing a permanent intervention/shock) for the observations: 1982:2; 1983:4; 1998:1. Constant (restricted) The test s statistics suggest the existence of two vectors

19 Cholesky ordering (recursive approach) The recursive approach restricts B to a k-dimensional identity matrix and A 0 to a lower triangular matrix with unit diagonal We order the endogenous variables as follows: GDP (private or regular), Tax Evasion, Government Spending, Tax Rate (net revenues/gdp). Fiscal variables, and namely public spending, have no immediate effect on real variables, whereas they are affected by GDP (business cycle). Average tax rates are affected not only by government spending and business cycle but also, of course, by compliance. As to the ordering of tax evasion and GDP, given that we focus mostly on regular GDP, we claim that undeclared VAT base is plausibly affected by decisions taken in the regular economy and not vice-versa, therefore we order tax evasion after regular GDP

20 Why the recursive approach We motivate our recursive ordering (GDP, Tax Evasion, G, Tax Rate) as follows: 1. Tax evasion as well as regular production value added, are macroeconomic aggregates mostly pertaining to the aggregate supply, whereas fiscal variables are mainly related to aggregate demand: starting from the paper by Blanchard and Quah (1989), a plausible empirical identification relies on restricting the long run effect of the demand shocks on output to be zero; we claim that this restriction can also be effective in the very short run (instantaneous relations between the variables), allow us to order demand shocks after supply shocks. 2. As well emphasized by Breitung at al (2004) and Lutkepohl (2009): although imposing structural restrictions may resolve the non uniqueness problem of innovations, it also raises the same order of criticisms already stressed by Sims (1980) with reference to econometric simultaneous equations models

21 Ordering in a Structural VAR Large debate about how to identify a structural shock in public spending Blanchard Perotti (2001, 2002) suggest to order G first: they argue that lags in fiscal policy implementation exclude any possible contemporaneous effect of GDP on discretionary spending: The key to our identification procedure is to recognize that the use of quarterly data virtually eliminates the second channel. Direct evidence on the conduct of fiscal policy suggests that it takes policymakers and legislatures more than a quarter to learn about a GDP shock However, this choice is questionable: it implies that G can affect contemporaneously GDP, which is not unanimously accepted: Favero 2002 Taylor fiscal rule

22 Regular/private GDP and Government Spending (HP filtered series) Gov. Spending Market GDP

23 Public spending multipliers Shock to G by 1% of total GDP (private GDP) Model 1 (private GDP) Model 2 (regular GDP) Impact (0) % (0.6)** 1.1% (0.9)** 1 year (+4) 2.2% (1.76)** 2.9% (2.2)** 5 years (+20) 2.5% (1.96)** 2.5% (1.96)**

24 Tax Shock Shock to tax rate by 1 percentage point Model 1 (Private GDP) Model 3 (regular GDP) Impact (0) % -0.1%** 1 year (+4) -0.1% -1.5%** 5 years (+20) -0.4% -2.4%*

25 Fiscal policy and tax evasion: the impact on tax evasion +4% -2.3% +1.4% +2.1% -5%

26 Fiscal policy and tax evasion: the effects of tax evasion

27 Tax evasion and regular GDP

28 Tax and spending or spending and tax? No evidence of spending and tax: Public spending in deficit? Higher fiscal pressure is followed by a spending reduction: fiscal consolidation to maintain the debt ratio?

29 Policy implications In economies with a sizeable underground sector and tax evasion, the standard aggregate estimate of fiscal multipliers are not reliable. Mechanisms at work in the underground and in the regular economy can obscure the total effect of fiscal policy, and this is particularly true for tax shocks Changes in public spending generate a reallocation from underground to the regular economy with the regular GDP which increases more than proportionately to government spending and the underground component of the economy which shrinks. Similarly, an increase in tax rate pushes up the hidden economy and tax evasion entailing a reallocation among sectors which blurs, at best, the total effect. To see the real effect of fiscal policy, we necessarily need to decompose the regular and the hidden production

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