metadata: authors: 0: author: Anos Casero,Paloma
1: author: Cerdeiro,Diego Alejandro
2: author: Trezzi,Riccardo
count: Argentina
docna: 0: docna: Estimating the fiscal multiplier in Argentina
docty: Policy Research Working Paper
subtopic: Macro-Fiscal Policy,Economic Conditions and Volatility,Economic Adjustment and Lending,Public Sector Economics,Macroeconomic Management,Public Finance Decentralization and
            Poverty Reduction
teratopic: Private Sector Development,Macroeconomics and Economic Growth,Finance and Financial Sector Development
abstracts: cdata!: Argentina's government has resorted
            to fiscal policy as a countercyclical tool to mitigate the
            negative impact of the current economic downturn on
            aggregate demand. Empirical results based on a vector error
            correction model suggest, however, that the fiscal
            multiplier is relatively small and short-lived. This could
            reflect a number of factors, including the higher propensity
            of households to save during the economic downturn, the
            implementation lag of public expenditures, particularly of
            capital expenditures, and the narrow tax base that limits
            the impact of countercyclical revenue measures on domestic demand.
geo_reg_key: 119228,517191
repnme: repnme: Estimating the fiscal multiplier in Argentina
display_title: Estimating the fiscal multiplier in Argentina
listing_relative_url: /research/2010/02/11867327/estimating-fiscal-multiplier-argentina
topicv3: Macroeconomic Vulnerability and Debt
            m1326057 1104,Government Expenditure m1326649 1112,Fiscal Stimulus and Fiscal Rules m1326652 1073,Fiscal Policy m1327144 445,Monetary Policy m1327609 444
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Private Sector Development,Macroeconomics and Economic Growth,Finance and Financial Sector Development
no_of_pages: 17
author_keys: 0: author_key: 621633
1: author_key: 1001287
2: author_key: 1006503
model_extractions: WPS5220 Policy Research Working Paper 5220 Estimating the Fiscal Multiplier in Argentina _Paloma Anós-Casero Diego Cerdeiro Riccardo Trezzi_ The World Bank Latin America and the Caribbean Economic Policy Sector February 2010
Policy Research Working Paper 5220

# **Abstract**

Argentina’s government has resorted to fiscal policy as a countercyclical tool to mitigate the negative impact of the current economic downturn on aggregate demand. Empirical results based on a vector error correction model suggest, however, that the fiscal multiplier is relatively small and short-lived. This could reflect a number of factors, including the higher propensity of households to save during the economic downturn, the implementation lag of public expenditures, particularly of capital expenditures, and the narrow tax base that limits the impact of countercyclical revenue measures on domestic demand.

This paper—a product of the Economic Policy Sector, Latin America and the Caribbean—is part of a larger effort in the department to estimate the fiscal multiplier in LAC countries. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The author may be contacted at panoscasero@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **ESTIMATING THE FISCAL MULTIPLIER IN ARGENTINA**

Authors: Paloma Anós-Casero, Diego Cerdeiro and Riccardo Trezzi

## **1. INTRODUCTION**

**The ongoing global downturn and financial turmoil have led many countries to resort to fiscal stimulus to cushion the impact on domestic economic activity** . In turn, this has reignited the long-standing debate among economists about the effectiveness of fiscal policy as a counter-cyclical tool. Supporters of an active role for fiscal policy suggest that economies lack an efficient mechanism to return to full potential. Critics, on the other hand, argue that economic agents will offset the impact of fiscal policy on aggregate demand through changes in their saving behavior. A middle-of-the-road view holds that fiscal policy can be effective provided certain conditions hold, including sound macroeconomic fundamentals, nominal wage and price stickiness, and/or economic agents with finite horizons and liquidity constraints.

**Argentina’s policy makers have also resorted to fiscal stimulus packages** to mitigate the negative impact of the current economic slowdown on aggregate demand (see Table 1 for details).
**Table 1 - Response to the Financial Crisis – Countercyclical Measures**

|**Countercyclical fiscal**<br>|**Details**|**Fiscal costs**<br>**(US$)**|
|---|---|---|
|**measures**||<br>**(-)=savings**|
|**_Credit lines_**||**_US$2.7bn_**|
|to the agricultural sector||US$500mn|
|to the manufacturingsector||US$380mn|
|to the SMEs||US$880mn<br>|
|to those buyingtheir first car||US$910mn|
|to those buyingappliances||US$1mn|
|Other subsidized credits for<br>consumption|The newly created SIPA (Social Security fund)<br>conducted an auction to allocate time deposits across<br>different banks. The winning bids will be those that<br>charge less to finance these activities. The cost is paid<br>byfuture retirees.|No immediate<br>fiscal costs,|
|**_Safety Nets_**||**_US$400mn_**|
|Lump-sum payment to<br>retirees|ARS200 lump sum payment for retirees**(for 2008**<br>**only**)|US$ 290mn|
|Otherprograms||US$110mn|
|**_PIT/exemptions/deductions_**||**_US$1.2bn_**|
|Lower export taxes|From 28 percent to 23 percent for wheat, 25 percent to<br>20percent for corn|US$ 170mn|
|Income tax reduction|The elimination of the tax brackets put in place in<br>2001 would benefit those who earn (after some Social<br>Security taxes) more than ARS7000 (US$2060) per<br>month|US$850mn|
|**_Infrastructure Investment_**||**_US$3.6bn_**|
|Program of public works|4-year infrastructure spending plan of about AR$71 bn<br>(US$20bn). Fiscal impact will depend on the sources<br>and details of financing. Most of the capital<br>expenditures to be announced for 2009 are likely to be<br>already included in the budget. It is assumed that 40<br>percent of the additional revenues from the<br>nationalization of private pension funds will be used to<br>finance additional infrastructure expenditures (about<br>AR$6bn or about 1.5 bn US$)|US$1.5bn|
|Other programs in<br>Infrastructure||US1.9bn|
|**_Other Measures_**||**_-US$760mn_**|
|Capital repatriation|Fiscal impact unclear||
|Tax moratorium|2 percent of annual tax collection (estimated)|-US$760mn|
|Employment formalization|No fiscal effect expected||
|**Total fiscal costs for 2009**||**US$ 2bn**|

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**But the implementation of countercyclical fiscal policies can be challenging, particularly for emerging economies.** For start, economic fluctuations tend to be more intense for these countries. A typical recession in Argentina reduces output by an average of 6.2 percent. In the OECD, output falls by 2 percent, on average. As the tax base is narrower and revenues are largely dependent on commodity exports, external shocks and fluctuations in economic activity often resulted in large changes in government revenues. Recessions can cost the Treasury an average of 9 percent of its revenues, compared with six percent for the OECD as a whole. Additionally, automatic stabilizers are weak when compared to those in developed economies, and discretionary government spending might take several months to be implemented. Another complicating factor common to most LAC economies is the increased cost of borrowing during recessions, as creditors are wary of buying emerging-market bonds during bad times<sup>1</sup> . This, in turn, prevents emerging-country governments from smoothing the cycle by borrowing, as their rich counterparts can afford to do.

**This paper empirically analyzes the effectiveness of fiscal policy in stimulating economic activity in Argentina** , drawing on a vector error correction model to derive the fiscal multiplier.

# **2. BRIEF LITERATURE REVIEW**

**Empirical studies based on structural vector autoregression models conclude that fiscal multipliers have declined over time and, in some cases, may even have been negative** (on this specific point see Perotti, 2005). According to Eskesen (2009), these results, which differ widely across countries, likely reflect: (i) increasing leakage through the trade channel due to higher openness of economies; (ii) a decline in the share of liquidity constrained households due to better access to credit; and (iii) a sharper focus of monetary policy on price stability.

In his study for OECD countries, Perotti (2005) finds that the effects of fiscal policy on GDP are small. He finds that only for the U.S. prior to 1980 the fiscal multiplier for government expenditures was larger than one. The figures below summarize these findings.

> 1 During the 2001-02 crisis interest rate shifted from 15.4 percent in June to 132.6 percent in November 2001.

3
<!-- Start of picture text --> Effect on GDP of a shock to government spending of 1 p.p. of GDP<br>cumulative response at 12 quarters (source: Perotti, 2005)<br>4<br>1960-1980<br>3<br>1980-2001<br>2<br>1<br>0<br>-1<br>-2<br>-3<br>Australia Canada Germany United Kingdom United States<br>Effect on GDP of a cut in net taxes of 1 p.p. of GDP<br>cumulative response at 12 quarters (source: Perotti, 2005)<br>3<br>1960-1980<br>2<br>1980-2001<br>1<br>0<br>-1<br>-2<br>-3<br>Australia Canada Germany United Kingdom United States<br><!-- End of picture text -->

**Studies drawing on aggregate dynamic macro models conclude that fiscal multipliers are in the range of 0.3 to 1.2 percent, and that expenditure measures appear to have a larger effect than tax measures** (Hemming et al 2002, Botman 2006). Other studies find that government investment has the largest impact on economic activity and inflation. However, the size of the estimated multipliers depends on assumptions about, among other things, the monetary regime, labor supply elasticities and liquidity constraints (IMF, 2008).

# **3. METHODOLOGY**

**This paper focuses on two measures: a general government tax cut and a general government expenditure increase** . The expenditure variable is defined as total purchases of goods and services, meaning government consumption plus government investment. The revenue variable is defined as total tax revenues minus transfers.

**The traditional approach in the literature consists in estimating impulse reaction functions using a vector autoregressive (VAR) model** (see for example Blanchard and Perotti, 1999 or Bernanke and Mihov, 1998 for monetary policy). Fiscal multipliers are than computed summing the first four, eight or 12 periods of the reaction functions. The basic reduced VAR specification is as follows: _Z t_ = Γ ( _L_ ) _Z t_ − 1 + _ut_ )1( where _Z t_ is a three' dimensional vector ( _Z t_ = [ _Yt_ , _Et_ , _Rt_ ] ) in the logarithms of quarterly observations for government consumption, government revenues and private consumption.

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_U t_ ≡ [ _uty_ , _ute_ , _utr_ ] is the corresponding vector of reduced form residuals, which in general will have no-cross correlations, and can be represented as follows: (2) _uty_ = α _eyute_ + α _ryutr_ + _vty_ (3) _ute_ = α _yeuty_ + β _revte_ + _vte_ (4) _utr_ = α _ryuty_ + β _er vte_ + _vtr_

**However, as is well known in the literature, the reduced form residuals represented by equations (2), (3) and (4) have little or no economic significance** . In fact, they are linear combination of the underlying “structural” tax, spending and private consumption shocks. Equation (2) states that unexpected movements in output can be due to unexpected movement in taxes and/or unexpected movements in government spending. Equation (4) states that unexpected movements in taxes within a quarter can be due to one of the following factors: the response to unexpected movements in private consumption (captured by α _ry_<sup>_u_</sup> _ty_ ), the response to structural shocks in spending (captured by β _er_<sup>_v_</sup> _te_ ), and to structural shocks to taxes, captured by<sup>_v_</sup> _tr_<sup>. Finally,</sup><sup>_v_</sup> _te_<sup>and</sup><sup>_v_</sup> _tr_<sup>are the</sup> mutually uncorrelated structural shocks to government expenditure and revenues that we seek to identify.  In order to do so, we follow a four-step procedure.

In the **<u>first step</u>** <u>, the reduced form residuals are estimated from the VAR specified in</u> equation (1). Given the fact that the reduced form residuals are correlated with the structural shocks, it is necessary to apply further restrictions in order to identify the coefficients α _ye_ and α _yr_ . However, since ordinary least squares in equation (2) and (4) would not generate consistent estimates α _yr_ and α _ye_ , external estimates are used.<sup>2</sup> _e adj_ With these estimates, in the **<u>second step</u>** , the cyclically adjusted fiscal shocks, _u y_<sup>,</sup> and _r adj u y_<sup>,</sup> can be calculated. Expressed in more detail: In the **<u>third step</u>** <u>, assuming that structural revenue shocks have no impact on structural</u> _e_ spending shock (meaning that β _r_ = 0 ), the structural fiscal shocks are identified. Equation (5) reduces to _ute_ , _adj_ = _vte_ = _ute_ . This simply implies that structurally adjusted expenditure shocks are effectively assumed equal to the cyclically adjusted expenditure

> 2 The elasticity of expenditure with respect to changes in economic activity is assumed to be close to zero within the quarter, as commonly assumed in many other empirical studies. The elasticity of revenues to economic activity is estimated to be 0.45 for Argentina.

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shocks. Finally, equation (6) can be estimated using ordinary least squares to get consistent estimates of β _er_ .<sup>3</sup> In the **<u>fourth step</u>** <u>, the coefficients</u> α _ey_ and α _ry_ in equation (2) can be determined using the structural uncorrelated fiscal shocks<sup>_v_</sup> _te_<sup>and</sup><sup>_v_</sup> _tr_<sup>as instruments for</sup><sup>_u_</sup> _te_<sup>and</sup><sup>_u_</sup> _tr_<sup>,</sup> respectively.

**Combined, the four steps** allow us to estimate the A and B matrices of the standard relation between the reduced-form innovations and the structural shocks _Aut_ = _Bvt_ , where:

With this, impulse responses are computed using Monte Carlo simulations based on 10,000 replications.

Given the non-stationary properties of the underlying series, we test for co-integrated relationships among variables. If no co-integrated relationships are found, a Vector Auto Regressive (VAR) model, specified in first log differences, is estimated. If there are cointegrated relationships, a vector error correction (VEC) model is estimated, without imposing additional restrictions in order to avoid over-identification. In its basic form, a VEC model can be represented as: Where Π is the long-run matrix which contains the equilibrium correction terms. As usual, the _number_ of co-integrating vectors is given by the number of linearly independent rows of Π , namely the rank of Π .

> 3 β _er_ is estimated to be 0.7541 for Argentina.

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