fiscal tightening after the crisis. a scenario analysis

Bank i Kredyt 42 (3) , 2011, 33–60

www.bankandcredit.nbp.plwww.bankikredyt.nbp.pl

Fiscal tightening after the crisis. A scenario analysis for Poland

Jan Hagemejer*, Tomasz Jędrzejowicz#, Zbigniew Żółkiewski‡

Submitted: 21 February 2011. Accepted: 31 May 2011.

AbstractPoland has experienced a great deal of worsening of its fiscal situation following the economic slowdown of 2008–2009 caused by the worldwide financial crisis. General government deficit reached around 8% of GDP in 2010 both as a result of lower economic activity but also due to structural loosening that took part in the period immediately preceding the crisis. We attempt to assess which of the two contrasting fiscal consolidation strategies: expenditure-versus revenue-focused may be considered as preferable from the point of view of economic activity. The assessment is carried out using a recursive dynamic computable general equilibrium model. Our results show that, while the tightening has a negative effect on consumption, in the short run, the reaction of private consumption, employment and GDP in the medium run will greatly depend on the flexibility of the labour market and the behavior of private investment. We conclude that the expenditure-focused tightening scheme is consistently superior under all closures to the revenue- -oriented scenario.

Keywords: fiscal tightening, computable general equilibrium

JEL: C68, E62, O52

* National Bank of Poland, Economic Institute; University of Warsaw, Department of Economic Science;

e-mail: [email protected]. # National Bank of Poland, Economic Institute.‡ National Bank of Poland, Economic Institute.

J. Hagemejer, T. Jędrzejowicz, Z. Żółkiewski34

1. Introduction1

As with practically all the countries around the globe, Poland experienced a drastic worsening of fiscal position during the economic downturn 2009–2010. General government deficit reached 7.9% of GDP in 2010 which is a 6.0 percentage point increase against pre-crisis 2007 year, while public debt (ESA definition2) soared from 45% to 55% of GDP (preliminary estimate) during the same period (European Commission 2010). While these figures seem to be of the same order of magnitude as for other countries within European Union3 and at a first glance may appear to be largely a consequence of the global economic crisis, some qualifying remarks need to be made. First, Poland did not experience recession, in a sense of negative growth rate in critical 2009 year, therefore one might expect that the adverse impact of automatic stabilizers on public finance would be relatively less pronounced than for other countries. This is confirmed by the European Commission estimates according to which between the cyclical peak of 2007 and the trough of 2009, the cyclical component of the budget balance deteriorated in Poland by 1.4 percentage points of GDP, while in the EU on average this worsening amounted to 3.1 p.p. Second, the Polish government did not in fact implement an anti-crisis fiscal stimulus package, although tax cuts legislated before the onset of the crisis have, somewhat coincidentally, contributed to sustaining economic activity during the downturn. Thirdly, not unlike some other EU countries, but contrary to the principles of the Stability and Growth Pact (SGP), Poland did not use the economic upturn of 2006–2008 to consolidate public finances and achieve its medium-term objective (MTO) of a structural deficit of 1% of GDP. Instead, a sizeable pro-cyclical loosening of fiscal policy took place. During this period social contributions and personal income taxes were cut by around 2.6% of GDP and these were not accompanied by an expenditure restraint. Finally, it should be pointed out that in case of Poland high fiscal deficits are more a rule than a crisis-related anomaly. Between 1995–2009 Poland recorded average ESA95 deficits of 4.4% of GDP and throughout this period the deficit fell below the Maastricht 3% of GDP reference value only on two occasions. The reason why these deficits have not led to an explosion of public debt lies in strong economic growth (4.5% on average) and high privatization receipts (0.9% of GDP per year on average). Neither of these factors is assured to continue in the future as potential output globally may have suffered after the crisis and the size of assets left to privatize is limited. These observations lead to a conclusion that public finance deterioration in Poland was rather a result of structural factors than a consequence of large-scale discretionary anti-crisis policies. Therefore the fiscal consolidation, in the case of Poland, should not be thought of as ‘exit strategy’ from fiscal anti-crisis stimulation, as in many other countries, but rather as structural reform aimed at strengthening of growth potential and resilience to shocks of the Polish economy. In the medium term, these reforms are expected to enable Poland to fulfil, in a sustainable manner, the Maastricht criteria and eventually adopt the euro.

Fiscal consolidation programmes differ, among others, with respect to their focus on revenue or expenditure side. Rich literature dealing with macroeconomic and growth effects of fiscal consolidations (eg., see Alesina, Ardagna 2009 and IMF 2010 for the latest results and a review of the

1 The views expressed in this paper are those of the authors and not the institution they represent.2 It was around 53.5% of GDP according to the domestic fiscal law definition, ie. below the critical Public Finance Act

threshold of 55%, the breaching of which would require the government to implement harsh austerity measures.3 General government deficit (as measured by net borrowing) in EU27 countries amounted to 6.8% of GDP in 2009–

2010 and public debt figures were, respectively, 74.0% and 79.1% (European Commission 2010).

Fiscal tightening after the crisis... 35

literature) seems to be close to the consensus that it is policies based on spending cuts that are more successful than those aimed at raising taxes in improving fiscal disequilibria and stabilizing debt level in sustainable way. It is argued (see: Alesina, Ardagna 2009) that spending cuts may improve economic performance through the improvement of the political economy process needed to build support for such changes but are also likely to generate positive effects both on supply and demand side. As the former are concerned, reduction of the government expenditures, especially on social transfers may generate positive adjustment of the labour market (raising labour participation), while reductions in the public sector wage bill may lead to a mitigation of wage pressure in the economy. On the demand side, these type of policies, if perceived as reliable and permanent, may raise agents expectations with respect their future income and thus shift up their consumption path. Spending cuts policies are also likely to be accompanied by loosening of monetary policy, as danger of increasing inflation caused by tax hikes was avoided and premium on government bonds is expected to decrease. Lower interest rates amplify pro-growth impact of spending cuts policies. While some recent literature (IMF 2010) appears to challenge the idea that spending cuts may also have short run pro-growth effects (eg., Alesina, Ardagna 2009; Afonso 2006; Rzońca, Ciżkowicz 2005), it also supports the view that spending-based fiscal adjustments have smaller adverse effects than tax-based ones. The latter are expected to have contractionary impact on the economic activity4 in the short run, with the main channels working both on demand (eg., drag on demand through lower disposable income, elevated prices for consumers, potentially increased interest rates) and supply (eg., drag on employment and investment through higher tax wedge, distorted allocation of resources). Despite the fact that cutting government spending seems to be a preferable way to equilibrate public finance, these policies have two practically hard constraints. First, many expenditure categories represent legally binding state obligations to different agents (eg., pensioners, unemployed, families with children etc.) and therefore are usually difficult to reform in a short time. Second, scaling down social transfers and public sector wages or employment is always a socially sensitive process that entails the political risk on the involved government. Even if some studies suggest that reforms aimed at contraction of expenditure side of public budget do not necessarily imply worse electoral results for the tough reform-oriented governments (eg., Brender, Drazen 2008), political economy factors may condition strongly implementation of this type of reforms through ‘political opportunism’ behaviour (see: Price 2010). One may plausibly assume that both constraints on implementation of expenditure-oriented fiscal consolidation are binding in case of Poland. As we will explain later, there is a large share of social transfers in the general government budget that are potentially sensitive to strong reactions of affected groups of interest and may trigger political disagreement if government would try to cut them. Given political elections calendar in Poland (presidential election and local elections in 2010, parliamentary election in 2011), government attitude to fiscal consolidation seems to understandingly take these considerations into account. Additionally, since the latest government documents on fiscal consolidation (eg., the Multi-year Financial Plan as of July 2010) cover the time horizon till 2013, reforms proposed by government and taken into account in our analysis are assumed to be feasible, given both election calendar and parliamentary and legal procedures involved.

4 As Blanchard (1990) argues, tax hikes may also generate expansionary effects if they generate expectations of less tough fiscal consolidation in the future (expectations channel).


In the present paper, we simulate fiscal reforms over 2011–2013, that would lead to a reduction of general government deficit to 3% of GDP by 2013, using a computable general equilibrium model. Our analysis aims at assessment, which of two types of fiscal consolidation policy packages: revenue-oriented versus expenditure-oriented may be considered as superior, from the macroeconomic point of view (ie., GDP, consumption, aggregate indicators of the labour market). Both scenarios are based on policy proposals which are present in the public debate. In this context, an assessment of their macroeconomic impact would be of policy relevance. The revenue- -based scenario is based on the reversal of measures to reduce the tax wedge introduced in 2007–2009 and therefore illustrates the effects of a return to the pre-2007 structure of labour taxation. The expenditure-based scenario is largely based on social expenditure reform proposals raised in the public debate, as well as advocated by international organisations (OECD, World Bank) on the basis of conducted spending reviews. Following the literature and the widely acknowledged opinions on the required reforms of the Polish public finance system (eg. OECD 2008; 2010), the superiority of the expenditure-oriented fiscal tightening with respect to the revenue oriented plan is our central hypothesis.

Simulation scenarios are stylized representation of the choices faced by the government but they are at the same time ‘realistic’ in a sense that they include measures which may feasibly be expected to deliver required adjustments over the simulation horizon, also taking into account legal constraints. Our paper belongs to the strand of the economic literature on the modelling of fiscal policy consolidation programmes that has become popular over the last years, given critical deterioration of the public finance after the financial crisis (eg., Clinton et al. 2010, Freedman et al. 2010; Roeger, in t’Veld 2010; Roeger, in t’Veld, Vogel 2010; Klyuev, Snudden 2011). To our best knowledge our paper is unique in analyzing current medium-term fiscal in Poland within the framework of formal economy-wide model.

Our paper is organized as follows. Section 2 discusses the rationale for and contents of fiscal simulations. In section 3 we describe data and model used for the simulations. Section 4 provides with an analysis of the simulation results, and section 5 concludes. Details of fiscal simulations are specified in the Appendix.

2. Fiscal adjustment scenarios

2.1. Expenditure-oriented scenario

The primary ‘target’ of the expenditure-oriented scenario proposed in our simulations are the social transfers and there are two important reasons for this. The first is that Poland is still characterised by a relatively high share of social expenditure, compared to most peer countries, but also some Western European countries. In the past five years, the average level of expenditure on social transfers was among the highest in Central and Eastern Europe and exceeded the EU average,5 as shown in Table 1. This is mainly a consequence of a low effective retirement age, as well as ‘excessive use [of permanent disability] benefits’ in the 1990s (World Bank 2003). In the

5 The picture looks somewhat different in 2009 which was, however, an exceptional year given the negative economic growth in most EU countries and its impact on the denominator of spending-to-GDP ratios.


late 1990s and early 2000s a number of measures have been undertaken to curtail access to these entitlements,6 which lead to a decline of social transfers from 17.0% of GDP in 2002 to 14.0% of GDP in 2008, followed by an increase to 14.7% in 2009, related to the economic slowdown.

Table 1Social transfers in cash (ESA code D.62) in Central and Eastern European countries (in % of GDP)

2005 2006 2007 2008 2009 2005–2009 (average)

Latvia 8.4 8.1 7.1 8.1 12.6 8.9

Romania 8.9 8.8 9.2 10.4 12.8 10.0

Estonia 8.9 8.7 8.6 10.6 14.0 10.2

Lithuania 8.6 8.5 9.1 11.0 15.3 10.5

Bulgaria 10.6 10.2 9.6 10.1 12.1 10.5

Slovakia 12.4 11.9 11.6 11.3 13.7 12.2

Czech Republic 12.6 12.6 12.8 12.8 13.9 12.9

Poland 15.7 15.2 14.2 14.0 14.7 14.8

Slovenia 15.7 15.3 14.4 14.7 16.5 15.3

Hungary 14.6 15.0 15.3 15.8 16.3 15.4

EU27 average (unweighted)

13.7 13.4 13.2 13.7 15.7 14.0

CEE10 average 11.6 11.4 11.2 11.9 14.2 12.1

The second major reason to focus on social transfers is that the relatively high level of expenditure is accompanied by benefit formulas, which in several cases may be considered more generous than in other EU countries (MISSOC) and likely to discourage labour market activity. One may therefore expect reforms of social transfers to generate positive incentive effects, which our modelling framework is particularly well-suited to capture.

The range of measures, which may be implemented with the aim of reducing social expenditure within the timeframe of our exercise, is limited. A number of reforms, which could be expected to significantly improve long-term sustainability of public finances, as well as the long-run potential growth rate, have severe implementation lags. These include measures to raise the retirement age, both the universal retirement age, which currently stands at only 60 years for women and 65 for men, and in particular for privileged professional groups, such as uniformed services (who may retire as early as at 35 years of age) and miners. Given the principle of respecting already acquired

6 This includes notably the tightening of access to disability benefits in the late 1990s, and numerous measures of the so-called ‘Hausner plan’ of expenditure reform, adopted in 2003–2004.


retirement rights, upheld in the past by the Constitutional Tribunal, these measures could only be implemented gradually, without affecting individuals currently close to retirement age. Therefore, their introduction would not have a noticeable impact on fiscal balances within the timeframe of our exercise and for this reason they will not be discussed further. The overall size of consolidation measures in the area of social expenditure, which we consider feasible within the timeframe of our exercise amounts to 0.9% of GDP and includes the following measures:

– reduction of sickness benefits (savings of 0.25% of GDP),– reduction of funeral benefits (savings of 0.13% of GDP),– improved targeting of social assistance (savings of 0.33% of GDP),– change in pension indexation formula (savings of 0.12% of GDP),– raising of entitlement age for survivor pensions (savings of 0.06% of GDP).The detailed description and rationale behind each of these measures is provided in Appendix.The next important area of expenditure reductions is government consumption, which largely

consists of discretionary central and local government expenditure on compensation of employees and goods and services. Government consumption has been very buoyant over the past economic upturn, growing on average by 5.7% per year in real terms between 2005 and 2008. This sort of growth rate appears to exceed the potential growth rate of the economy, what implies a need for adjustment. In our exercise we assume a reduction in government consumption over the three-year horizon by a total of 0.9% of GDP.

The expenditure-reducing measures described above would not be sufficient to achieve the target of a deficit below 3% of GDP. We decided, however, not to introduce additional spending cuts. One reason for this is that we assumed not to cut government investment, which is generally considered in the literature to be a productive category of spending.7 This is particularly so in the case of new EU Member States, where expenditures on domestic public investment are augmented by co-financing from EU structural funds. Therefore, an additional part of the required fiscal adjustment in this scenario will come from a VAT increase. A 3 percentage-point increase in all VAT rates is expected to yield additional revenues of 1.3% of GDP.

7 See Turrini (2004) for a discussion.

Table 2Composition of fiscal adjustment – expenditure-oriented scenario (in % of GDP)

2011 2012 2013 Total

Revenue side

VAT 1.3 0.0 0.0 1.3

Social contributions (farmers) 0.1 0.0 0.0 0.1

Expenditure side

Social transfers -0.7 -0.1 -0.1 -0.9

Government consumption -0.3 -0.3 -0.3 -0.9

Interest payments -0.1 -0.1 0.0 -0.2

Deficit impact -2.6 -0.4 -0.4 -3.3


Together with savings in interest payments arising from the deficit reduction in the first and second year of the consolidation package, the overall deficit reduction in this scenario amounts to 3.3% of GDP, with more than 60% of the adjustment taking place on the expenditure side. The adjustment is sufficient to achieve the target of bringing the general government deficit below 3% in 2013.

The details of the expenditure-oriented scenario of fiscal consolidation are presented in Table 2.

2.2. Revenue-oriented scenario

The revenue-oriented scenario of fiscal consolidation largely relies on reversing the sizeable reductions to the tax wedge, which took place in 2007–2009. These included:

– a reduction in the disability benefit contribution rate by a total of 7% of the salary,– a move from a three-tier personal income tax schedule with a top rate of 40% to a two-tier

one with a top rate of 32%.8

The reversal of these tax cuts may be expected to yield an additional 2.1% of GDP in general government revenues. This would not be sufficient to achieve the assumed objective, particularly since, as we will show, the fiscal contraction will have a depressing impact on economic activity, stronger than in the expenditure-oriented scenario. Therefore the hikes in social contributions and personal income taxes will be accompanied by an increase in VAT, of the same structure and magnitude as in the expenditure-oriented scenario. Some savings in interest payments will also materialise. Overall, the ex-ante size of fiscal adjustment in this scenario is 3.6% of GDP, of which 95% takes place on the revenue side of general government finances.

The structure and timing of the revenue-oriented scenario are illustrated in the Table 3.

Table 3Composition of fiscal adjustment – revenue-oriented scenario (in % of GDP)

2011 2012 2013 Total

Revenue sideVAT 1.3 0.0 0.0 1.3

Social contributions 1.5 0.0 0.0 1.5

Personal income taxes -0.1 0.7 0.0 0.6

Expenditure side

Interest payments -0.1 -0.1 0.0 -0.2Deficit impact -2.8 -0.8 0.0 -3.6

8 In addition, a new child-raising tax allowance has been introduced in 2007, but its reversal is not included in our simulations.


3. Model and data

In order to evaluate the effects of fiscal tightening, we use a Computable General Equilibrium model. The model used here was developed through a joint project of several institutions: the World Bank, the National Bank of Poland, the Ministry of Finance and the Ministry of Economic Affairs and Labour. The model contains several hundred equations and is based on optimization of economic decision on the part of agents: households maximize utility subject to budget constraints and firms maximize profits. The version of the model employed in this study assumes price taking (i.e. perfect competition in all goods, services and factor markets).

The detailed documentation of the model is provided by Gradzewicz, Griffin, Zólkiewski (2006, freely available online). Given the space constraints we do not replicate this documentation here, but we present in detail the most relevant features of the model.

All the model equations used for actual computations are written down as percentage deviations of economic variables from the benchmark equilibrium. Levels of variables enter the equations as constants that are revised in each simulation iteration. The notation uses upper-case letters to denote variables in levels and lower-case letters do denote percentage changes.

The agents in the model are referred to as institutions and all belong to a set INST. In order to make the model structure as close to national accounts as possible, the institutions are: households, government, firms, banks and the external sector. We will briefly describe the production activities and the set-up of the households and the government.

The financial sector is not explicitly modelled, therefore the bank account is a way to capture value flows in the economy therefore banks are an agent that owns a part the capital stock and rents it to the firms at the going rate, receives transfers from other institutions and transfers out incomes to other institutions, saving at a constant rate.

Supply of goods is driven by an assumption of imperfect substitutes in production, governed by a constant elasticity of transformation function between the domestically delivered and exported products. Agents in the economy are assumed to take the exogenous world prices as given. The supply is (in percentage deviation form9):

+=o mom

mwomw zpx

mwxmwo

=

=

l mml

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mamlq

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jojjwowj tdqm

jwo

ojq

jtd

+=f i

ihhfhfh PTRSWYT

hYT

hfW hfS

ihPTR

hYD hIT

hTS

+=hp

hhphphh TSDQYDEY

hpQ hpD hpS ) (

hpL hpD

hpLU

)( hphphphp LUDLS +=

+=l

hhnhlhhlhn eyqd

hphphp WSUBSTQ )1(= hpSUBST

t

ttt

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λ

λ mmlλ

ε

ε

λ

λ_

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_

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where

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hpL hpD

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+=l

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t

ttt

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∑

∑

∑

∑

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∑

∑

λ

λ mmlλ

ε

ε

λ

λ_

_

_

_

_

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is the percentage output of good m to destination w (domestic or any export destination o),

+=o mom

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∑

∑

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λ

λ mmlλ

ε

ε

λ

λ_

_

_

_

_

ε γ

are the own and cross price elasticities of supply good m in all destinations, pom are the prices of good m in each of the destinations and zm is the percentage change of total output of good m.

The production technology is a multi-nested concept with a CES aggregates of value added (three types of labour and capital) and intermediate goods.10 Firms minimize costs (expenditure on inputs) given the factor prices and the level of supply. The demand for factors of production can be expressed, in percentage form as:

+=o mom

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=

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hpL hpD

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+=l

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t

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∑

∑

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∑

λ

λ mmlλ

ε

ε

λ

λ_

_

_

_

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ε γ

9 Derivation of the demand for factors and supply to markets together with the technique of linearization is described in detail in the model documentation.

10 This sort of treatment is now standard in general equilibrium literature.


where:

+=o mom

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=

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jojjwowj tdqm

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ihhfhfh PTRSWYT

hYT

hfW hfS

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hhphphh TSDQYDEY

hpQ hpD hpS ) (

hpL hpD

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+=l

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t

ttt

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∑

∑

∑

∑

∑

∑

∑

λ

λ mmlλ

ε

ε

λ

λ_

_

_

_

_

ε γ

– the demand for factor n in production of good m,

+=o mom

mwomw zpx

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=

=

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+o

jojjwowj tdqm

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+=hp

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hpL hpD

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t

ttt

PITS

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∑

∑

∑

∑

∑

∑

∑

λ

λ mmlλ

ε

ε

λ

λ_

_

_

_

_

ε γ

– the own and cross elasticities of factor demand,

+=o mom

mwomw zpx

mwxmwo

=

=

l mml

mmlmn aqv

mnv

mml

mamlq

+o

jojjwowj tdqm

jwo

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+=f i

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+=hp

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hpL hpD

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+=l

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t

ttt

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∑

∑

∑

∑

∑

∑

∑

λ

λ mmlλ

ε

ε

λ

λ_

_

_

_

_

ε γ

– the rate of technical progress in the production of good m. In the above equation,

+=o mom

mwomw zpx

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=

=

l mml

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+o

jojjwowj tdqm

jwo

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+=f i

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hpL hpD

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+=l

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t

ttt

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DPRCAPCAP +=+ )1(1

∑

∑

∑

∑

∑

∑

∑

λ

λ mmlλ

ε

ε

λ

λ_

_

_

_

_

ε γ

is the price that the firm has to pay for a unit of each factor of production l, including all taxes and social contributions. In the case of labour, we will refer to this as ‘cost of labour’.

Firms operate under zero profit conditions, therefore all the expenditures on employment of factors of production equal to the overall revenue across markets. Firms behave in a similar fashion to banks – they save a constant rate of the inflows of funds they receive from other institutions and transfer out the remaining portion of income.

Intermediate goods can be either domestically produced or imported. Both intermediate and final demand is driven by the Armington (1969) assumption, stating that goods domestically produced are imperfect substitutes to those imported (CES Armington aggregate). Similarly, imported goods are imperfect substitutes depending on the country of origin. The import demand for good m from destination j is therefore (in percentage deviation form) equal to:

+=o mom

mwomw zpx

mwxmwo

=

=

l mml

mmlmn aqv

mnv

mml

mamlq

+o

jojjwowj tdqm

jwo

ojq

jtd

+=f i

ihhfhfh PTRSWYT

hYT

hfW hfS

ihPTR

hYD hIT

hTS

+=hp

hhphphh TSDQYDEY

hpQ hpD hpS ) (

hpL hpD

hpLU


+=l

hhnhlhhlhn eyqd


t

ttt

PITS

DPRCAPCAP +=+ )1(1

∑

∑

∑

∑

∑

∑

∑

λ

λ mmlλ

ε

ε

λ

λ_

_

_

_

_

ε γ

where:

+=o mom

mwomw zpx

mwxmwo

=

=

l mml

mmlmn aqv

mnv

mml

mamlq

+o

jojjwowj tdqm

jwo

ojq

jtd

+=f i

ihhfhfh PTRSWYT

hYT

hfW hfS

ihPTR

hYD hIT

hTS

+=hp

hhphphh TSDQYDEY

hpQ hpD hpS ) (

hpL hpD

hpLU


+=l

hhnhlhhlhn eyqd


t

ttt

PITS

DPRCAPCAP +=+ )1(1

∑

∑

∑

∑

∑

∑

∑

λ

λ mmlλ

ε

ε

λ

λ_

_

_

_

_

ε γ

– the so called Armington (own and cross) elasticities of demand,

+=o mom

mwomw zpx

mwxmwo

=

=

l mml

mmlmn aqv

mnv

mml

mamlq

+o

jojjwowj tdqm

jwo

ojq

jtd

+=f i

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hYT

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hTS

+=hp

hhphphh TSDQYDEY

hpQ hpD hpS ) (

hpL hpD

hpLU


+=l

hhnhlhhlhn eyqd


t

ttt

PITS

DPRCAPCAP +=+ )1(1

∑

∑

∑

∑

∑

∑

∑

λ

λ mmlλ

ε

ε

λ

λ_

_

_

_

_

ε γ

– the price of the imported good from country o in the domestic currency net of all taxes and tariffs,

+=o mom

mwomw zpx

mwxmwo

=

=

l mml

mmlmn aqv

mnv

mml

mamlq

+o

jojjwowj tdqm

jwo

ojq

jtd

+=f i

ihhfhfh PTRSWYT

hYT

hfW hfS

ihPTR

hYD hIT

hTS

+=hp

hhphphh TSDQYDEY

hpQ hpD hpS ) (

hpL hpD

hpLU


+=l

hhnhlhhlhn eyqd


t

ttt

PITS

DPRCAPCAP +=+ )1(1

∑

∑

∑

∑

∑

∑

∑

λ

λ mmlλ

ε

ε

λ

λ_

_

_

_

_

ε γ

– (percentage change) of total demand for good j encompassing all demand sources by agents in the economy.

The non-standard features of the model include non-homothetic utility function of households generating demand with non-unitary income elasticities, allowing varying shares of expenditures of normal vs. inferior goods. Each household h derives its income from renting its endowments of factors of production to the firm (in absolute terms):

+=o mom

mwomw zpx

mwxmwo

=

=

l mml

mmlmn aqv

mnv

mml

mamlq

+o

jojjwowj tdqm

jwo

ojq

jtd

+=f i

ihhfhfh PTRSWYT

hYT

hfW hfS

ihPTR

hYD hIT

hTS

+=hp

hhphphh TSDQYDEY

hpQ hpD hpS ) (

hpL hpD

hpLU


+=l

hhnhlhhlhn eyqd


t

ttt

PITS

DPRCAPCAP +=+ )1(1

∑

∑

∑

∑

∑

∑

∑

λ

λ mmlλ

ε

ε

λ

λ_

_

_

_

_

ε γ

where:

+=o mom

mwomw zpx

mwxmwo

=

=

l mml

mmlmn aqv

mnv

mml

mamlq

+o

jojjwowj tdqm

jwo

ojq

jtd

+=f i

ihhfhfh PTRSWYT

hYT

hfW hfS

ihPTR

hYD hIT

hTS

+=hp

hhphphh TSDQYDEY

hpQ hpD hpS ) (

hpL hpD

hpLU


+=l

hhnhlhhlhn eyqd


t

ttt

PITS

DPRCAPCAP +=+ )1(1

∑

∑

∑

∑

∑

∑

∑

λ

λ mmlλ

ε

ε

λ

λ_

_

_

_

_

ε γ

– the taxable income,

+=o mom

mwomw zpx

mwxmwo

=

=

l mml

mmlmn aqv

mnv

mml

mamlq

+o

jojjwowj tdqm

jwo

ojq

jtd

+=f i

ihhfhfh PTRSWYT

hYT

hfW hfS

ihPTR

hYD hIT

hTS

+=hp

hhphphh TSDQYDEY

hpQ hpD hpS ) (

hpL hpD

hpLU


+=l

hhnhlhhlhn eyqd


t

ttt

PITS

DPRCAPCAP +=+ )1(1

∑

∑

∑

∑

∑

∑

∑

λ

λ mmlλ

ε

ε

λ

λ_

_

_

_

_

ε γ

and

+=o mom

mwomw zpx

mwxmwo

=

=

l mml

mmlmn aqv

mnv

mml

mamlq

+o

jojjwowj tdqm

jwo

ojq

jtd

+=f i

ihhfhfh PTRSWYT

hYT

hfW hfS

ihPTR

hYD hIT

hTS

+=hp

hhphphh TSDQYDEY

hpQ hpD hpS ) (

hpL hpD

hpLU


+=l

hhnhlhhlhn eyqd


t

ttt

PITS

DPRCAPCAP +=+ )1(1

∑

∑

∑

∑

∑

∑

∑

λ

λ mmlλ

ε

ε

λ

λ_

_

_

_

_

ε γ

– the (after-tax and social contribution) take-home wages (as opposed to the ‘cost of labour’ variable) and supply levels of each factor f,

+=o mom

mwomw zpx

mwxmwo

=

=

l mml

mmlmn aqv

mnv

mml

mamlq

+o

jojjwowj tdqm

jwo

ojq

jtd

+=f i

ihhfhfh PTRSWYT

hYT

hfW hfS

ihPTR

hYD hIT

hTS

+=hp

hhphphh TSDQYDEY

hpQ hpD hpS ) (

hpL hpD

hpLU


+=l

hhnhlhhlhn eyqd


t

ttt

PITS

DPRCAPCAP +=+ )1(1

∑

∑

∑

∑

∑

∑

∑

λ

λ mmlλ

ε

ε

λ

λ_

_

_

_

_

ε γ

– the transfers received from all other institutions i. The disposable income

+=o mom

mwomw zpx

mwxmwo

=

=

l mml

mmlmn aqv

mnv

mml

mamlq

+o

jojjwowj tdqm

jwo

ojq

jtd

+=f i

ihhfhfh PTRSWYT

hYT

hfW hfS

ihPTR

hYD hIT

hTS

+=hp

hhphphh TSDQYDEY

hpQ hpD hpS ) (

hpL hpD

hpLU


+=l

hhnhlhhlhn eyqd


t

ttt

PITS

DPRCAPCAP +=+ )1(1

∑

∑

∑

∑

∑

∑

∑

λ

λ mmlλ

ε

ε

λ

λ_

_

_

_

_

ε γ

is obtained by applying the income tax rate

+=o mom

mwomw zpx

mwxmwo

=

=

l mml

mmlmn aqv

mnv

mml

mamlq

+o

jojjwowj tdqm

jwo

ojq

jtd

+=f i

ihhfhfh PTRSWYT

hYT

hfW hfS

ihPTR

hYD hIT

hTS

+=hp

hhphphh TSDQYDEY

hpQ hpD hpS ) (

hpL hpD

hpLU


+=l

hhnhlhhlhn eyqd


t

ttt

PITS

DPRCAPCAP +=+ )1(1

∑

∑

∑

∑

∑

∑

∑

λ

λ mmlλ

ε

ε

λ

λ_

_

_

_

_

ε γ

and deducting all the outgoing transfers to other institutions. Households are assumed to save

+=o mom

mwomw zpx

mwxmwo

=

=

l mml

mmlmn aqv

mnv

mml

mamlq

+o

jojjwowj tdqm

jwo

ojq

jtd

+=f i

ihhfhfh PTRSWYT

hYT

hfW hfS

ihPTR

hYD hIT

hTS

+=hp

hhphphh TSDQYDEY

hpQ hpD hpS ) (

hpL hpD

hpLU


+=l

hhnhlhhlhn eyqd


t

ttt

PITS

DPRCAPCAP +=+ )1(1

∑

∑

∑

∑

∑

∑

∑

λ

λ mmlλ

ε

ε

λ

λ_

_

_

_

_

ε γ

at fixed percentage of the disposable income.

Households derive utility from consumption of physical goods and leisure and therefore labour supply is endogenous and conditional both on household income from various sources and relative prices of factors of production and physical goods and services. The budget constraint of the household has to therefore include the value of leisure, and the total amount that is spent on consumption is therefore:


+=o mom

mwomw zpx

mwxmwo

=

=

l mml

mmlmn aqv

mnv

mml

mamlq

+o

jojjwowj tdqm

jwo

ojq

jtd

+=f i

ihhfhfh PTRSWYT

hYT

hfW hfS

ihPTR

hYD hIT

hTS

+=hp

hhphphh TSDQYDEY

hpQ hpD hpS ) (

hpL hpD

hpLU


+=l

hhnhlhhlhn eyqd


t

ttt

PITS

DPRCAPCAP +=+ )1(1

∑

∑

∑

∑

∑

∑

∑

λ

λ mmlλ

ε

ε

λ

λ_

_

_

_

_

ε γ

where

+=o mom

mwomw zpx

mwxmwo

=

=

l mml

mmlmn aqv

mnv

mml

mamlq

+o

jojjwowj tdqm

jwo

ojq

jtd

+=f i

ihhfhfh PTRSWYT

hYT

hfW hfS

ihPTR

hYD hIT

hTS

+=hp

hhphphh TSDQYDEY

hpQ hpD hpS ) (

hpL hpD

hpLU


+=l

hhnhlhhlhn eyqd


t

ttt

PITS

DPRCAPCAP +=+ )1(1

∑

∑

∑

∑

∑

∑

∑

λ

λ mmlλ

ε

ε

λ

λ_

_

_

_

_

ε γ

and

+=o mom

mwomw zpx

mwxmwo

=

=

l mml

mmlmn aqv

mnv

mml

mamlq

+o

jojjwowj tdqm

jwo

ojq

jtd

+=f i

ihhfhfh PTRSWYT

hYT

hfW hfS

ihPTR

hYD hIT

hTS

+=hp

hhphphh TSDQYDEY

hpQ hpD hpS ) (

hpL hpD

hpLU


+=l

hhnhlhhlhn eyqd


t

ttt

PITS

DPRCAPCAP +=+ )1(1

∑

∑

∑

∑

∑

∑

∑

λ

λ mmlλ

ε

ε

λ

λ_

_

_

_

_

ε γ

are the price and demand for leisure type p. The household labour supply

+=o mom

mwomw zpx

mwxmwo

=

=

l mml

mmlmn aqv

mnv

mml

mamlq

+o

jojjwowj tdqm

jwo

ojq

jtd

+=f i

ihhfhfh PTRSWYT

hYT

hfW hfS

ihPTR

hYD hIT

hTS

+=hp

hhphphh TSDQYDEY

hpQ hpD hpS ) (

hpL hpD

hpLU


+=l

hhnhlhhlhn eyqd


t

ttt

PITS

DPRCAPCAP +=+ )1(1

∑

∑

∑

∑

∑

∑

∑

λ

λ mmlλ

ε

ε

λ

λ_

_

_

_

_

ε γ

is the labour endowment

+=o mom

mwomw zpx

mwxmwo

=

=

l mml

mmlmn aqv

mnv

mml

mamlq

+o

jojjwowj tdqm

jwo

ojq

jtd

+=f i

ihhfhfh PTRSWYT

hYT

hfW hfS

ihPTR

hYD hIT

hTS

+=hp

hhphphh TSDQYDEY

hpQ hpD hpS ) (

hpL hpD

hpLU


+=l

hhnhlhhlhn eyqd


t

ttt

PITS

DPRCAPCAP +=+ )1(1

∑

∑

∑

∑

∑

∑

∑

λ

λ mmlλ

ε

ε

λ

λ_

_

_

_

_

ε γ

minus the demand for leisure

+=o mom

mwomw zpx

mwxmwo

=

=

l mml

mmlmn aqv

mnv

mml

mamlq

+o

jojjwowj tdqm

jwo

ojq

jtd

+=f i

ihhfhfh PTRSWYT

hYT

hfW hfS

ihPTR

hYD hIT

hTS

+=hp

hhphphh TSDQYDEY

hpQ hpD hpS ) (

hpL hpD

hpLU


+=l

hhnhlhhlhn eyqd


t

ttt

PITS

DPRCAPCAP +=+ )1(1

∑

∑

∑

∑

∑

∑

∑

λ

λ mmlλ

ε

ε

λ

λ_

_

_

_

_

ε γ

and the number of unemployed

+=o mom

mwomw zpx

mwxmwo

=

=

l mml

mmlmn aqv

mnv

mml

mamlq

+o

jojjwowj tdqm

jwo

ojq

jtd

+=f i

ihhfhfh PTRSWYT

hYT

hfW hfS

ihPTR

hYD hIT

hTS

+=hp

hhphphh TSDQYDEY

hpQ hpD hpS ) (

hpL hpD

hpLU


+=l

hhnhlhhlhn eyqd


t

ttt

PITS

DPRCAPCAP +=+ )1(1

∑

∑

∑

∑

∑

∑

∑

λ

λ mmlλ

ε

ε

λ

λ_

_

_

_

_

ε γ

:

+=o mom

mwomw zpx

mwxmwo

=

=

l mml

mmlmn aqv

mnv

mml

mamlq

+o

jojjwowj tdqm

jwo

ojq

jtd

+=f i

ihhfhfh PTRSWYT

hYT

hfW hfS

ihPTR

hYD hIT

hTS

+=hp

hhphphh TSDQYDEY

hpQ hpD hpS ) (

hpL hpD

hpLU


+=l

hhnhlhhlhn eyqd


t

ttt

PITS

DPRCAPCAP +=+ )1(1

∑

∑

∑

∑

∑

∑

∑

λ

λ mmlλ

ε

ε

λ

λ_

_

_

_

_

ε γThe demand functions of the model can be derived from a general non-homothetic utility function (eg. Linear Expenditure System) given the budget constraint. In percentage change form, this specification boils down to the following simple specification of the demand for consumption or leisure is expressed as:

+=o mom

mwomw zpx

mwxmwo

=

=

l mml

mmlmn aqv

mnv

mml

mamlq

+o

jojjwowj tdqm

jwo

ojq

jtd

+=f i

ihhfhfh PTRSWYT

hYT

hfW hfS

ihPTR

hYD hIT

hTS

+=hp

hhphphh TSDQYDEY

hpQ hpD hpS ) (

hpL hpD

hpLU


+=l

hhnhlhhlhn eyqd


t

ttt

PITS

DPRCAPCAP +=+ )1(1

∑

∑

∑

∑

∑

∑

∑

λ

λ mmlλ

ε

ε

λ

λ_

_

_

_

_

ε γ

where

+=o mom

mwomw zpx

mwxmwo

=

=

l mml

mmlmn aqv

mnv

mml

mamlq

+o

jojjwowj tdqm

jwo

ojq

jtd

+=f i

ihhfhfh PTRSWYT

hYT

hfW hfS

ihPTR

hYD hIT

hTS

+=hp

hhphphh TSDQYDEY

hpQ hpD hpS ) (

hpL hpD

hpLU


+=l

hhnhlhhlhn eyqd


t

ttt

PITS

DPRCAPCAP +=+ )1(1

∑

∑

∑

∑

∑

∑

∑

λ

λ mmlλ

ε

ε

λ

λ_

_

_

_

_

ε γ is the percentage deviation of Dhn, the demand for commodity l of the consumer and qhl is the price of this commodity. We denote by ε and γ the price and income elasticities of demand respectively. The general form of preferences allows the use of non-unitary income elasticity of demand. Note that the price for leisure in absolute terms is equal to

+=o mom

mwomw zpx

mwxmwo

=

=

l mml

mmlmn aqv

mnv

mml

mamlq

+o

jojjwowj tdqm

jwo

ojq

jtd

+=f i

ihhfhfh PTRSWYT

hYT

hfW hfS

ihPTR

hYD hIT

hTS

+=hp

hhphphh TSDQYDEY

hpQ hpD hpS ) (

hpL hpD

hpLU


+=l

hhnhlhhlhn eyqd


t

ttt

PITS

DPRCAPCAP +=+ )1(1

∑

∑

∑

∑

∑

∑

∑

λ

λ mmlλ

ε

ε

λ

λ_

_

_

_

_

ε γ

due to subsidy to leisure

+=o mom

mwomw zpx

mwxmwo

=

=

l mml

mmlmn aqv

mnv

mml

mamlq

+o

jojjwowj tdqm

jwo

ojq

jtd

+=f i

ihhfhfh PTRSWYT

hYT

hfW hfS

ihPTR

hYD hIT

hTS

+=hp

hhphphh TSDQYDEY

hpQ hpD hpS ) (

hpL hpD

hpLU


+=l

hhnhlhhlhn eyqd


t

ttt

PITS

DPRCAPCAP +=+ )1(1

∑

∑

∑

∑

∑

∑

∑

λ

λ mmlλ

ε

ε

λ

λ_

_

_

_

_

ε γ

. The leisure subsidy is to be understood as the part of the social transfers (as opposed to those covered by the PTR variable) that is supposed to affect the opportunity cost of time.

Another feature of the model that is worth elaborating on is the behavior of the government that can be summarized by the formation of the budget that encompasses:

• Tax revenues net of subsidies on the production of goods (exogeneous tax/subsidy rates diversified by goods)

• Import tariffs net of export subsidies (exogeneous tax/subsidy rates diversified by good/destination)

• Taxes on the factor supply net of subsidies to leisure consumption (different tax/subsidy rate for each factor type/household)

• Income taxes from all the other institutions (different rates for each household/institution)• The value of government consumption measured at the aggregate price index• Government transfers to/from other institution.In the standard closure the government consumption is exogeneously determined in real

terms, while transfers are exogeneously determined in monetary terms. All the tax revenues and expenditures on subsidies are determined endogenously at fixed rates given the activity and income levels. This includes the expenditures on leisure subsidies and unemployment benefits that are conditional on the activity rates on the household and the demand for labour.

The equilibrium is defined as a set of prices/factor wages and quantities such that:• Firms minimize expenditure given technology, factor prices and tax/subsidy rates and

choose optimal bundle of inputs (demand for inputs is determined).• Firms maximize revenue across markets (home/foreign) and choose optimal supply levels

(supply to markets is determined).


• Firms operate at zero profits (goods prices are pinned to production costs).• Consumers maximize utility given preferences, goods and factor prices and tax/subsidy

rates, transfers and exogenous savings rates (demand for goods/services and supply of labour is determined).

• Product markets clear, ie. supply equals demand across uses (private/public consumption, investment, exports and domestic intermediate use) – prices of goods assure market clearing.

• Factor markets clear, ie. supply of labour is equal demand of labour and the demand for capital is equal to the stock of capital (wages assure labour market clearing, the rental rate of capital assure capital market clearing).

• Government determines its savings given the (exogeneous) public consumption, tax/subsidy rates, (endogeneous) goods prices, quantities and incomes.

• The foreign savings are determined as a difference between total imports and total exports and (exogeneous) net transfers.

• The total value of investment is equal to the total savings in the economy. Investment demand is determined given goods prices.

This recursive-dynamic general equilibrium model is solved as a series of short-run static simulations (one for each period of time-year). The simulations are linked to each other through capital accumulation equation:

+=o mom

mwomw zpx

mwxmwo

=

=

l mml

mmlmn aqv

mnv

mml

mamlq

+o

jojjwowj tdqm

jwo

ojq

jtd

+=f i

ihhfhfh PTRSWYT

hYT

hfW hfS

ihPTR

hYD hIT

hTS

+=hp

hhphphh TSDQYDEY

hpQ hpD hpS ) (

hpL hpD

hpLU


+=l

hhnhlhhlhn eyqd


t

ttt

PITS

DPRCAPCAP +=+ )1(1

∑

∑

∑

∑

∑

∑

∑

λ

λ mmlλ

ε

ε

λ

λ_

_

_

_

_

ε γ

where:

CAP – the capital stock in a given period,DPR – the depreciation rate,TS – the amount of total savings, PI – the price of the investment good (produced using a Cobb-Douglas technology).

The database used together with the model is a social accounting matrix based on National Accounts together with the input and output table. The latest National Accounts data available at the time of the database preparation was that from 2007. We use the latest available input-output table for 2005 provided by the Central Statistical Office. The two datasets are balanced to be compatible with national accounts subtotals but the structure of the intermediate and primary use reflects that of the input-output table. The main aggregates of the database are updated in line with the 2009 aggregate National Accounts and main revenues and expenditures of the public sector. The resulting social accounting matrix covers 39 sectors of economic activity based on the NACE rev. 1 classification.

The dataset is supplemented with data coming from auxiliary sources. The labour market data comes from the Labour Force Survey that allows us to disaggregate the labour supply into three categories of labour (low, medium and high skilled based on the level of education). The Household Budget Survey provides the disaggregated data on the household level (incomes, consumption spending etc.) based on which 10 aggregate household accounts are created (employed, self- -employed, farmer, pensioner and other each in poor vs. non-poor category). The consumption data is matched to sectoral data through a concordance table. The detailed sectoral VAT revenues data together with disagregated international trade data in the NACE classification comes from


the Ministry of Finance. The National Accounts data is augmented with the tax revenue data obtained from the Ministry of Finance and the Household Budget Surveys in order to compute the income tax rates for every household. While the model itself does not take into account progression (ie. households moving between tax thresholds), the initial tax rates are different based on the tax revenues from each of the households and they can be shocked accordingly to take into account changes in the effective tax rates.

The resulting database is balanced using a iterative Friedlander procedure resulting in a social accounting matrix that satisfies the double accounting principle, ie. each institutions income receipts are equal to the sum of its expenditures and similarly the value of produced goods plus imports is equal to the value of domestically consumed goods plus exports.

The model requires a large set of elasticities and other parameters. The share parameters of all respective utility and production function are calibrated upon the social accounting matrix data. The income elasticities of demand are estimated through Engel curves using the households budget surveys as detailed in Gradzewicz, Griffin, Zólkiewski (2006). Time endowment and utilization rates of time are computed using the household budgets data. The price elasticities of demand and Armington elasticities are based on GTAP data11 and the data provided by the World Bank during the joint model preparation.

The resulting base year for the database is 2009.

4. Database updating and baseline

In order to be able to perform precise simulations we use model simulations to create an updated database reflecting the structure of national and government accounts for 2010 using the June projection of the National Bank of Poland. Therefore 2010 is the starting point of all simulations and the database reflects the state of the economy at the time of preparation of the simulations.

The simulations are run recursively for 2011, 2012 and 2013 separately with capital accumulation through investment net of depreciation. The baseline for the counterfactual simulations is based on the June 2010 projection of the NBP due to the fact that it does not contain any fiscal contraction measures unlike the newer NBP projections. The model is subjected to productivity, savings rates, exchange rates and tax rates shocks so that the endogenously determined aggregate activity measures, such as GDP components, labour market indicators and the government budget is in line with the NBP projections. The exact results are obtained through a closure swap which treats the target measures as exogenous where the adjusted parameters are temporarily endogenized. Once the required shocks to model parameters are found, parameters are fixed while activity measures endogenized.

11 See Hertel et al. (2008) for details.


5. Closures

As said above, two fiscal adjustment scenarios: revenue-oriented and expenditure-oriented were simulated over the horizon 2011–2013. For each of the scenarios, three versions of the model were used and they differed with respect to the so called ‘closure’, ie. the assumed working of some key macro-mechanisms of the model (see: Lofgren, Harris, Robinson 2002). The first is neoclassical closure according to which savings fully and immediately are transformed into investment and remuneration of labour (wage) is perfectly elastic to balance supply of and demand for labour. In the context of fiscal consolidation programme, we will interpret this closure of saving – investment balance as the proxy of the situation in which economic agents have full confidence in the government will and ability to restore sound public finances and therefore they invest to increase their production capacities to satisfy new demand in the future. This kind of ‘confidence’ channel of fiscal consolidation programs is highlighted in the literature advocating expansionary effects of fiscal contractions (eg., Alesina et al. 2002; Alesina, Ardagna 2009) and other works (eg., Rother, Schuknecht, Stark 2010). Labour market closure is a stylized representation of the increasing market elasticity of the labour market in Poland in terms of reduced real wage rigidity as documented by the research studies (eg., Strzelecki 2009) and stylized facts on adjustment of the Polish economy to the recent global crisis. It also may be interpreted as a representation of the effects of structural reforms in the labour market in the direction of increasing its flexibility. As claimed in Rother, Schuknecht, Stark (2009), ‘...Fiscal reforms should be coupled with structural reforms of social security and financial systems and of labour and product markets in order to maximise the benefits for growth and sustainability’ (p. 7). The second closure we will call Johansenian, following the tradition of CGE literature (eg., Robinson 2003). In this type of closure investment is fixed (at baseline level) and thus total saving adjust. With government (negative) savings increasing both in revenue- and expenditure-oriented consolidation packages, that results in the decrease of private savings. In the Johansenian closure labour market clears through wage adjustment as in the first closure. The last closure is eclectic in a sense that it assumes investment adjusting to saving level (as in neoclassical closure) and fixed (at the baseline level) wages what induces involuntary unemployment. The latter is typical for the so called Keynesian closure of CGE models although not the former assumption of this closure. Since we have an open economy model, an additional assumption (closure) is necessary to determine the way external equilibrium of the domestic economy is modelled. In the CGE models one has to decide (see Lofgren, Harris, Robinson 2002) whether the foreign savings, driven mainly by the trade balance, is assumed fixed and endogenous changes in real exchange rate equilibrate the system, or alternatively, real exchange rate is exogeneously fixed and foreign savings adjust as the equilibrating mechanism. Throughout all the simulations, we keep real exchange rate fixed and balance of trade endogenously adjusts. Although changes in the real exchange rate are important part of macro adjustment to fiscal consolidation (see eg. Lambertini, Tavares 2005; IMF 2010), our model is not well suited to the exchange rate determination (eg., there is no monetary policy and financial markets) and therefore we assumed that fiscal consolidation will not affect real exchange rate.12

12 While this choice is not crucial for stability of results, those with variable exchange rate are available upon request.


6. Results of the simulations

Let us start discussion of the simulations’ results from the case of economy characterised by the neoclassical closure, ie when wages are perfectly flexible and savings are automatically transformed into investment. These conditions provide the model with the broadest scope of adjustment and therefore may be expected to deliver the strongest effects of fiscal consolidation. The other closures: Johansenian and eclectic constrain adjustment of the economy to fiscal shocks either through switching-off investment channel or by removing assumption of wage flexibility. For the sake of the compact and transparent presentation of the results, only the most general case of neoclassical closure will be discussed in full detail. The other two regimes, will be analysed mostly with respect to the neoclassical case. Numerical results of all simulations are displayed in Tables 4–9.

6.1. Fiscal consolidation under neoclassical closure

We begin the discussion of the results with the revenue-oriented consolidation package. Under this scheme, the main policy tools are increases of: VAT tax revenues (1.3% of GDP over 2011–2013) and social contributions (disability insurance) which amount to roughly 1.5% of GDP. Application of these measures produced a strong adverse supply shock that led to a noticeable increase in consumer prices (3 percentage points rise in VAT rates), elevated production costs and introduced a distortion to labour – capital relative prices. Since most of this shock (2.8% of GDP) was concentrated in 2011, it produced contractionary impact on economic activity (GDP went down13 by 0.4 percentage points and employment shrunk by 0.7 percentage points ) in this year (see Table 4). Private consumption contracted by 3.1 percentage points, following deterioration of labour market (take-home wages dropped14 by 6.1 percentage points). Over the next years (2012–2013) growth resumed since cuts in government deficit improved overall savings that under this closure were fully channelled into investment that increased by 4.3 percentage points. Accumulation of capital stock was then accompanied by acceleration of wages and employment. Eventually, cumulative impact of fiscal consolidation on growth was slightly positive (by 0.3 percentage points) but private consumption suffered heavily (by 3.9 percentage points) as wages and employment decreased. Composition of GDP changed in favour to investment and export goods. Detailed results of this simulation are given in Table 4.

Table 4 reports how the economy reacted to the combination of shocks, focused on revenue side of the public finance. Table 5 provides a decomposition of the impact of isolated shocks on the major macro variables.15

13 Results of the simulation are presented, if not defined the other way, as percentage deviations from the baseline.14 However, the cost of labour borne by employers dropped only slightly (by -0,1 percentage points) because of assumed

in this scenario increase of social contributions.15 The decomposition is calculated as a series of separate simulations. The model is linearized and therefore results

are additive – however, minor differences (eg. 0.1–0.2 percentage point) due to rounding, data discrepancies and the error caused by linearization.


Table 5Decomposition: the revenue-oriented fiscal consolidation under neoclassical closure (percentage point deviations from the baseline)

VAT PIT & social contributions Debt payments Sum

GDP -0.1 0.4 0.0 0.3

Private consumption -1.1 -2.7 0.0 -3.8

Government consumption 0.0 0.0 0.0 0.0

Investments 0.8 7.8 0.2 8.8

Domestic demand -0.5 0.1 0.0 -0.4

Net wages -0.9 -4.4 0.0 -5.3

Cost of labour -0.9 1.7 0.0 0.8

Employment -0.2 -0.2 0.0 -0.3

Activity rate -0.1 -0.2 0.0 -0.3

Unemployment 0.1 -0.9 0.0 -0.8

Capital 0.1 0.7 0.0 0.9

Table 4The revenue-oriented fiscal consolidation under neoclassical closure (percentage point deviations from the baseline)

2011 2012 2013 2011– 2013GDP -0.4 0.3 0.4 0.3




Exports 0.4 0.5 0.5 1.4

Imports -1.1 0.4 0.5 -0.3


Net tax contribution 0.6 0.1 0.1 0.8

Wages -6.1 0.3 0.5 -5.3

Cost of labour -0.1 0.3 0.5 0.7

Employment -0.7 0.1 0.2 -0.3

Activity rate -0.6 0.1 0.1 -0.3

Unemployment 0.1 -0.4 -0.5 -0.9

Capital 0.0 0.3 0.5 0.8

Government deficit (% GDP) -4.7 -3.4 -2.7

Revenues (% GDP) 40.0 40.9 41.0

Expenditures (% GDP) 44.7 44.2 43.7


The most important isolated shock under this scenario is the increase of social contribution rate (1.5% of GDP). It had a direct strong effect on the labour market. Labour cost increased moderately as a first order effect (by 1.7% percentage point) what resulted in rather muted drop in employment (by 0.2 percentage points). Net wage shrunk sharply by 4.4 percentage points, and accordingly private consumption was reduced considerably (by 2.7 percentage points). While consumer demand declined, following deterioration at the labour market, sizeable additional savings of the general government were transformed into the demand for capital goods (increase by 7.8 percentage points). It is the investment boom that explains why this measure alone caused the acceleration of GDP over baseline (by 0.4 percentage points).

The other major shock, the increase of VAT tax, had much less impact although has similar size (1.3% of GDP). It’s direct effect was a rise in consumer prices what in turn adversely affected consumer demand (1.1 percentage points). However, firms simultaneously adjusted their costs downward through labour cost reduction (by 0.9 percentage points) what limited the negative impact of VAT increase on employment (decrease by 0.2 percentage points). Given the minor effect of this policy measure on the macro variables, the isolated impact of VAT increase on national savings and investment was 0.8 percentage points, with a negligible consequence for GDP.

The expenditure-oriented package, concentrates most of the consolidation burden (2.6% of GDP out of total 3.3%) in 2011. This scenario introduces a combination of a supply shock (increase in VAT revenues by 1.3% of GDP) and of a demand shock, resulting from expenditure cuts (social

Table 6The expenditure-oriented fiscal consolidation under neoclassical closure (percentage point deviations from the baseline)

2011 2012 2013 OverallGDP 0.2 0.4 0.5 1.1Private consumption -2.5 0.1 0.1 -2.2Government consumption -2.0 -2.0 -2.0 -6.0Investments 7.7 2.6 3.2 13.5Exports 1.6 0.6 0.8 3.0Imports 0.3 0.7 0.8 1.8Domestic demand -0.3 0.4 0.5 0.5Net tax contribution 0.5 0.0 0.0 0.6 Wages -3.4 0.4 0.3 -2.7Cost of labour -3.4 0.4 0.3 -2.7Employment 0.7 -0.1 0.1 0.7Activity rate 0.6 0.0 0.1 0.6Unemployment -0.1 0.1 0.1 0.1Capital 0.0 0.5 0.7 1.2

Government deficit (% GDP) -4.6 -3.6 -2.5Revenues (% GDP) 38.7 38.7 38.8Expenditures (% GDP) 43.3 42.4 41.4


transfers – by 0.7% GDP, and government consumption – by 0.3% of GDP). The package negatively affects consumption (drop by 2.5 percentage points) but in a less severe way than in the revenue- -oriented scenario (see Table 6). The difference may be explained by the fact that the reduction of transfers to households mitigates negative impact of the shock on the labour market and as a result activity rate increases (by 0.6 percentage points) adding to downward pressure on wages. However, as there was no significant increase in the tax wedge, not only the take-home wage dropped considerably but also the cost of labour decreased for the employer (both by 3.4 percentage points). The latter factor positively affect the labour demand which eventually increases by 0.7 percentage points, with further supportive impact on private consumption. As before, smaller government deficit improves overall saving that fully translate into investment. This time investment reacts more vigorously than before (increase by 7.7 percentage points) because of better (relative to previous scenario) financial standing of the households and higher profits of firms.

Over the whole simulation scenario, GDP increased sizeably (by 1.1 percentage point) at smaller than in the previous scenario drop in consumption (2.2 percentage points), together with improvement in the labour market in terms of employment and activity rate. As before, gains in GDP were mostly driven by investments and exports.

Let us have a disaggregated look on the impact of individual policy measures affected macroeconomic processes (see Table 7).

Table 7Decomposition: the expenditure-oriented fiscal consolidation under neoclassical closure (percentage point deviations from the baseline)

VATGovernment

consump-tion

Social transfers Debt payments Sum

GDP -0.1 0.1 1.0 0.0 1.1

Private consumption -1.1 -0.1 -0.9 0.0 -2.2

Government consumption 0.0 -6.0 0.0 0.0 -6.0

Investments 0.8 5.5 7.3 0.2 13.8

Domestic demand -0.5 0.1 1.0 0.0 0.5

Net wages -0.9 -0.6 -1.2 0.0 -2.7

Cost of labour -0.9 -0.6 -1.2 0.0 -2.7

Employment -0.2 -0.5 1.3 0.0 0.7

Activity rate -0.1 -0.4 1.1 0.0 0.6

Unemployment 0.1 0.1 -0.1 0.0 0.1

Capital 0.1 0.4 0.8 0.0 1.2

The three main impulses under expenditure-side fiscal consolidation package are: the VAT increase (1.3% of GDP), the reduction of social transfers (by 0.9% of GDP) and the cuts in government consumption (by 0.8% of GDP). We shall concentrate on the two latter impulses since


the isolated impact of the former is by construction identical to the previous scenario. The direct effect of the reduction of social transfers, treated in the model as subsidies to leisure, is a sizeable increase of the participation in the labour market (1.1 percentage points). Accordingly, growing supply of labour exerts downward pressure on wages and the labour cost (fall 1.2 percentage points). As a result of these adjustments in the labour market, the private consumption suffers (by 0.9 percentage points) but this is outweighed by a substantial improvement of the demand for capital goods (by 7.3 percentage points) as additional government savings are transformed into investment. Developments in the labour market and strong acceleration of investment activities explain sizeable increase of employment (by 1.3 percentage points). The reduction of social transfers alone contributes to 1 percentage points expansion of GDP.

The second isolated fiscal policy measure, ie. the reduction of government consumption directly affects employment (drop by 0.5 percentage points) as this shock affects primarily labour intensive non-market services. As wages are flexible in this simulation variant, they adjust downward (by 0.6 percentage points), following the weakening demand for labour, but thus curbing its decline. Therefore, private consumption goes down only slightly (by 0.1 percentage points) while investment flourish (increase by 5.5 percentage points), due to increase in the overall savings. Finally, implementation of this measure alone is slightly favourable to GDP (by 0.1 percentage points).

6.2. Alternative investment response – Johansenian closure

In the two subsequent simulations we assume that economic agents do not revise their investment plans with respect to the baseline, as the reaction to fiscal consolidation. As a result, with increasing government savings, household savings will drop and some consumption smoothing will occur. Therefore other demand categories will bear the burden of adjustment, especially private consumption as wages are perfectly flexible under this closure.

In the revenue-oriented consolidation package under Johansenian closure the drop in the disposable income of households leads to a reduction private consumption of overall 2.1% against the baseline over the simulation horizon (concentrated in the first and second year) and with no extra investment, the domestic demand falls deeper (overall fall by 1.3%) than with flexible investment. This drop in economic activity is reflected in a deeper reaction of net wages (overall fall by 4.9%) and a reduction of employment (by 1.2%). The overall effect on GDP is negative and amounts to a combined drop of GDP by 0.6% over the simulation horizon.

The expenditure-oriented consolidation package under Johansenian closure, brings a slight increase of private consumption (of 0.6%) due to a reduction in savings of the households offsetting the overall drop in net wages by 2.0. In absence of the expansion of investments, the overall domestic demand falls by 0.7%, in contrast to the neoclassical closure, which has a more detrimental effect to employment. The overall effect on GDP is negative (0.3%) and considerably lower than in the neoclassical scenario. However, similarly to the neoclassical closure, the results of expenditure- -oriented consolidation under Johansenian closure show that a reduction of expenditures that create disincentives to work (social transfers), given sufficient elasticity of wages, delivers more favourable effects, in terms of private consumption and GDP, in comparison with raising taxes and social contributions, like in revenue-oriented scenario.


Table 9The expenditure-oriented fiscal consolidation under Johansenian closure (percentage point deviations from the baseline)

2011 2012 2013 OverallGDP -0.1 -0.1 -0.1 -0.2Private consumption -0.3 0.4 0.5 0.6Government consumption -2.0 -2.0 -2.0 -6.0Investments 0.0 0.0 0.0 0.0Exports 0.8 0.0 0.0 0.8Imports -0.4 0.1 0.2 -0.1Domestic demand -0.5 -0.1 0.0 -0.7Net tax contribution 0.5 0.0 0.0 0.5 Wages -2.2 0.2 0.1 -2.0Cost of labour -2.2 0.2 0.1 -2.0Employment 0.0 -0.4 -0.3 -0.7Activity rate 0.0 -0.3 -0.3 -0.6Unemployment 0.0 0.2 0.2 0.4Capital 0.0 0.0 0.0 0.0 Budget deficit -4.6 -3.9 -3.0Revenues 38.7 38.9 38.9Expenditures 43.3 42.7 41.9

Table 8The revenue-oriented fiscal consolidation under Johansenian closure (percentage point deviations from the baseline)

2011 2012 2013 2011–2013GDP -0.5 -0.1 0.0 -0.6Private consumption -1.9 -0.2 0.0 -2.1Government consumption 0.0 0.0 0.0 0.0Investments 0.0 0.0 0.0 0.0Exports -0.1 -0.1 0.0 -0.1Imports -1.5 -0.1 0.1 -1.5Domestic demand -1.2 -0.1 0.0 -1.3Net tax contribution 0.6 0.1 0.0 0.7 Wages -5.4 0.5 0.0 -4.9Cost of labour 0.6 0.5 0.0 1.1Employment -1.0 -0.2 0.0 -1.2Activity rate -0.9 -0.2 0.0 -1.1Unemployment 0.1 -0.3 -0.5 -0.7Capital 0.0 0.0 0.0 0.0 Budget deficit -4.7 -3.5 -3.0Revenues 40.1 41.0 41.0Expenditures 44.8 44.5 44.0


6.3. Labour market rigidity – ‘eclectic closure’

Under this closure, government savings resulting from the consolidation programme translate automatically into investment and at the same time real wages (as borne by employers) are rigid, ie. fixed at baseline level. If the revenue-oriented consolidation package is introduced, then the key adjustment mechanism is labour market performance. Part of this package is an increase in the rate of social contributions. Since we have assumed that social contributions are increased in equal part for the employer and employee, accordingly the labour cost for the producer go up (by 3.0% points) and simultaneously the take-home wage go down by 3.0% overall. This in turn affects employment, which drops by 1.9% overall.

The reduction of wages results in a drop in private consumption (by 4.1% overall) and a considerable increase of activity rate that, with shrinking labour demand, leads to an increase of unemployment (by 12.4% overall). Expanding investment (4.6% increase) remains the only important growth driver and therefore the composition of GDP changes in favour of investment demand and net exports.

In the expenditure-oriented consolidation package with wages fixed at baseline level we also observe sizeable adjustment in the labour market: the cuts in social transfers reduce disposable income of the households, contributing mostly to the fall of private consumption (by 2.6% over

Table 10The revenue-oriented fiscal consolidation under ‘eclectic’ closure (percentage point deviations from the baseline)

2011 2012 2013 OverallGDP -1.1 0.1 0.3 -0.7




Exports -0.8 0.4 0.5 0.0

Imports -2.3 0.3 0.4 -1.7



Wages -3.0 0.0 0.0 -3.0

Cost of labour 3.0 0.0 0.0 3.0

Employment -2.3 0.1 0.2 -1.9

Activity rate 3.6 -0.1 -0.3 3.2

Unemployment 4.9 4.1 3.4 12.4

Capital 0.0 0.1 0.3 0.4 Budget deficit -5.0 -3.7 -3.1Revenues 40.2 41.0 41.1Expenditures 45.1 44.7 44.2


the simulation horizon). With a reduction of government consumption by 6%, savings-induced increase in investment of 8.6% overall remains the only important contributor to the change of GDP which remains neutral overall.

Due to income effects, activity rate increases up significantly (by 4.3% overall). Employment goes down significantly (by 1.2 percentage points) and unemployment increases dramatically (by 14.3%).

Table 11The expenditure-oriented fiscal consolidation under ‘eclectic’ closure (percentage point deviations from the baseline)

2011 2012 2013 Overall

GDP -0.5 0.2 0.3 0.0

Private consumption -2.6 0.0 0.0 -2.6

Government consumption -2.0 -2.0 -2.0 -6.0


Exports 0.3 0.5 0.7 1.5

Imports -1.1 0.5 0.6 0.1



Wages 0.0 0.0 0.0 0.0

Cost of labour 0.0 0.0 0.0 0.0

Employment -1.1 -0.1 0.0 -1.2

Activity rate 5.0 -0.5 -0.3 4.3

Unemployment 5.1 4.7 4.5 14.3

Capital 0.0 0.3 0.4 0.7

Budget deficit -4.9 -4.0 -3.0

Revenues 38.8 38.9 39.0

Expenditures 43.6 42.9 42.0

What is characteristic for the results of this simulation is that labour market adjusts to fiscal shocks by a pronounced quantity change (eg., sharp rise of activity rate), given rigid wages. However, with suppressed labour demand, especially in the labour-intensive sectors of consumer goods and public services, increasing activity resulted in a dramatic increase of unemployment rate. Labour rigidity makes the fiscal consolidation much more costly in terms of growth and private consumption to other closures when elastic wages adjustment cushioned against drop of employment and worsening of unemployment. However, even with labour rigidity, the expenditure- -oriented scenario remains superior to the revenue-oriented consolidation package, as far as GDP performance is taken into consideration. However, the difference between them in terms of private consumption and employment is less pronounced, while the overall effect on the unemployment rate is actually worse than in the revenue-oriented scenario.


7. Conclusions

The simulation performed using a computable general equilibrium model have shown that a reduction of budget (public finance) deficit to 3% of GDP over 2011–2013 can be achieved under plausible fiscal consolidation measures, either focused on revenues or expenditures side. What is also very important, the choice of the type of consolidation (revenues versus expenditures oriented) matters a lot.

Over all simulation variants, the ‘expenditure-oriented’ program is systematically superior to ‘revenue-based’ in terms of economic growth and private consumption. This result is mainly driven by the response of the labour market to the types of shocks included in the scenario. Cutting social transfers, the key element of this programme, is expected to increase incentives of households to participate in the labour market and this, given wage flexibility, positively affected employment and consumption in our simulations. Therefore, labour market elasticity with respect to wages is crucial for the materialization of this type of adjustment.

The second important assumption, ie. aggregate investment reaction to changes in savings, matters significantly for the results. If total investments are kept at the baseline level, then GDP rebounds more slowly and labour market recovers to a smaller extent than in the scenarios with neoclassical closure (however, consumption is less affected due to its ‘smoothing’ via a reduction in saving rates).

Overall, the implementation of the consolidation programme is expected to bring a reduction of private consumption, while the effect on GDP depends on the flexibility of the economy. The more flexible is economy the more favourable is the adjustment to fiscal shocks in terms of general activity level.

Our results show the importance of supplementing fiscal consolidation with structural reforms. The more flexible are wages and the more conducive to investment activities is product market, the better environment to take up successfully comprehensive fiscal austerity packages as simulated in this paper. This however means that the most favourable results, require rather demanding assumptions on the structural features of the Poland’s economy, notably close to perfect labour and product markets.

Moreover, the model as ours, with very simplified dynamics, may overestimate the speed of adjustment to the shocks, ie. the gains may materialize beyond 2013. Therefore, risks are on the downside and the some results may be overly optimistic, particularly as regards the immediate positive effects of fiscal consolidation on economic growth. With all these reservations we think that our results shed some light on the costs and benefits of different types of fiscal consolidation, to be implemented in Poland in the coming years. The structural reforms, portrayed in a stylized way in our simulations, may be beneficial not only for the smooth implementation of a fiscal consolidation package, but will be also crucial per se for the enhancing resistance to shocks and potential growth prospects of the Poland’s economy (see: OECD 2010).


Figure 1Comparison of simulation results

-6.0 -5.0 -4.0 -3.0 -2.0 -1.0 0.0 1.0

GDP

Private consumption

Investment

Employment

Johansenian closure

Revenue--oriented Expenditure- -oriented Baseline

-6 -4 -2 0 2 4 6 8

10 GDP

Private consumption

Investment

Employment

Eclectic closure


-6 -4 -2 0 2 4 6 8

10 12 14

GDP

Private consumption

Investment

Employment

Neoclassical closure



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Appendix

1. Sickness benefits

A reduction of the sickness benefit replacement rate to 70% of earnings was one of the proposals included in the Rationalization of public expenditure report (Hausner 2003). In view of regulations in place in other EU countries (MISSOC), one may consider farther reaching reforms, involving for example a reduction of the replacement rate to 60% of earnings together with introducing a ceiling limiting the benefit level. According to OECD SOCX database, expenditure on sickness benefits in Poland in 2007 was around 0.61% of GDP, which was higher than most OECD countries (average for countries for which data is available was 0.47%).

2. Social assistance benefits

Studies suggest, that social assistance spending in Poland is not well addressed, indicating a need for an improvement of the means testing approach followed in granting of the benefits, specifically via a more efficient use of different income and asset administrative data held by government agencies (World Bank 2010).

According to the report on execution of local government budgets in 2009, expenditure on social assistance transfers in that year amounted to 12.2 billion złoty.

3. Indexation of old-age and disability benefits

According to OECD figures, spending on old-age and disability benefits in Poland amounted to 11.8% of GDP in 2007, far exceeding the OECD average of 7.9% of GDP.

In the present state of public finances one may consider restoring inflation-only indexation, which was in place in 2005–2007, as a measure contributing to reduction of public expenditure on pension benefits in the medium term. Such a recommendation is included in the World Bank report on expenditure reform (World Bank 2010). Under the assumed scenario of a gradual recovery and moderate increases in real salaries, this measure may be expected to yield savings of 0.1% of GDP in the third year from its implementation.

4. Survivor pensions

This reform proposal is based on a PKPP Lewiatan (Lewiatan 2010) report, according to which raising the age at which widows become eligible for survivor benefits from the current 50 to 60 years (actual retirement age), would yield savings of around 0.2 billion złoty in the first year and 4 billion złoty in the eleventh year since the introduction of the reform.


5. Funeral benefits

The proposal is based on a comparison of funeral benefit regulations with those of other EU countries (MISSOC 2010) and a proposal made in Rzońca, Wojciechowski, Kalina (2010) to reduce the size of the funeral benefit from 200% of the average salary to 30%, while at the same time making it a means-tested benefit, in line with principles applied to social assistance benefits. According to these authors’ estimates, potential savings in 2011 terms may be estimated at 2.0 billion złoty.

fiscal tightening after the crisis. a scenario analysis

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