Jan Hagemejer, Tomasz Jędrzejowicz, Zbigniew Żółkiewski – Fiscal tightening after the crisis. A scenario analysis for Poland

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Bank i Kredyt 42 (3), 2011, 33–60

www.bankandcredit.nbp.pl www.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.

Abstract

Poland 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: jan.hagemejer@nbp.pl.

#_{National Bank of Poland, Economic Institute.} ‡ _{National Bank of Poland, Economic Institute.}

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J. Hagemejer, T. Jędrzejowicz, Z. Żółkiewski

34 1. Introduction

1

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–}

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Fiscal tightening after the crisis...

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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}

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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}

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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 1

Social 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}

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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 2

Composition 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

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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 3

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

2011 2012 2013 Total Revenue side

VAT 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 -0.2 Deficit 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}

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40 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 om+ m m wo mw p z x mw x m wo = = l m m l m ml mn q a v mn v m ml m a m l q + o oj j j wo wj q td m j wo oj q j td + = f hf hf i ih h W S PTR YT h YT hf W S hf ih PTR h YD IT _h h TS + = hp hp hp h h h YD Q D TS EY hp Q Dhp ( S ) hp hp L Dhp hp LU ) ( _hp _hp hp hp L D LU S = + + = l hl hn h h hl hn q ey d hp hp hp SUBST W Q =(1 ) SUBST_hp t t t t PI TS DPR CAP CAP +1= ₍₁ ₎+

∑

λ λ m ml λ ε ε λ λ _ _ _ _ _ ε γ where + = o om m m wo mw p z x mw x m wo = = l m m l m ml mn q a v mn v m ml m a m l q + o oj j j wo wj q td m j wo oj q j td + = f hf hf i ih h W S PTR YT h YT hf W S _hf ih PTR h YD IT _h h TS + = hp hp hp h h h YD Q D TS EY hp Q Dhp ( S ) hp hp L D_hp hp LU ) ( hp hp hp hp L D LU S = + + = l hl hn h h hl hn q ey d hp hp hp SUBST W Q =(1 ) SUBST_hp t t t t PI TS DPR CAP CAP +1 = ₍₁ ₎+

∑

λ λ m ml λ ε ε λ λ _ _ _ _ _ ε γ

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

+ = o om m m wo mw p z x mw x m wo = = l m m l m ml mn q a v mn v m ml m a m l q + o oj j j wo wj q td m j wo oj q j td + = f hf hf i ih h W S PTR YT h YT hf W S hf ih PTR h YD IT _h h TS + = hp hp hp h h h YD Q D TS EY hp Q Dhp ( S ) hp hp L Dhp hp LU ) ( hp hp hp hp L D LU S = + + = l hl hn h h hl hn q ey d hp hp hp SUBST W Q =(1 ) SUBST_hp t t t t PI TS DPR CAP CAP +1= ₍₁ ₎+

∑

λ λ m ml λ 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 z_m 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 mwo om m mw p z x mw x m wo = = l m m l m ml mn q a v mn v m ml m a m l q + o oj j j wo wj q td m j wo oj q j td + = f hf hf i ih h W S PTR YT h YT hf W S hf ih PTR h YD IT _h h TS + = hp hp hp h h h YD Q D TS EY hp Q Dhp ( S ) hp hp L Dhp hp LU ) ( _hp _hp hp hp L D LU S = + + = l hl hn h h hl hn q ey d hp hp hp SUBST W Q =(1 ) SUBST_hp t t t t PI TS DPR CAP CAP +1 = ₍₁ ₎+

∑

λ λ m ml λ ε ε λ λ _ _ _ _ _ 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.

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where: + = _o mwo om m mw p z x mw x m wo = = l m m l m ml mn q a v mn v m ml m a m l q + o oj j j wo wj q td m j wo oj q j td + = f hf hf i ih h W S PTR YT h YT hf W S hf ih PTR h YD IT _h h TS + = hp hp hp h h h YD Q D TS EY hp Q Dhp ( S ) hp hp L Dhp hp LU ) ( _hp _hp hp hp L D LU S = + + = l hl hn h h hl hn q ey d hp hp hp SUBST W Q =(1 ) SUBST_hp t t t t PI TS DPR CAP CAP +1= ₍₁ ₎+

∑

λ λ m ml λ ε ε λ λ _ _ _ _ _ ε γ

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

+ = _o mwo om m mw p z x mw x m wo = = l m m l m ml mn q a v mn v m ml m a m l q + o oj j j wo wj q td m j wo oj q j td + = f hf hf i ih h W S PTR YT h YT hf W S hf ih PTR h YD IT _h h TS + = hp hp hp h h h YD Q D TS EY hp Q Dhp ( S ) hp hp L Dhp hp LU ) ( _hp _hp hp hp L D LU S = + + = l hl hn h h hl hn q ey d hp hp hp SUBST W Q =(1 ) SUBST_hp t t t t PI TS DPR CAP CAP +1 = ₍₁ ₎+

∑

λ λ m ml λ ε ε λ λ _ _ _ _ _ ε γ

– the own and cross elasticities of factor demand, + = _o mwo om m mw p z x mw x m wo = = l m m l m ml mn q a v mn v m ml m a m l q + o oj j j wo wj q td m j wo oj q j td + = f hf hf i ih h W S PTR YT h YT hf W S hf ih PTR h YD IT _h h TS + = hp hp hp h h h YD Q D TS EY hp Q Dhp ( S ) hp hp L Dhp hp LU ) ( _hp _hp hp hp L D LU S = + + = l hl hn h h hl hn q ey d hp hp hp SUBST W Q =(1 ) SUBST_hp t t t t PI TS DPR CAP CAP +1 = ₍₁ ₎+

∑

λ λ m ml λ ε ε λ λ _ _ _ _ _ ε γ

– the rate of technical progress in the production of good m.

In the above equation,

+ = o om m m wo mw p z x mw x m wo = = l m m l m ml mn q a v mn v m ml m a m l q + o oj j j wo wj q td m j wo oj q j td + = f hf hf i ih h W S PTR YT h YT hf W S hf ih PTR h YD IT _h h TS + = hp hp hp h h h YD Q D TS EY hp Q Dhp ( S ) hp hp L D_hp hp LU ) ( hp hp hp hp L D LU S = + + = l hl hn h h hl hn q ey d hp hp hp SUBST W Q =(1 ) SUBST_hp t t t t PI TS DPR CAP CAP +1 = ₍₁ ₎+

∑

λ λ m ml λ 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 m _om _m wo mw p z x mw x m wo = = l m m l m ml mn q a v mn v m ml m a m l q + o oj j j wo wj q td m j wo oj q j td + = f hf hf i ih h W S PTR YT h YT hf W S hf ih PTR h YD IT _h h TS + = hp hp hp h h h YD Q D TS EY hp Q Dhp ( S ) hp hp L Dhp hp LU ) ( hp hp hp hp L D LU S = + + = l hl hn h h hl hn q ey d hp hp hp SUBST W Q =(1 ) SUBST_hp t t t t PI TS DPR CAP CAP+1 = ₍₁ ₎+

∑

λ λ m ml λ ε ε λ λ _ _ _ _ _ ε γ where: + = o om m m wo mw p z x mw x m wo = = l m m l m ml mn q a v mn v m ml m a m l q + o oj j j wo wj q td m j wo oj q j td + = f hf hf i ih h W S PTR YT h YT hf W S_hf ih PTR h YD ITh h TS + = hp hp hp h h h YD Q D TS EY hp Q D_hp ( S ) hp hp L Dhp hp LU ) ( hp hp hp hp L D LU S = + + = l hl hn h h hl hn q ey d hp hp hp SUBST W Q =(1 ) SUBSThp t t t t PI TS DPR CAP CAP +1= ₍₁ ₎+

∑

λ λ m ml λ ε ε λ λ _ _ _ _ _ ε γ

– the so called Armington (own and cross) elasticities of demand, + = o om m m wo mw p z x mw x m wo = = l m m l m ml mn q a v mn v m ml m a m l q + o oj j j wo wj q td m j wo oj q j td + = f hf hf i ih h W S PTR YT h YT hf W S hf ih PTR h YD IT _h h TS + = hp hp hp h h h YD Q D TS EY hp Q Dhp ( S ) hp hp L D_hp hp LU ) ( _hp _hp hp hp L D LU S = + + = l hl hn h h hl hn q ey d hp hp hp SUBST W Q =(1 ) SUBST_hp t t t t PI TS DPR CAP CAP +1 = ₍₁ ₎+

∑

λ λ m ml λ 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 om m m wo mw p z x mw x m wo = = l m m l m ml mn q a v mn v m ml m a m l q + o oj j j wo wj q td m j wo oj q j td + = f hf hf i ih h W S PTR YT h YT hf W S hf ih PTR h YD IT _h h TS + = hp hp hp h h h YD Q D TS EY hp Q Dhp ( S ) hp hp L Dhp hp LU ) ( _hp _hp hp hp L D LU S = + + = l hl hn h h hl hn q ey d hp hp hp SUBST W Q =(1 ) SUBST_hp t t t t PI TS DPR CAP CAP +1 = ₍₁ ₎+

∑

λ λ m ml λ 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 mwo om m mw p z x mw x m wo = = l m m l m ml mn q a v mn v m ml m a m l q + o oj j j wo wj q td m j wo oj q j td + = f hf hf i ih h W S PTR YT h YT hf W S hf ih PTR h YD IT _h h TS + = hp hp hp h h h YD Q D TS EY hp Q Dhp ( S ) hp hp L Dhp hp LU ) ( _hp _hp hp hp L D LU S = + + = l hl hn h h hl hn q ey d hp hp hp SUBST W Q =(1 ) SUBST_hp t t t t PI TS DPR CAP CAP+1 = ₍₁ ₎+

∑

λ λ m ml λ ε ε λ λ _ _ _ _ _ ε γ where: + = o om m m wo mw p z x mw x m wo = = l m m l m ml mn q a v mn v m ml m a m l q + o oj j j wo wj q td m j wo oj q j td + = f hf hf i ih h W S PTR YT h YT hf W S hf ih PTR h YD IT _h h TS + = hp hp hp h h h YD Q D TS EY hp Q Dhp ( S ) hp hp L Dhp hp LU ) ( _hp _hp hp hp L D LU S = + + = l hl hn h h hl hn q ey d hp hp hp SUBST W Q =(1 ) SUBST_hp t t t t PI TS DPR CAP CAP +1 = ₍₁ ₎+

∑

λ λ m ml λ ε ε λ λ _ _ _ _ _ ε γ

– the taxable income, + = o om m m wo mw p z x mw x m wo = = l m m l m ml mn q a v mn v m ml m a m l q + o oj j j wo wj q td m j wo oj q j td + = f hf hf i ih h W S PTR YT h YT hf W S hf ih PTR h YD IT h h TS + = hp hp hp h h h YD Q D TS EY hp Q Dhp ( S ) hp hp L D_hp hp LU ) ( hp hp hp hp L D LU S = + + = l hl hn h h hl hn q ey d hp hp hp SUBST W Q =(1 ) SUBST_hp t t t t PI TS DPR CAP CAP +1 = ₍₁ ₎+

∑

λ λ m ml λ ε ε λ λ _ _ _ _ _ ε γ and + = o om m m wo mw p z x mw x m wo = = l m m l m ml mn q a v mn v m ml m a m l q + o oj j j wo wj q td m j wo oj q j td + = f hf hf i ih h W S PTR YT h YT hf W S hf ih PTR h YD IT _h h TS + = hp hp hp h h h YD Q D TS EY hp Q Dhp ( S ) hp hp L Dhp hp LU ) ( _hp _hp hp hp L D LU S = + + = l hl hn h h hl hn q ey d hp hp hp SUBST W Q =(1 ) SUBST_hp t t t t PI TS DPR CAP CAP +1 = ₍₁ ₎+

∑

λ λ m ml λ 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 om m m wo mw p z x mw x m wo = = l m m l m ml mn q a v mn v m ml m a m l q + o oj j j wo wj q td m j wo oj q j td + = f hf hf i ih h W S PTR YT h YT hf W S _hf ih PTR h YD IT h h TS + = hp hp hp h h h YD Q D TS EY hp Q D_hp ( S ) hp hp L Dhp hp LU ) ( hp hp hp hp L D LU S = + + = l hl hn h h hl hn q ey d hp hp hp SUBST W Q =(1 ) SUBSThp t t t t PI TS DPR CAP CAP +1= ₍₁ ₎+

∑

λ λ m ml λ ε ε λ λ _ _ _ _ _ ε γ

– the transfers received from all other institutions i.

The disposable income

+ = o om m m wo mw p z x mw x m wo = = l m m l m ml mn q a v mn v m ml m a m l q + o oj j j wo wj q td m j wo oj q j td + = f hf hf i ih h W S PTR YT h YT hf W S hf ih PTR h YD IT _h h TS + = hp hp hp h h h YD Q D TS EY hp Q Dhp ( S ) hp hp L Dhp hp LU ) ( _hp _hp hp hp L D LU S = + + = l hl hn h h hl hn q ey d hp hp hp SUBST W Q =(1 ) SUBST_hp t t t t PI TS DPR CAP CAP +1 = ₍₁ ₎+

∑

λ λ m ml λ ε ε λ λ _ _ _ _ _ ε γ

is obtained by applying the income tax rate

∑

λ λ m ml λ ε ε λ λ _ _ _ _ _ ε γ

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

∑

λ λ m ml λ 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:

Jan Hagemejer, Tomasz Jędrzejowicz, Zbigniew Żółkiewski – Fiscal tightening after the crisis. A scenario analysis for Poland

Fiscal tightening after the crisis. A scenario

analysis for Poland