Macroeconomic Effects of Simultaneous Implementation of Reforms

• DOI: http://doi.org/10.1111/infi.12082
• Author: Massimiliano Pisani,Alessandro Notarpietro,Andrea Gerali
• Date: 01 April 2016
• Published date: 01 April 2016

Macroeconomic Effects of

Simultaneous Implementation

of Reforms

Andrea Gerali, Alessandro Notarpietro

and Massimiliano Pisani

Bank of Italy, Modelling and Forecasting Division, Rome, Italy.

Abstract

This paper evaluates the macroeconomic effects of simultaneously

implementing growth-friendly fiscal consolidation and competition-

friendly reforms in one European country by simulating a dynamic

general equilibrium model. Our results are as follows. First, in the case

of joint implementation, the increase in gross domestic product (GDP)

is larger than the sum of GDP increases obtained from implementing

reforms separately. Growth-friendly public debt consolidation uses

lower interest payments in the long run to permanently reduce tax

The views expressed in this pape r are those of the authors alone and should not be attributed to the

Bank of Italy. We thank Giuseppe Ferrero, Samuel Hurtado, Henrik Kucser a, Alberto Locarno, Eva

Ortega, Mate Toth and participants in the Magyar Nemz eti Bank 12th Macroeconomic Policy Research

Workshop on ‘Growth, Rebalancing and Macroeconomic Adjustm ent after Large Shock s’(2013), a

Bank of Italy seminar (2014), the Royal Econ omic Society Conference (20 14), the Working Group on

Econometric Modelling of th e European System of Central Banks (2014 ), the Central Bank Macroeco-

nomic Modelling Workshop (2014) and the Banco de E spa~

na-Banque de France Research Conference

‘Structural Reforms in the Wake of Recovery: Where Do We Stand’? (2015) . This is a revised version

of a paper previously circu lated as ‘Macroeconomic effects of simultaneous i mplementation of reforms

after the crisis’.

International Finance 19:1, 2016: pp. 42–65

DOI: 10.1111/infi.12082

© 2016 John Wiley & Sons Ltd

rates, and competition-friendly reform expands the tax base, allowing

for further rate reductions. Second, the medium-term output loss

associated with the temporary increase in taxes during the fiscal

consolidation is mitigated by its implementation alongside the compe-

tition-friendly reform, whose expansionary effects limit the tax rate

increase. Third, in the short run (the first two years), all measures

imply a macroeconomic cost in terms of output loss, which is smaller

than the permanent output gain in the long run.

Fiscal consolidation should be designed in a g rowth friendly manner whi le structural reforms

will boost potential g rowth.

ECB President Mario Drag hi, (2014).

I. Introduction

Two legacies of the recent European sovereign crisis are the high level of public de bt

and persistently wea k economic performan ce. They are clo sely related and likely to

condition European econom ic growth and pol icy for several yea rs to come. ‘Growth-

friendly’public debt consolidati on that allows lower taxation in the lon g run should

be achieved by limiting the short- and medium-run increase in tax rates, which

could further jeopa rdize European economic perform ance (according to the Euro-

pean Union Europe 2020 Strategy, ‘raising taxes on labour, as has occurred in the

past at great costs to jobs, should be avoided’).

1

At the same time, competit ion-

friendly reforms can f avour economic growth and, thus, e xpand the tax base an d

limit the increase in tax rate s needed to improve public finances. All in all, the close

connection be tween public debt sustainability a nd growth performa nce calls for

possible syner gies across policies to foster a str uctural (supply-side) improvement of

the European economy.

This paper evaluates the mac roeconomic effects of simult aneously implementi ng

growth-friendly fiscal consolidation an d competition-fri endly reforms in one Euro-

pean country. The assessment is based on simulating a three-countr y large-scale

New Keynesian dynamic gen eral equilibrium m odel of one country in the euro area

(labelled ‘Home’), the rest of the eu ro area (REA) and the rest of the world ( RW)

economy, akin to the Eurosystem EAGLE model (Euro Area and Global Econ omy

model, see Gomes et al. 2010).

2

The euro area (EA) is a two-reg ion monetary u nion

and, therefore, has a common m onetary pol icy and nominal exch ange rate against

1

See European Commission (201 0).

2

See also the Global Economi c Model developed at the Internati onal Monetary Fund (Lax ton and

Pesenti 2003 and Pesenti 2008) and th e New Area Wide Model developed at the European Centr al

Bank (Christoffel et al. 2 008; Coenen et al. 2008 ).

Simultaneous Implementation of Reforms 43

© 2016 John Wiley & Sons Ltd