The Costs of Fiscal Thrift

The deepening economic crisis in the euro-area has brought thrift measures to the fore of economic policy debate. Most European countries anticipate rising levels of age-related spending in the decades to come, calling for some measure of austerity to ensure fiscal sustainability, but in most of these countries, there are few signs of a resumption of economic growth. Since raising more revenue and saving on public expenditure comes with a price, a comprehensive evaluation of the structure of the whole tax system and the effects of public spending is called for. Finland has weathered the crisis remarkably well compared to most EU-countries – or at least her public finances have – but she is also facing the problems and fiscal pressures of a rapidly declining working-age population and the growing costs of an ageing population. These concerns have lead to a lively debate on the extent of a sustainability gap, and to measures aimed at keeping the gap at bay by increasing taxes and curbing public spending. The aim of this study is to compare the welfare costs of improving fiscal stance by raising revenue with different types of taxes, as well as by cutting public spending. We provide a framework that can be used in the evaluation of thrift. We use the Finnish economy as an example, focussing on the effects of tax hikes taking effect from 2013 on, comprising both income taxes and value added taxes. We also take into account the spending cuts taking effect in 2013. The cuts reduce government spending on certain central government functions and on education, as well as slashing certain subsidies and public investments. Our analysis introduces several extensions on standard models. We are using VATTAGE, an AGE model of the Finnish economy, to compare the welfare effects of the policies designed to reduce Finland’s budget deficits by using the concept of marginal cost of funds (MCF). VATTAGE is a MONASH-style model of Finland documented in Honkatukia (2009). However, unlike the original MONASH model, VATTAGE has been extended to include leisure and savings choice in the specification of household behaviour. We also allow for differences between household behaviour between income deciles. These extensions are necessary for useful MCF calculations because the essence of these calculations is tax-induced distortions in choices between consumption, leisure and savings, and because the progressivity of income taxation. As to the effects of cuts in public spending, unlike most AGE models that treat the public sector essentially as a burden to the economy, we have modified the model to account for the direct utility effects from free public provision of educational, health care and social services, a characteristic of most Nordic “welfare states”. Under this set-up, cuts in these services will have a two-fold effect: they will reduce the welfare costs of financing public services, but they will also have a negative, direct impact on consumers’ utility. A third effect is to encourage demand for privately provided services. We shall use the concept of Marginal Cost of Funds (MCF) to try and internalize the overall welfare implications of fiscal thrift. Underlying our interest for using this measure is the well-known result from general equilibrium theory, found in e.g. Dahlby (2008) and Liu (2004), that interactions between different taxes as well as the changes in the cost of public sector production induced by a tax reform will have an effect on MCF. When the government raises taxes, or cuts spending, all its revenues will be affected, which we feel calls for the use of a general efficiency measure. MCF compares the welfare effects of taxes and government spending to their revenue implications.