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DDTC Working Paper 1315
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2. Tax Policies during Economic Crisis: policy and a relaxed fiscal policy; and tight
Literature Review fiscal policy and expansive monetary policy.
However, in the long run the combination
whIle a decrease In complIance of expansive monetary policy (e.g. lowering
durInG The slowdown may have BI rate to spur credit growth) and tight
some counTercyclIcal effecTs fiscal policy (e.g. increase effort to increase
on The economy, ToleraTInG and improve tax collection) has a healthier
noncomplIance Is noT an outcome in comparison to tight monetary
approprIaTe response To The policy combined with relaxed fiscal policy.
crIsIs because IT Is dIsTorTIonary, This is because the policy leads to crowding
InequITable, and perhaps mosT in of investment from the private sector and
ImporTanTly, hampers The possibility to generate more outputs (see
Figure 1 below).
rebuIldInG of Tax bases over The
medIum-Term. To understand the conclusion from the
matrix, one should also take into account
2.1 Fiscal and Monetary Policy-Mix timing of policy execution and stage of
the economy. Although from the model, a
Disbursement in total government combination of expansive monetary policy
spending has been pro-cyclical to economic and tight fiscal policy is the right option, it
growth. The effectiveness of fiscal policy applies only in the long run. In the short and
will depend on the pace of the disbursement medium terms, the government might use
of discreationary spending and macro expansive fiscal policy to bring the economy
prudential policies taken by the monetary to its potential level; and maintain sizeable
authority. Several empirical studies have monetary policy to stabilize inflation and
been conducted to determine the impact of currency fluctuation.
monetary and fiscal coordination. A popular
method involves game theory approach in Figure 1 - Sustainable Policy Mix
ascertaining the absence of monetary and in the Long-Run
fiscal policy coordination.
r
Table 1 - Monetary and Fiscal Game Theory LM
Expansive
Tight Monetary Monetary LM
Policy 1
Policy
Tight
Fiscal Tight Fiscal Policy Low Inflation
Policy
Expansive
Fiscal Less Employment Moderate Inflation
Policy IS 1 IS
Source: Bennet, H and Norman Loayza (2002),”Policy Biases When
the Monetary and Fiscal Authorities Have Different Objectives”, in the y
book Monetary Policy: Rules and Transmission Mechanism, Norman
Loayza and Klaus Shmidt-Hebbel (ed.). Santiago, Chile, Central Bank
of Chile.
Note: IS stands for Investment and Saving (Fiscal Policy); whereas
LM is Liquidity of Money (Monetary policy). r is real interest rate and
y is GDP (Gross Domestic Product). Theoretically, as real interest
rate decrease, private investment will increase as the cost of fund of
Bennet and Loayza assumed that there borrowing will be lower.
are two policy options in each policy
authority, namely tight and expansive
policy. If both authorities opt for tight policy, Based on the Marginal Efficiency of
inflation will low but with fewer jobs for Investment (MEI), a decline of real interest
the workforce. If both authorities decide rate will spur more credit growth by enticing
on relaxed policy, inflation will be high and more firms to borrow and generating their
unemployment low. Additionally, if one of investments for further economic growth.
the policies is tight and other is expansive, This is what famously known as “private
both inflation and unemployment will tend sector crowding-in’. In addition, degree
to be moderate. The Nash Equilibrium in this of capital mobility affects monetary-fiscal
game, therefore, consists of a tight monetary policy effectiveness. Private and bank flows
