Fiscal Policy and Debt Dynamics in Developing Countries

Utilizing a new database of tax rates, tax revenues and tax income-elasticities we contribute to the debate on the effects of …fiscal policyon economic activity in a number of ways. First, using both panelGMM and panel VAR methods, we …find that the effects of tax cuts onGDP growth are signi…ficant in developing countries. A tax cut thatlowers the personal income tax rate by one percentage point, or cutsrevenues by one percent of GDP causes an increase in GDP of 0.3-0.4%on impact and approximately 0.8% in the long run. Consistent withearlier studies using Structural VAR methods, the tax multiplier inhigh-income countries is small. We …find that cuts in personal incometaxes are more effective in stimulating growth than cuts in corporateor VAT rates. Second, using the methods of Favero and Giavazzi,2007 (FG) to incorporate debt dynamics into a …fiscal VAR, we …findthat debt dynamics signi…ficantly alter estimates of the impact of …fiscalpolicy on GDP in some countries. In other countries, as in FG's studyof the United States, the effects are negligible. Finally, we …find thatestimates of the multiplier on government consumption are in line withthe …findings of Ilzetzki, Mendoza and Végh, 2010 (multipliers are largerin high-income-, closed-, and …fixed-exchange-rate economies than indeveloping-, open-, and flexible-exchange rate economies, respectively)even after controlling for the effects of taxes in a panel VAR.[...]