A DSGE model of fiscal stabilizers and informality in Sub-Sahara Africa

Abstract

This paper investigates the effects of fiscal impulses on macroeconomic variables within a New-Keynesian DSGE framework featuring an informal economy that allows for the examination of the effectiveness of automatic stabilizers in stimulating some selected sub-Saharan African (SSA) economies during crises. Stabilizers were modelled such that fiscal instruments react to their own lagged values and the official sector output. The results indicate that tax hikes lead to sizeable tax evasion and reallocation of factor inputs from the official sector to the shadow sector making the standard aggregate estimates of fiscal policies ineffective while government spending shocks slow down activities in the shadow sector. The findings also showed that automatic stabilizers on government spending (income taxes) stabilized the economy by reducing (raising) output levels even in the presence of the shadow economy. For policy implications, effective implementation of government policies should incorporate the informal sector in macroeconomic modelling, especially for countries with a large informal sector.

Keywords:

• Fiscal policy
• automatic stabilizers
• informality
• DSGE models
• Sub-Sahara Africa

JEL codes:

• D58
• E12
• E26
• E52
• E62

Acknowledgements

No fund or grant was received for this study.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1. See contributions from (Albonico et al., 2016; Basile et al., 2016; Bhattarai & Trzeciakiewicz, 2017; Christiano et al., 2011; Coenen et al., 2012; Faia et al., 2013; Hemming et al., 2002).

2. Fiscal gap variable is defined as the difference between the variable value (output) in the case with fiscal stabilizers and the variable value in the case without fiscal stabilizers.

3. Smets and Wouters (2003, 2007) followed a partial indexation of prices.

4. Superscript i are ignored here.

5. The investment adjustment cost function is given by:

$S\left(\frac{i_t^i}{i_{t-1}^i}\right)=\frac{{\kappa }^I}{2}(\frac{i_t^i}{i_{t-1}^i}-1{)}^2$

In the steady state, $S\left(1\right)=S\prime \left(1\right)=0$, $S\left(1\right)>0\equiv \varpi$ with $\varpi$ being the adjustment cost parameter.

6. We assume a stochastic shock to the price of investment to affect only the official sector for tractability.

7. In the steady state, utilization cost function implies that: $u_s^i=1$ and $a\left(1\right)=0$.

8. In the official sector, consumption tax drives a wedge between final goods price set by firms and the corresponding consumption price.

9. See, Gali (2008). The labour market equilibrium requires that $w_t^i=mr{s}_t^i$, where $mr{s}_t=-U_{l,t}^i/U_{c,t}^i$ is the marginal rate of substitution between consumption and labour supplied in period $t+n$ for the households. This means that the official and shadow sector would pay the same consumption wage to workers.

10. A detailed derivations of all the first order conditions are available upon request.

11. In the steady state, we impose that $\frac{g_s}{y_s^o}=gs$ in order to obtain the public consumption-output ratio.

12. See, Coenen et al. (2012, 2013) for similar discussions. Here, the study does not necessarily consider feedback on debt and output but we assume the economy to react to fiscal shocks. Albonico et al. (2016) argued that a more restricted model without the feedbacks is better specified than models with fiscal reaction functions. Therefore, by considering fiscal shocks the model stability is obtained because the implicit lump-sum taxation ensures government solvency.

13. To the best of our knowledge, none of the empirical literature on SSA countries have estimated these feedback rule parameters. The study uses the parameter values from Coenen et al. (2012, 2013) and Corsetti et al. (2012) as a proxy for this work.

14. That is, deviation of inflation rate from the inflation target.

15. We note here that, the official sector resource constraint incorporates the government expenditure.

16. Through a straight forward manipulation using (9) and (10) we obtain steady state $SH$ as:

$SH=\frac{y_s^u}{y_s^o}=\frac{1-{\phi }_c}{{\phi }_c}(\frac{P_s^u}{P_s^o\left(1+{\tau }^c\right)}{)}^{-{ }_c}\frac{\left(1-i_s^o/y_s^o-g_s\right)}{\left(1-i_s^u/y_s^u\right)}$

17. The full set of the first order conditions, steady state derivations and log-linearized equations are available upon request.

Additional information

Funding

The authors received no direct funding for this research.

Notes on contributors

Eric Amoo Bondzie

Eric Amoo Bondzie is currently a Lecturer at the Department of Economic Studies, University of Cape Coast – Ghana where he teaches both at the undergraduate and graduate levels. He holds a master’s degree in Economic Policy and Institutions from La Sapienza University of Rome and a PhD in Economics from the Catholic University of Milan all in Italy. His research areas are Macroeconomics, Monetary Economics, DSGE modelling and Time Series Econometrics.

Mark Kojo Armah

Mark Kojo Armah received his PhD in Economics at the University of Hull Business School’s Centre for Economic Policy in the U.K. He has consulting experiences with the AERC based in Nairobi, Kenya; and an active member of the American Economic Association. His research interest include exchange rate economics, energy economics, applied general equilibrium and poverty analysis in developing countries.