Dynamic Applied General Equilibrium Analysis for Fiscal Reconstruction Based on a Multi-sector Overlapping Generations Model

Author Name KIMURA Shin  (Hokkaido University) /HASHIMOTO Kyoji  (Faculty Fellow, RIETI)
Creation Date/NO. August 2008 08-J-041
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In this paper we use a multi-sector overlapping generations, life-cycle general equilibrium model to conduct a simulation analysis with regard to fiscal reconstruction in Japan. An overlapping generations life-cycle general equilibrium model is a dynamic model comprising a household sector that from a long-term perspective engages in consumption activity and provides a corporate sector with labor and capital, a corporate sector that engages in production activity, and a government sector that collects taxes and insurance premiums from households and firms, supplies public goods, and provides pensions and other forms of social security. This model enables us to conduct long-term simulations of the impact of policy changes, for example increases in consumption taxes and reductions of expenditure, on economic variables such as economic growth rates and levels of consumption by households. Hitherto, most life-cycle general equilibrium analyses in Japan have simplified the manufacturing sector as a single sector, making it impossible to give consideration to differences between the targets of expenditure cuts. A feature of this paper is that it makes this possible by extending this to multiple sectors.

A temporary shock seen in the results of the simulation in this paper is that an increase in consumption taxes causes a rise in GDP. This rise in GDP, however, is caused by an increase in the consumption of fixed capital, and national income declines. As regards differences in the methods of reducing expenditure, cuts in education spending and other government spending cause a greater reduction in gross production than reductions in public investment. This is because the reduction of public investment causes capital formation to decline and thus has a long-term negative impact on production activity, whereas the reduction of education spending and other such government spending has a negative impact directly on production activity at the time of the reduction. In the medium term, cases in which consumption taxes are increased make it possible to achieve high GDP, though in the long term GDP increases in cases in which public investment and education spending are reduced. Our analysis also shows that cases of reductions in other types of government spending are accompanied by lower GDP than in any of the other cases. As regards the ratio of public debt to GDP we find that there are only slight differences between the cases, but that it is lowest in cases of increases in consumption taxes, followed by the cases in which public investment is reduced.