Monday, March 09, 2009
FISCAL POLICY IN ECONOMIC CRISIS
A new study by IMF (link) suggests a framework for fiscal policy during recessionary periods. IMF admits that discretionary fiscal policy could further deteriorate economic recovery, increasing budget deficits and public debt which already reached new heights in G20 countries (link). It also suggets that vulnerabilities from financial markets should be addressed in preventing economic downturns. Agreeably, IMF does not suggest an introduction of large-scale entitlement programs which are politically almost impossible to reverse as well as an increase in public sector bill that could downsize productivity performance and exert a growing pressure on cost inflation. The study also concludes that industry-specific subsidies are harmful and could escalate protectionism. The study, however, does not recommend lower corporate tax rate, saying that tax reduction is likely to be ineffective leading to tax fraud. Numerous empirical studies have shown that high corporate tax rate is the primary reason for tax evasion, pushing private sector to move to jurisdictions with lower tax rates. And second, it would be suspicious to claim that corporate tax cut is ineffective because business profits are low. It is true that corporate tax reductions lead to higher tax multiplier and exert strong upward pressure during expansionary period, but that does not mean that corporate tax cut is ineffective during recessions. In fact, cutting taxes during recession eases the economic downturn as well as the pace of the recovery.