## 5. Personal Income Tax Reduction

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### Context and objectives
- China (and other East Asian economies) seek to shift growth from investment- and export-led to higher private consumption to reduce risks from excess capacity, falling prices, and non-performing loans.
- Policy options analyzed: nominal exchange rate revaluation and fiscal measures (personal income tax cuts or government transfers).
- Key trade-offs highlighted: revaluation can increase consumption via cheaper imports but may raise real interest rates and affect ability of domestic investors to service debt; tax cuts can raise consumption but expand budget deficits and influence interest rates and FDI.

### Model structure and mechanisms
- General equilibrium model with:
  - n discrete time periods; agents optimize over a 2-period horizon with adaptive expectations thereafter.
  - 8 factors of production and 3 types of financial assets; five non-agricultural capital types.
  - Banking sector: at least one bank per non-agricultural sector; each bank holds 50 percent of its sector’s debt and the remainder uniformly across other sectors.
  - Bankruptcy rule: a sector defaults if present value of investment returns falls below debt service; bankrupt firms cannot invest.
  - Bank insolvency rule: if " percent of a bank's assets are in default then the bank is declared insolvent; regulators seize a fraction of deposits. (Simulation uses " = 8 percent.)
- FDI is endogenized as a function of:
  - past real GDP growth,
  - current domestic vs foreign nominal interest rate differential,
  - expected change in the exchange rate.
- Consumption channel: higher consumption reduces savings, raising interest rates and lowering asset prices, which tends to attract FDI; but a revaluation increases purchasing power and may increase consumption while having ambiguous effects on FDI.

### FDI estimation (panel evidence and elasticities)
- Estimation sample: panel of 11 developing Asian countries (1985–2005) for the main calibration; robustness checks with G20 and OECD sets.
- Dependent variable: first-differenced FDI (% GDP); independent variables: GDP growth (% annual), real interest rates (% annual), year-on-year average nominal devaluation (%).
- Key estimated elasticities (Table 1; three specifications: (1) Simple FE, (2) AR(1), (3) FGLS):
  - East Asia
    - efr (elasticity wrt real interest rates): 0.162, 0.186, 0.145
    - efg (elasticity wrt GDP growth): 0.198, 0.229, 0.179
    - efd (elasticity wrt nominal devaluation): 0.032, 0.039, 0.027
- Interpretation used in simulations:
  - A one percent higher real interest rate differential increases the change in FDI flows (%GDP) from the previous year by 0.2 percent (approximation from estimated efr).
  - A one percent nominal devaluation increases FDI flows by about 0.03 percent.
  - A one percent higher GDP growth increases FDI (%GDP change) by about 0.2 percent.

### Simulations and calibrated experiments
- Calibration uses China-stylized data for IO matrices and initial allocations; benchmark dynamics assume fixed exchange rate (period 1 rate as numeraire) and average foreign inflation of 2 percent in reported notes.
- Bank solvency threshold: 8 percent of assets in default triggers seizure of deposits.
- Base-case (Table 2; indices normalized):
  - Real GDP index across periods 1–8: 100.0, 107.2, 110.9, 119.0, 123.1, 132.0, 136.6, 146.2
  - Nominal GDP index across periods 1–8: 100.0, 127.5, 142.6, 183.4, 190.4, 244.9, 245.6, 315.7
  - Price Level index: 100.0, 118.9, 128.6, 154.1, 154.7, 185.6, 179.8, 216.0
  - Nominal rate (periods 1–8): 0.9, 2.7, 1.7, 7.4, 2.3, 10.5, 2.8, 12.6
  - Average annual inflation noted as 11.6 percent in the base simulation context.
  - Average real GDP growth over 8 years: 5.6 percent.
  - Budget deficit (% of GDP, periods 1–8): 7.7, 6.9, 9.3, 8.3, 10.6, 9.6, 9.8, 9.6
  - Trade balance (% of GDP, periods 1–8): 10.4, 7.5, 4.7, 2.1, 1.2, -1.1, -1.1, -3.2
  - FDI in Period 8 (index, Base period = 100): 105.4
  - No borrower defaults and no bank failures in base case.
- Revaluation experiments:
  - 9.5 percent annual revaluation (Table 3):
    - Real GDP index periods 1–8: 100.0, 107.0, 111.0, 119.0, 122.9, 131.3, 136.5, 146.1
    - Trade balance (% of GDP, periods 1–8): 10.3, 7.2, 4.1, 1.3, -1.2, -6.1, -5.5, -10.3
    - FDI in Period 8 (index): 95.4 (decline vs Base)
    - Some consumers experience welfare gains; no bank failures.
  - 10.0 percent annual revaluation (Table 4):
    - Real GDP index periods 1–8: 99.8, 107.1, 110.5, 118.2, 122.5, 131.3, 136.3, 145.6
    - Trade balance (% of GDP, periods 1–8): 10.3, 7.2, 4.1, -1.5, -1.1, -6.5, -5.9, -11.1
    - FDI in Period 8 (index): 94.6
    - By final period sector 2 defaults on its debts; sector 2 default spreads to banks, each bank exceeds the 8 percent failure rate → entire banking system collapse.
    - Despite banking collapse, consumers realized intertemporal utility increases driven by cheaper imports and increased leisure consumption; outcome deemed unsustainable.
- Personal income tax reduction experiment (Table 5):
  - Effective personal income tax reduced from 5 percent (assumed in base) to 3 percent.
  - Real GDP index periods 1–8: 100.3, 107.6, 110.9, 118.8, 123.0, 131.7, 136.1, 145.7
  - Nominal GDP index periods 1–8: 101.7, 129.4, 146.1, 187.9, 196.7, 253.0, 255.8, 328.7
  - Price Level index: 101.3, 120.3, 131.8, 158.1, 159.9, 192.1, 187.9, 225.6
  - Nominal rate periods 1–8: 1.2, 2.9, 2.0, 7.7, 2.6, 11.0, 3.0, 13.1
  - Budget deficit (% of GDP): 8.8, 8.0, 10.4, 9.5, 11.9, 10.9, 13.2, 12.0
  - Trade balance (% of GDP): 9.9, 7.3, 4.1, 1.6, 0.6, -1.6, -1.8, -3.8
  - FDI in Period 8 (index): 105.6 (slightly higher than Base)
  - No loan defaults and banking system remains solvent.
  - Welfare: Consumer 1 (urban) utility approximately same as in 9.5% revaluation; Consumer 2 lower than with revaluation. Overall tax cut increases consumption and yields general intertemporal welfare increases without financial failures.

### Main findings and policy implications
- Revaluations:
  - Can increase consumption by lowering import prices and raise welfare for some consumers.
  - Have ambiguous effects on FDI: nominal revaluation can reduce FDI by raising domestic asset prices; higher consumption via revaluation can attract FDI via lower asset prices from higher interest rates — net effect ambiguous and parameter-dependent.
  - Large or sustained revaluations can trigger banking crises by reducing returns to capital and precipitating borrower insolvencies (example: 10.0 percent annual revaluation → sectoral default → systemic bank failure).
- Fiscal policy (personal income tax cuts):
  - A targeted reduction in the personal income tax (from 5 percent to 3 percent in the experiment) can raise consumption and overall welfare without generating banking collapses in the simulations.
  - Tax cuts increase budget deficits and nominal interest rates, which can attract FDI; domestic investment may decline if real interest rates rise, but in the simulated tax-cut case no defaults occurred.
- Comparative assessment:
  - It is possible to achieve general intertemporal welfare increases without financial failures through fiscal measures (e.g., tax cuts or transfers).
  - Exchange rate revaluations may produce larger gains for particular consumer groups but risk financial instability if taken far enough.
- Recommendation (implied by simulation results):
  - Prefer fiscal instruments that directly boost household consumption (e.g., transfers, tax cuts) over large nominal revaluations when the policy objective is to raise consumption while maintaining financial stability.

### Key numeric facts and parameters used
- Bank insolvency threshold: 8 percent of assets in default.
- Base-case average annual real GDP growth over 8 years: 5.6 percent.
- Base-case average annual inflation referenced: 11.6 percent.
- Foreign (US) interest rate assumed in examples: 2 percent (contextual reference).
- Revaluation experiments: 9.5 percent annual revaluation; 10.0 percent annual revaluation.
- Personal income tax rate: base assumed effective rate 5 percent → experiment reduced to 3 percent.
- FDI elasticities for East Asia (three specifications):
  - efr: 0.162, 0.186, 0.145
  - efg: 0.198, 0.229, 0.179
  - efd: 0.032, 0.039, 0.027
- Base-case FDI index in Period 8 (Base period = 100): 105.4
- FDI index Period 8 under 9.5% revaluation: 95.4
- FDI index Period 8 under 10.0% revaluation: 94.6
- FDI index Period 8 under personal income tax reduction: 105.6
- Appendix consumption shares (Average 2001-05) examples:
  - China: Household 44.8, Government 14.1, Total 58.9
  - US: Household 71.0, Government 15.0, Total 86.0
- Appendix Gross National Savings and Investment (Average 2001-05) examples:
  - China: Savings 42.1, Investment 43.4
  - US: Savings 14.0, Investment 19.0

*Source: IMF working paper section "5. Personal Income Tax Reduction" (internal PDF content).*

### References .............................................................................................................

### References

### Tables

- 1. Elasticities of Changes in FDI Inflows with Respect to Real Interest Rates, Growth and Changes in Exchange Rate ............................................................................................ 21
- 2.      Base Case ................................................................................................................................. 23
- 3.      9.5 Percent Revaluation............................................................................................................ 24
- 4.      10.0 Percent Revaluation.......................................................................................................... 25

*Source: _wp07278 - References .............................................................................................................*

### 5.      Personal Income Tax Reduction...................................................................................

### 5.      Personal Income Tax Reduction

### Context and objectives
- China (and other East Asian economies) seek to shift growth from investment- and export-led to higher private consumption to reduce risks from excess capacity, falling prices, and non-performing loans.
- Policy options analyzed: nominal exchange rate revaluation and fiscal measures (personal income tax cuts or government transfers).
- Key trade-offs highlighted: revaluation can increase consumption via cheaper imports but may raise real interest rates and affect ability of domestic investors to service debt; tax cuts can raise consumption but expand budget deficits and influence interest rates and FDI.

### Model structure and mechanisms
- General equilibrium model with:
  - n discrete time periods; agents optimize over a 2-period horizon with adaptive expectations thereafter.
  - 8 factors of production and 3 types of financial assets; five non-agricultural capital types.
  - Banking sector: at least one bank per non-agricultural sector; each bank holds 50 percent of its sector’s debt and the remainder uniformly across other sectors.
  - Bankruptcy rule: a sector defaults if present value of investment returns falls below debt service; bankrupt firms cannot invest.
  - Bank insolvency rule: if " percent of a bank's assets are in default then the bank is declared insolvent; regulators seize a fraction of deposits. (Simulation uses " = 8 percent.)
- FDI is endogenized as a function of:
  - past real GDP growth,
  - current domestic vs foreign nominal interest rate differential,
  - expected change in the exchange rate.
- Consumption channel: higher consumption reduces savings, raising interest rates and lowering asset prices, which tends to attract FDI; but a revaluation increases purchasing power and may increase consumption while having ambiguous effects on FDI.

### FDI estimation (panel evidence and elasticities)
- Estimation sample: panel of 11 developing Asian countries (1985–2005) for the main calibration; robustness checks with G20 and OECD sets.
- Dependent variable: first-differenced FDI (% GDP); independent variables: GDP growth (% annual), real interest rates (% annual), year-on-year average nominal devaluation (%).
- Key estimated elasticities (Table 1; three specifications: (1) Simple FE, (2) AR(1), (3) FGLS):
  - East Asia
    - efr (elasticity wrt real interest rates): 0.162, 0.186, 0.145
    - efg (elasticity wrt GDP growth): 0.198, 0.229, 0.179
    - efd (elasticity wrt nominal devaluation): 0.032, 0.039, 0.027
  - OECD and G20 estimates reported for robustness; in those groups contemporaneous growth is the most robust correlate of FDI.
- Interpretation used in simulations:
  - A one percent higher real interest rate differential increases the change in FDI flows (%GDP) from the previous year by 0.2 percent (approximation from estimated efr).
  - A one percent nominal devaluation increases FDI flows by about 0.03 percent.
  - A one percent higher GDP growth increases FDI (%GDP change) by about 0.2 percent.

### Simulations and calibrated experiments
- Calibration uses China-stylized data for IO matrices and initial allocations; benchmark dynamics assume fixed exchange rate (period 1 rate as numeraire) and average foreign inflation of 2 percent in reported notes.
- Bank solvency threshold: 8 percent of assets in default triggers seizure of deposits.
- Base-case (Table 2; indices normalized):
  - Real GDP index across periods 1–8: 100.0, 107.2, 110.9, 119.0, 123.1, 132.0, 136.6, 146.2
  - Nominal GDP index across periods 1–8: 100.0, 127.5, 142.6, 183.4, 190.4, 244.9, 245.6, 315.7
  - Price Level index: 100.0, 118.9, 128.6, 154.1, 154.7, 185.6, 179.8, 216.0
  - Nominal rate (periods 1–8): 0.9, 2.7, 1.7, 7.4, 2.3, 10.5, 2.8, 12.6
  - Average annual inflation noted as 11.6 percent in the base simulation context.
  - Average real GDP growth over 8 years: 5.6 percent.
  - Budget deficit (% of GDP, periods 1–8): 7.7, 6.9, 9.3, 8.3, 10.6, 9.6, 9.8, 9.6
  - Trade balance (% of GDP, periods 1–8): 10.4, 7.5, 4.7, 2.1, 1.2, -1.1, -1.1, -3.2
  - FDI in Period 8 (index, Base period = 100): 105.4
  - No borrower defaults and no bank failures in base case.
- Revaluation experiments:
  - 9.5 percent annual revaluation (Table 3):
    - Real GDP index periods 1–8: 100.0, 107.0, 111.0, 119.0, 122.9, 131.3, 136.5, 146.1
    - Trade balance (% of GDP, periods 1–8): 10.3, 7.2, 4.1, 1.3, -1.2, -6.1, -5.5, -10.3
    - FDI in Period 8 (index): 95.4 (decline vs Base)
    - Some consumers experience welfare gains; no bank failures.
  - 10.0 percent annual revaluation (Table 4):
    - Real GDP index periods 1–8: 99.8, 107.1, 110.5, 118.2, 122.5, 131.3, 136.3, 145.6
    - Trade balance (% of GDP, periods 1–8): 10.3, 7.2, 4.1, -1.5, -1.1, -6.5, -5.9, -11.1
    - FDI in Period 8 (index): 94.6
    - By final period sector 2 defaults on its debts; sector 2 default spreads to banks, each bank exceeds the 8 percent failure rate → entire banking system collapse.
    - Despite banking collapse, consumers realized intertemporal utility increases driven by cheaper imports and increased leisure consumption; outcome deemed unsustainable.
- Personal income tax reduction experiment (Table 5):
  - Effective personal income tax reduced from 5 percent (assumed in base) to 3 percent.
  - Real GDP index periods 1–8: 100.3, 107.6, 110.9, 118.8, 123.0, 131.7, 136.1, 145.7
  - Nominal GDP index periods 1–8: 101.7, 129.4, 146.1, 187.9, 196.7, 253.0, 255.8, 328.7
  - Price Level index: 101.3, 120.3, 131.8, 158.1, 159.9, 192.1, 187.9, 225.6
  - Nominal rate periods 1–8: 1.2, 2.9, 2.0, 7.7, 2.6, 11.0, 3.0, 13.1
  - Budget deficit (% of GDP): 8.8, 8.0, 10.4, 9.5, 11.9, 10.9, 13.2, 12.0
  - Trade balance (% of GDP): 9.9, 7.3, 4.1, 1.6, 0.6, -1.6, -1.8, -3.8
  - FDI in Period 8 (index): 105.6 (slightly higher than Base)
  - No loan defaults and banking system remains solvent.
  - Welfare: Consumer 1 (urban) utility approximately same as in 9.5% revaluation; Consumer 2 lower than with revaluation. Overall tax cut increases consumption and yields general intertemporal welfare increases without financial failures.

### Main findings and policy implications
- Revaluations:
  - Can increase consumption by lowering import prices and raise welfare for some consumers.
  - Have ambiguous effects on FDI: nominal revaluation can reduce FDI by raising domestic asset prices; higher consumption via revaluation can attract FDI via lower asset prices from higher interest rates — net effect ambiguous and parameter-dependent.
  - Large or sustained revaluations can trigger banking crises by reducing returns to capital and precipitating borrower insolvencies (example: 10.0 percent annual revaluation → sectoral default → systemic bank failure).
- Fiscal policy (personal income tax cuts):
  - A targeted reduction in the personal income tax (from 5 percent to 3 percent in the experiment) can raise consumption and overall welfare without generating banking collapses in the simulations.
  - Tax cuts increase budget deficits and nominal interest rates, which can attract FDI; domestic investment may decline if real interest rates rise, but in the simulated tax-cut case no defaults occurred.
- Comparative assessment:
  - It is possible to achieve general intertemporal welfare increases without financial failures through fiscal measures (e.g., tax cuts or transfers).
  - Exchange rate revaluations may produce larger gains for particular consumer groups but risk financial instability if taken far enough.
- Recommendation (implied by simulation results):
  - Prefer fiscal instruments that directly boost household consumption (e.g., transfers, tax cuts) over large nominal revaluations when the policy objective is to raise consumption while maintaining financial stability.

### Key numeric facts and parameters used
- Bank insolvency threshold: 8 percent of assets in default.
- Base-case average annual real GDP growth over 8 years: 5.6 percent.
- Base-case average annual inflation referenced: 11.6 percent.
- Foreign (US) interest rate assumed in examples: 2 percent (contextual reference).
- Revaluation experiments: 9.5 percent annual revaluation; 10.0 percent annual revaluation.
- Personal income tax rate: base assumed effective rate 5 percent → experiment reduced to 3 percent.
- FDI elasticities for East Asia (three specifications):
  - efr: 0.162, 0.186, 0.145
  - efg: 0.198, 0.229, 0.179
  - efd: 0.032, 0.039, 0.027
- Base-case FDI index in Period 8 (Base period = 100): 105.4
- FDI index Period 8 under 9.5% revaluation: 95.4
- FDI index Period 8 under 10.0% revaluation: 94.6
- FDI index Period 8 under personal income tax reduction: 105.6
- Appendix consumption shares (Average 2001-05) examples:
  - China: Household 44.8, Government 14.1, Total 58.9
  - US: Household 71.0, Government 15.0, Total 86.0
- Appendix Gross National Savings and Investment (Average 2001-05) examples:
  - China: Savings 42.1, Investment 43.4
  - US: Savings 14.0, Investment 19.0

*Source: IMF working paper section "5. Personal Income Tax Reduction" (internal PDF content)._

### References

### _wp07278 - References

### Banking and financial stability
- Ball, S., and A. Feltenstein (2001), “Bank Failures and Fiscal Austerity: Policy Prescriptions for a Developing Country,” Journal of Public Economics, 82 (November), pp. 247-70.
- Blejer, M, E. Feldman, and A. Feltenstein (2002), “Exogenous Shocks, Contagion, and Bank Soundness:  A Macroeconomic Framework,” Journal of International Money and Finance, vol. 22, pp. 33-52.
- Calormiris, C., and B. Wilson (1998), “Bank Capital and Portfolio Management: The 1930's Capital Crunch and Scramble to Shed Risk,” NBER Working Paper No. W6649, July National Bureau of Economic Research.

### Foreign direct investment, multinational firms, and trade
- Bergstrand, J.H.and Egger, P. (2007), “A Knowledge-and-Physical-Capital Model of International Trade, Foreign Direct Investment, and Foreign Affiliate Sales: Developed Countries,” Journal of International Economics, 2007, forthcoming.
- Blonigen, B. A., (1997), “Firm-Specific Assets and the Link between Exchange Rates and Foreign Direct Investment,” American Economic Review, American Economic Association, vol. 87(3), pages 447-65.
- Blonigen, B. A., (2005), “A Review of the Empirical Literature on FDI Determinants,” NBER Working Paper No. W11299, National Bureau of Economic Research.
- Ekholm, K. & R. Forslid & J. Markusen, (2003), “Export-Platform Foreign Direct Investment,” NBER Working Papers 9517, National Bureau of Economic Research.
- Froot, K. A. & J. Stein, (1991), “Exchange Rates and Foreign Direct Investment: An Imperfect Capital Markets Approach,” The Quarterly Journal of Economics, MIT Press, vol. 106(4), pages 1191-217.
- Fung, K. C., H. Iizaka, & S. Parker, (2002), “Determinants of U.S. and Japanese Direct Investment in China”, Journal of Comparative Economics, Elsevier, vol. 30(3), pages 567-578.
- Hanson, G. H. & R. J. Mataloni, Jr. & M. J. Slaughter, (2001), “Expansion Strategies of U.S. Multinational Firms,” NBER Working Papers 8433, National Bureau of Economic Research.
- Leonard K.C. & Y. K. Kwan, (1998), “What Are The Determinants of The Location of Foreign Direct Investment? The Chinese Experience,” Finance Working Papers 174, East Asian Bureau of Economic Research. 
- Markusen, J. R. & K.E. Maskus, (1999), “Multinational Firms: Reconciling Theory and Evidence,” NBER Working Paper No. W7163, National Bureau of Economic Research.
- Markusen, J., C. Ekholm & R. Forslid, (2007), “Export-Platform Foreign Direct Investment,” Journal of the European Economic Association, MIT Press, vol. 5(4), pages 776-795. 
- Nunnenkamp, P. , (2002), “Determinants of FDI in Developing Countries: Has Globalization Changed the Rules of the Game?,” Kiel Institute for World Economics, Kiel Working Paper No. 1122. 
- Zhang, K. H. & S. Song, (2001), “Promoting Exports: the Role of Inward FDI in China,” China Economic Review, Elsevier, vol. 11(4), pages 385-396. 

### China, India, and regional studies
- Eichengreen, B. & H. Tong, (2005), “Is China’s FDI coming at the expense of other countries?” NBER Working Papers 11335, National Bureau of Economic Research.
- Feltenstein, A., S.M. Nsouli (2003), “‘Big Bang’ versus Gradualism in Economic Reforms: an Intertemporal Analysis with an Application to China,” IMF Staff Papers, Vol. 50, No.3, pp. 458-80. 
- Kuijs, L. (2005), “Investment and Saving in China,” Working Paper 3633, World Bank Policy Research.
- Lane, P.R. & S.L.  Schmukler, (2006), “The International Financial Integration of China and India,” CEPR Discussion Papers 5852, C.E.P.R. Discussion Papers.
- Whalley, J. & X. Xin, (2006), “China's FDI and Non-FDI Economies and the Sustainability of Future High Chinese Growth,” NBER Working Papers 12249, National Bureau of Economic Research.

### Theoretical and methodological contributions in macroeconomics
- Kydland, F., and E. Prescott (1977), “Rules Rather than Discretion: The Inconsistency of Optimal Plans,” Journal of Political Economy vol. 85, no. 3, June 1977, pp. 473-491.
- Strotz, R. (1956), “Myopia and Inconsistency in Dynamic Utility Maximization,” Review of Economic Studies, vol. 23 (3), no. 62, pp.165-180.

### IMF and global outlook publications
- Regional Economic Outlook: Asia and Pacific (2006), International Monetary Fund.
- World Economic Outlook (2005), International Monetary Fund.

*Source: _wp07278 - References*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2007/_wp07278.pdf_