## _wp13133 — 10. Real Economy Response to a Permanent Decline in Tax Revenues

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---

### I. Introduction — objective and central finding
- Objective:
  - Model the tradeoff between investment and security spending in a low-income, conflicted economy (Afghanistan) and trace impacts of exogenous shocks (decline in foreign aid) or policy failures (lower domestic revenue yield) on fiscal stance, economic output, and poverty reduction.
- Framework:
  - Adaptation of IMF workhorse model for low-income countries (Buffie et al., 2012) with explicit government choice between security services and public infrastructure; both supply positive externalities and government aims to maximize social welfare.
- Central finding:
  - Mobilization of domestic revenue is the government’s best response to exogenous shocks that shrink the resource envelope. Raising additional taxes, despite distortionary effects on private consumption, helps offset shortfalls in foreign aid and maintain public service supply near original levels. Alternatives (debt financing or cutting public expenditures) risk sacrificing fiscal sustainability or public service supply and output.

### II. Afghanistan’s economic landscape — fiscal structure, security, and revenues
- Fiscal structure and donor dependence:
  - Estimated total public spending: 52 percent of gross domestic product (GDP).
  - Donors financed 31 percent of GDP via extra-budgetary operations ('off-budget') and provided 10 percent of GDP in grants directly to the Afghan budget ('on-budget').
  - Domestic revenue supplied the remaining 11 percent of GDP.
- Security spending and donor role:
  - Government spends an estimated 4 percent of GDP in 2012 of its own resources on security; an additional 20 percent of GDP is funded by donors.
  - Donors funded 60 percent of the on-budget costs of Afghan security forces in 2011.
  - Donors directly paid for costs of foreign troops in Afghanistan to the tune of US$ 12 billion (60 percent of GDP in 2011).
  - Afghanistan agreed to contribute up to 23 percent of its security costs (NATO/Chicago summit context).
- Maintenance and transition:
  - IMF and World Bank estimate cost of maintaining donor-built capital stock at 15 percent of GDP.
  - Transition: military draw-down began in 2012 and expected largely finalized by 2014; donors pledged US$16 billion through 2016 at the 2012 Tokyo Conference.
- Revenue prospects and constraints:
  - Domestic revenue quadrupled in absolute terms between 2005/06 and 2010/11.
  - IMF estimate (assuming stable security outlook): domestic revenues around 17 percent of GDP by 2025, donor support may account for 23 percent of GDP.
  - Potential revenue sources: mining revenues, VAT, excise duties, broadening tax base, reducing reliance on import duties and border taxes.
  - Debt financing constraints: government building a government bond market based on sukuk securities; success depends on domestic banking liquidity, foreign investor appetite, and security provision.

### III. Macroeconomic model — agents, technologies, and fiscal mechanisms
- Agents and sectors:
  - Households: savers and hand-to-mouth (fraction f = 0.6 are hand-to-mouth).
  - Producers: representative competitive firm with public services externality weight ψ = 0.27 and production shares αn = 0.8, αk = 0.1.
  - Government: public-agency (public-services producer) and treasury (revenue, funding, redistribution).
  - Rest of the world: R_w,t, P_w,t, Y_w,t set at long-run equilibrium levels ̄R_w, ̄P_w, ̄Y_w.
- Key behavioral and institutional features:
  - Public services G_t enter production as an externality with weight ψ.
  - Public services are produced as CRS substitutes from security H_t and infrastructure z_t; security share parameter φ = 0.9 in baseline (security overwhelmingly important).
  - Public investment efficiency s = 0.6; investment inefficiencies and cost overruns captured by Ω_t.
  - Financial frictions: capital imperfectly mobile via country risk premium prem = 0.1 and loan-to-value LV R = 0.02; foreign gross interest rate ̄R_w = 1.06 1/4.
  - Monetary policy: inflation-targeting with φ_π = 1.5 and π∗ = 0.

### IV. Baseline calibration and key macro ratios (selected)
- Baseline parameters (select):
  - β = 1/1.1; η = 0.2; δ (physical capital) = 0.03; δ z (infrastructure) = 0.3; δ d (security capital) = 0.2; χ = 0.8; ̄τ = 0.14; ρ d = 0.9; ω = 0.2; ǫ x = 2; ξ I = 20.
- Baseline GDP ratios (in percent):
  - Overall fiscal deficit: 0
  - Tax revenues: 11
  - Donors’ aid: 34
  - Private consumption expenditures: 75
  - Domestic goods: 30
  - Foreign goods: 45
  - Private fixed investment: 14
  - Government expenditures: 45
  - Infrastructure: 5
  - Security: 40
  - Trade deficit: 34
- Baseline fiscal and public investment features:
  - Foreign aid under baseline: 34 percent of domestic GDP.
  - Government preference for security investment to infrastructure in baseline driven by φ = 0.9 and δ_z = 0.3 > δ_d = 0.2.
  - Baseline fiscal balance: overall fiscal deficit (including grants) is zero.

### V. Long-run public investment multipliers (baseline balanced-budget, foreign aid sterilized)
- One dollar (unit) of each fiscal instrument yields the following long-run effects:
  - Gross domestic product:
    - Donors’ aid: 1.4
    - Security investment: 0.1
    - Infrastructure investment: 0.8
    - Sales tax revenues: 0
  - Private consumption expenditures:
    - Donors’ aid: 0.4
    - Security investment: 0.1
    - Infrastructure investment: 0.9
    - Sales tax revenues: -0.7
  - Private fixed investment:
    - Donors’ aid: 0.1
    - Security investment: -0.2
    - Infrastructure investment: 0
    - Sales tax revenues: (not listed)
  - Public investment:
    - Donors’ aid: 1.1
    - Security investment: 0.4
    - Infrastructure investment: 0.1
- Note: fiscal expansion financed by increasing tax revenues has no positive impact on macroeconomy in the baseline: an increase in tax revenues by one Afghani generates no real increase in economic activity—GDP and private investment remain unchanged due to distortionary consumption effects offsetting gains.

### VI. Fiscal experiments — design and three policy responses
- Two shocks analyzed:
  1. Permanent decline in foreign donors’ aid (scaled back by half in experiment).
  2. Permanent decline in tax revenues due to increased tax evasion (sales tax revenue share falls by 1 percentage point, from 11 percent to 10 percent of GDP).
- Three fiscal response options for each shock:
  - Debt financing policy:
    - Shortfall financed by issuance of domestic debt; all budget chapters unchanged; real public investment kept constant; effective tax rate unchanged.
  - Tax policy:
    - Government maintains balanced budget by increasing effective tax rate until balanced; government expenditures constant at initial steady-state levels.
  - Expenditure policy:
    - Government maintains balanced budget by scaling back public investment expenditures; debt and effective tax rate unchanged.

### VII. Experiment A — Permanent 50 percent cut in foreign aid (results and ranking)
- Overall outcome:
  - Sudden shortfall permanently shrinks the size of the economy; none of the three responses fully offsets negative impact.
- Comparative assessment:
  - Debt financing:
    - Minimizes contraction but leads to unsustainable debt. Public debt would reach 80 percent of GDP in ten years.
  - Tax increases (mobilization of domestic revenues):
    - Most favorable for economic outcomes.
    - Domestic sales tax increases more than two fold (from 10 to about 23 percent).
    - GDP level largely unchanged; over ten years projected to decline by 3 percentage points from its initial level.
    - Private consumption initially falls more than under expenditure cuts; three years into the shock both tax and expenditure cuts converge to a permanent decline in private consumption of 19 percentage points compared to baseline.
    - Dynamics include increased private borrowing (mostly foreign), country credit risk rise, and domestic currency depreciation of about 20 percent relative to baseline.
    - Imports fall and trade balance improves.
  - Cutting public investment expenditures:
    - Least favorable option.
    - Real GDP per capita permanently drops by about 5 percent relative to baseline over a decade.
    - Investment in security declines by 5 percent and investment in infrastructure declines by 10 percent compared to baseline.
    - Public disinvestment causes direct aggregate demand contraction and a negative externality equivalent to a negative TFP shock.
    - Trade balance improves as imports fall; domestic revenues slightly lower but larger expenditure cuts improve operating deficit as share of GDP.
- Policy ranking (qualitative):
  - Tax increases (domestic revenue mobilization) preferred for economic outcomes, subject to feasibility.
  - Debt financing preserves output but is fiscally unsustainable.
  - Expenditure cuts (public investment) produce largest long-run welfare losses.

### VIII. Experiment B — Permanent decline in tax revenues (1 percentage point sales-tax revenue drop)
- Shock specification:
  - Sales tax revenue share permanently declines by 1 percentage point, from 11 percent to 10 percent of GDP (modeled as lower effective tax rate).
- Aggregate first-round effect:
  - Lower effective tax rate is expansionary if public spending remains constant (higher disposable income → higher private consumption).
- Policy option outcomes:
  - Debt financing (to offset lower revenue):
    - Partially offsets expansionary effect as households increase permanent saving.
    - Private investment declines.
    - Net effect: mildly expansionary on real economy but results in permanently higher overall deficit and rising debt-to-GDP ratio.
    - Debt-to-GDP ratio rises by 6 percentage points by the end of the 10th year, reaching 62 percent and rising (accumulated debt over 10 years fiscally unsustainable).
    - Results in 0.3 percentage points lower real GDP compared to baseline.
  - Public investment cuts:
    - Negative externality of lower public spending offsets expansionary gain from evasion; strong negative effects similar to Experiment A.
  - Additional tax measures (increasing effective tax rate):
    - Will tend to offset the effect of evasion; because initial evasion-induced effect is expansionary, the required tax increase need not match the initial decline in magnitude to fully reverse the expansion.
- Summary judgment:
  - Debt financing and revenue measures are superior to cuts in public investment in this experiment; optimality of borrowing depends on shock magnitude and fiscal sustainability.

### IX. Robustness, feasibility, and model limitations
- General robustness:
  - Expenditure cuts in public investment are least preferred due to amplified negative effects from positive externalities of public goods.
  - Domestic revenue mobilization (broadening tax base, VAT, excise duties, mining, reducing tax evasion via administrative improvements) is the most preferred option, subject to feasibility.
- Feasibility caveats:
  - In the aid fall-by-50-percent experiment, effective tax rate would need to increase by 13 percentage points to 23 percent within a decade (more than doubling current rate).
  - Success depends on improvements in revenue administration given Afghanistan’s low revenue-to-GDP ratio and poor revenue administrations.
- Model limitations and extensions noted:
  - Did not consider cutting recurrent spending (wages), which could have lower negative effects than cutting investment but would require unrealistic wage cuts or retrenchment in security sector.
  - Evasion likely a function of tax rate in a poorly administered country (not modeled).
  - Uncertainty about domestic and global market tolerance for debt when starting from zero debt.
  - Partial equilibrium political economy and stability considerations not modeled.
- On borrowing:
  - Public borrowing on world capital markets is not sustainable for permanent revenue shortfalls given limited Afghan capacity to carry public debt.
  - Some scope exists for domestic issuance to develop markets, but without growth dividend debt servicing crowds out spending and leads to explosive debt path.

### X. Policy conclusions and research avenues
- Main policy message:
  - Public investment in security and development and sustained domestic revenue efforts reinforce one another in supporting growth.
  - Government needs to balance security and development spending as complements in raising living standards.
- Policy implications and priorities:
  - Mobilize domestic revenue where feasible (VAT, excises, mining royalties, administration improvements) before cutting public investment.
  - Avoid indiscriminate cuts to public investment given high multipliers and positive externalities of public services.
  - Use borrowing cautiously; preserve fiscal sustainability.
  - Consider combinations of policy alternatives rather than isolated responses.
  - Allocation of any public investment cuts should depend on returns to production of public services; current calibration gives predominance to security investment over infrastructure.
- Suggested avenues for future research:
  - Interaction between formal and informal economy and role of informal sector in financing current account and linking tax effort to informal sector size.
  - Impact of financial intermediaries (provision of credit).
  - Extending framework for endogenous growth to analyze long-term growth effects of public investment in security and infrastructure.

*Source: IMF working paper chapter "10. Real Economy Response to a Permanent Decline in Tax Revenues" (extracted from _wp13133).*

### 1. Savers ..............................................................................................................

### _wp13133 - 1. Savers ..............................................................................................................

### Major sections (chapter and subsection structure)
- 1. Savers ...................................................................................................................... 7
- 2. Hand-to-mouth Consumers ..................................................................................... 8
- 3. Aggregation ............................................................................................................. 9
- B. Domestic Producers ....................................................................................................... 9
- C. Imports .......................................................................................................................... 10
- D. Exporters ...................................................................................................................... 10
- E. Financial Intermediaries ............................................................................................... 11
- F. Monetary Policy ........................................................................................................... 11
- G. Government .................................................................................................................. 11
- 1. Government Agency: Public-services Producer ..................................................... 12
- 2. Treasury .................................................................................................................. 14
- H. The Rest of the World .................................................................................................. 14
- I. Market Clearing ............................................................................................................ 14

### Security and infrastructure investment; model calibration and experiments
- IV. Security and Infrastructure Investment in the Long and Short Run ................................... 15
  - A. Baseline Calibration ..................................................................................................... 15
  - B. Structure of Public Services ......................................................................................... 16
  - C. Public Investment Multipliers ...................................................................................... 17
  - D. Impact of Government Spending Shock ...................................................................... 17
- V. Fiscal Experiments ............................................................................................................. 18
  - A. Shortfall in Foreign Donors’ Aid ................................................................................. 18
  - B. Shortfall in Tax Revenues ............................................................................................ 20
  - C. Results Discussion ........................................................................................................ 21
- VI. Conclusion .......................................................................................................................... 22
- References ................................................................................................................................ 23

### Tables (listed)
- Table 1. Baseline Calibration ........................................................................................................... 24
- Table 2. Baseline GDP Rations (in percent) .................................................................................... 24
- Table 3. Selected Fiscally Relevant Long-run Multipliers ............................................................... 25

### Charts (listed)
- Chart 1. Model Schematics .............................................................................................................. 25
- Chart 2. Importance of Security, Output and Consumption ............................................................. 26
- Chart 3. The Effects of Changing Structure of Public Services ....................................................... 27
- Chart 4. The Effects of Depreciation on the Supply of Public Services .......................................... 28
- Chart 5. Impact of Government Spending Shock ............................................................................ 29
- Chart 6. Fiscal Response to Consumption Shock ............................................................................ 30
- Chart 7. Public Finance Response to a Permanent 50 Percent Cut in Foreign Aid ......................... 31
- Chart 8. Real Economy Response to a Permanent 50 Percent Cut in Foreign Aid .......................... 32
- Chart 9. Public Finance Response to a Permanent Decline in Tax Revenues ................................. 33

*Source: _wp13133 - 1. Savers (PDF content list provided).*

### 10. Real Economy Response to a Permanent Decline in Tax Revenues .................................. 34

### 10. Real Economy Response to a Permanent Decline in Tax Revenues

### I. INTRODUCTION
- Objective: Model the tradeoff between investment and security spending in a low-income, conflicted economy (Afghanistan) and trace impacts of exogenous shocks (decline in foreign aid) or policy failures (lower domestic revenue yield) on fiscal stance, economic output, and poverty reduction.
- Framework: Adaptation of IMF workhorse model for low-income countries (Buffie et al., 2012) with explicit government choice between security services and public infrastructure; both supply positive externalities and government aims to maximize social welfare.
- Central finding: Mobilization of domestic revenue is the government’s best response to exogenous shocks that shrink the resource envelope. Raising additional taxes, despite distortionary effects on private consumption, helps offset shortfalls in foreign aid and maintain public service supply near original levels. Alternatives (debt financing or cutting public expenditures) risk sacrificing fiscal sustainability or public service supply and output.
- Paper structure: Sections summarize Afghanistan’s situation, model apparatus, public sector behavior and allocation between infrastructure and security, fiscal experiments on (i) shortfall in foreign aid and (ii) increase in tax avoidance, and policy implications.

### II. AFGHANISTAN’S ECONOMIC LANDSCAPE
- Fiscal structure and donor dependence:
  - Estimated total public spending: 52 percent of gross domestic product (GDP).
  - Donors financed 31 percent of GDP via extra-budgetary operations ('off-budget') and provided 10 percent of GDP in grants directly to the Afghan budget ('on-budget').
  - Domestic revenue supplied the remaining 11 percent of GDP—i.e., one-fifth of Afghan public spending was funded from domestic means.
- Security spending:
  - Government spends an estimated 4 percent of GDP in 2012 of its own resources on security; an additional 20 percent of GDP is funded by donors.
  - Donors funded 60 percent of the on-budget costs of Afghan security forces in 2011.
  - Donors directly paid for costs of foreign troops in Afghanistan to the tune of US$ 12 billion (60 percent of GDP in 2011).
  - NATO/Chicago summit note: Afghanistan agreed to contribute up to 23 percent of its security costs (contextual pledge noted).
- Maintenance and transition challenges:
  - IMF and World Bank estimate cost of maintaining donor-built capital stock at 15 percent of GDP.
  - Transition (draw-down of foreign military and civilian engagement) has begun (military from 2012, expected largely finalized by 2014) and donor support may decline; donors pledged US$16 billion through 2016 at the 2012 Tokyo Conference.
  - Policymakers expect domestically produced security services to eventually be cheaper than foreign security services.
- Revenue prospects:
  - Domestic revenue quadrupled in absolute terms between 2005/06 and 2010/11.
  - IMF estimate (assuming stable security outlook): domestic revenues around 17 percent of GDP by 2025, donor support may account for 23 percent of GDP.
  - Potential revenue sources: mining revenues, VAT, excise duties, broadening tax base, reducing reliance on import duties and border taxes.
- Debt financing constraints:
  - Government building a government bond market based on sukuk securities; success depends on domestic banking liquidity, foreign investor appetite, and security provision.

### III. MACROECONOMIC MODEL — STRUCTURE & BEHAVIOR
- Agents and sectors: households (savers and hand-to-mouth), producers, government (treasury + public agency), and rest of the world. Model gauges output captured by GDP excluding informal sector.
- Households:
  - Two types:
    - Savers: maximize lifetime welfare from consumption and leisure; own capital K_s, invest in domestic sukuks D_t and foreign sukuks B_t; face consumption tax at time-varying rate τ_t; external habit formation parameter ̄C_s,t = ξ C_t−1 with 0 < ξ < 1.
    - Hand-to-mouth: consume all income each period; no savings or assets; utility without habits.
  - Consumption baskets for both groups are Leontieff (fixed proportions): domestic share ω and foreign share 1−ω; aggregate price level P_t = ω P_d,t + (1−ω) P_m,t.
  - Aggregation: fraction f are hand-to-mouth; aggregate variables are weighted sums, e.g., C_t = (1−f) C_s,t + f C_h,t.
- Producers:
  - Representative competitive firm maximizes profits subject to CES Cobb-Douglas production: Y_t = A (N_t)^αn (K_t−1)^αk (M^y_t)^(1−αn−αk) G_t^ψ with 0 < αn, αk < 1 and αn + αk = 1.
  - Public services G_t enter as a positive externality with weight ψ (ψ < αn to avoid endogenous growth).
  - First-order conditions yield factor demands proportional to shares αn, αk, and 1−αn−αk.
- Imports and exports:
  - Total imports M_t = C_f,t + M^y_t; import price P_m,t applies to both.
  - Exports X_t = ̄X (P_x,t /(P_w,t FX_t))^(−ε_x) Y_w,t with export price derived from terms of trade T_t = P_x,t / P_m,t; ε_x > 1.
- Financial intermediation:
  - Capital imperfectly mobile via a risk premium on foreign borrowing: R_l,t = R_w,t + cr_t.
  - Country risk premium cr_t = prem [ log( R_l,t B_t FX_t / P_k,t K_t ) − log(LVR) ] where LVR is loan-to-value ratio.
- Monetary policy:
  - Simple inflation-targeting rule: R_t = ρ_r R_t−1 + (1−ρ_r) [ ̄R + φ_π (π_t − π^*) ] with 0 < ρ_r < 1.
- Government:
  - Two parts: agency (public-services producer) and treasury (revenue collection, external funding, redistribution).
  - Treasury budget constraint (balanced): τ_t P_t (C_s,t + C_h,t) + FX_t T^d_t + D_{t+1} R_t = P_d,t [Ω_t (I_g,t − ̄I_g) + ̄I_g] + D_t + T^s_t + T^h_t.
  - Cost overruns on public investment: Ω_t = ( 1 + I_z,t / z^e,t−1 − ̄I_z / ̄z^e )^ψ capturing absorptive capacity constraints.
- Public-agency problem (public services supply):
  - Public services G_t produced from security services H_t and infrastructure z_t as CRS substitutes: maximize E_0 Σ Λ_t (A_g,t H_t)^φ z_t^{1−φ}, subject to I_g,t ≥ I_z,t + I_H,t and accumulation laws:
    - H_t = (1−δ_H) H_{t−1} + s (I_H,t − ̄I_H) + s ̄I_H
    - z_t = (1−δ_z) z_{t−1} + s (I_z,t − ̄I_z) + s ̄I_z
  - s (0 < s < 1) captures investment inefficiencies; stochastic discount factor Λ_t derived from savers’ marginal utility and makes agency supply countercyclical.
  - Optimality conditions allocate spending between H and z depending on depreciation rates {δ_H, δ_z} and φ; special case δ_H = δ_z and Λ_t / λ_{G,t} = 1 implies H_t = φ/(1−φ) z_t and I_H,t = φ I_G,t.
- Rest of world: R_w,t, P_w,t, and Y_w,t set at long-run equilibrium levels ̄R_w, ̄P_w, and ̄Y_w.
- Market clearing and resource constraints:
  - Domestic goods market clears: Y_t = C_d,t + I_t + I_g,t + X_t + adjustment cost term for private investment.
  - External balance: B_t FX_t = R_l,t−1 B_{t−1} FX_t − (P_x,t X_t + T_d,t FX_t − P_m,t M_t).

### IV. SECURITY AND INFRASTRUCTURE INVESTMENT — LONG AND SHORT RUN
- Baseline calibration highlights:
  - Government prefers security investment to infrastructure under baseline calibration primarily because φ = 0.9 (security overwhelmingly important) and infrastructure depreciates faster than security (δ_z = 0.3 while δ_d = 0.2).
  - Baseline fiscal balance: overall fiscal deficit (including grants) is zero.
  - Foreign aid under baseline: 34 percent of domestic GDP (substantial share of government expenditures).
  - Major macro ratios under baseline: private consumption accounts for 85 percent of GDP; two-thirds of consumption goods are imported; trade deficit about 34 percent of GDP.
  - Public-sector preference for security motivated by empirical findings that a minimum level of security is required for development spending to be effective.
- Structure and policy implications of public services:
  - When security capital is more durable than infrastructure capital (baseline), the agency maximizes welfare by supplying only security services.
  - Increasing the public importance of security increases the share of security capital and decreases the share of infrastructure capital; infrastructure share reacts with greater sensitivity.
  - Faster depreciation of infrastructure reduces levels of infrastructure, security, and aggregate public services (shares of GDP); when security capital depreciates faster, the size of public sector (share of public services in GDP) increases and resources shift toward infrastructure.
  - Counterintuitive result: GDP can increase even as public services fall because higher public investment expenditures (to replace depreciating security capital) can more than offset loss from declining public services externality.
- Long-run public investment multipliers (baseline balanced-budget, foreign aid sterilized):
  - A permanent US$1 increase in donor aid to the domestic government yields about US$1.4 of additional real GDP; foreign aid has the largest impact on consumption and public investment.
  - Multipliers are smaller when additional foreign aid flows only to security or only to infrastructure, indicating complementarity between the two.
  - Fiscal expansion financed by increasing tax revenues has no positive impact on macroeconomy in baseline: an increase in tax revenues by one Afghani generates no real increase in economic activity—GDP and private investment remain unchanged because positive effects are muted by distortionary effects of tax increases on private consumption.

*Source: IMF working paper chapter "10. Real Economy Response to a Permanent Decline in Tax Revenues" (extracted content).*

### 0.7 Afghani as a result of the additional tax of 1 Afghani thatconsumers must pay. The increase in

### _wp13133 - 0.7 Afghani as a result of the additional tax of 1 Afghani thatconsumers must pay. The increase in

### Impact of government spending shock
- Model prediction: fiscal expansion financed by tax increases may have short-run expansionary effects.
- Key quantified effects:
  - A 1 percent increase in government expenditures increases output on impact by 0.3 percent.
  - Initial consumption falls by 0.1 percent under balanced-budget financing of additional public expenditures.
- Mechanisms:
  - Higher taxes initially reduce consumption, partially offset by increased labor supply.
  - Positive wealth effect from expenditure expansion (higher private sector productivity due to more public services) eventually offsets higher taxes, raising consumption before reverting to long-run equilibrium.
  - Real wages increase and labor supply declines as public services enhance productivity.
- Behavioral response to negative aggregate demand shocks:
  - Government spending behaves countercyclically: supply of public services increases when consumption falls (example: consumption falls by 1 percent).
  - During downturns, government allocates relatively more resources to the security sector because security capital is more durable and more valuable for producing public services.

### Fiscal experiments — design and policy options
- Context: anticipated withdrawal of foreign troops scheduled for 2014 and gradually declining inflow of foreign aid.
- Two experiments analyzed:
  1. Permanent decline in foreign donors’ aid.
  2. Shortfall in tax revenues due to increased tax evasion.
- Three fiscal response options considered for each experiment:
  - Debt financing policy:
    - Shortfall supplemented by issuance of domestic debt.
    - All budget chapters unchanged; real public investment kept constant at steady-state; effective tax rate unchanged.
  - Tax policy:
    - Government commits to a balanced budget.
    - Shortfall consolidated by effective tax rate increases until budget is balanced.
    - Government expenditures mandatory and constant at initial steady-state levels.
  - Expenditure policy:
    - Government commits to a balanced budget.
    - Shortfall consolidated by scaling back public investment expenditures.
    - Debt and the effective tax rate remain unchanged at initial steady-state levels.
- Policy ranking: qualitative criteria based on economic sustainability, plausibility, and effects on output (equal weights).

### A. Shortfall in foreign donors’ aid (aid permanently scaled back by half)
- Overall outcome:
  - Sudden shortfall permanently shrinks the size of the economy.
  - None of the three policy responses fully offsets negative fiscal and economic impact.
- Comparative assessment:
  - Debt financing:
    - Minimizes contraction but leads to unsustainable debt buildup.
    - Public debt would reach 80 percent of GDP in ten years (unsustainable path).
  - Tax increases (mobilization of domestic revenues):
    - Most favorable for economic outcomes.
    - Domestic sales tax increases more than two fold (from 10 to the level of about 23 percent).
    - GDP level remains largely unchanged; over the ten-year period projected to decline by 3 percentage points from its initial level.
    - Private consumption initially falls more than under expenditure cuts; three years into the shock both tax and expenditure cuts converge to a permanent decline in private consumption of 19 percentage points compared to baseline.
    - Resulting dynamics:
      - Households smooth disposable income via private borrowing (mostly foreign), raising country credit risk and causing domestic currency depreciation to the order of 20 percent compared to baseline.
      - Imports fall, trade balance improves.
  - Cutting public investment expenditures:
    - Least favorable option.
    - Real GDP per capita permanently drops by about 5 percent relative to baseline over a decade.
    - Investment in security declines by 5 percent and investment in infrastructure declines by 10 percent compared to baseline.
    - Public disinvestment causes:
      - Direct aggregate demand contraction.
      - Negative externality acting as a negative TFP shock (reducing productivity and returns to factors).
    - Trade balance improves as imports fall; domestic revenues slightly lower but offset by larger expenditure cuts improving operating deficit as share of GDP.

### B. Shortfall in tax revenues (permanent decline due to tax evasion)
- Shock specification:
  - Sales tax revenue, as a share of GDP, permanently declines by 1 percentage point, from the baseline 11 percent down to 10 percent.
  - Modeled as a reduction in effectiveness of tax collection (lower effective tax rate).
- Aggregate effects:
  - Lower effective tax rate is expansionary if public spending remains constant (boosts private consumer demand via higher disposable income).
- Policy option outcomes:
  - Debt financing (domestic borrowing to reverse lower revenue):
    - Partially offsets expansionary effect as households increase permanent saving.
    - Private investment declines.
    - Net effect: mildly expansionary on real economy but results in permanently higher overall deficit and rising debt-to-GDP ratio.
    - Debt-to-GDP ratio rises by 6 percentage points by the end of the 10th year, putting cumulative debt-to-GDP ratio to 62 percent and rising.
    - Accumulated debt over 10 years is fiscally unsustainable; stabilization measures required.
    - Results in 0.3 percentage points lower real GDP compared to baseline.
  - Public investment cuts:
    - Negative externality of lower public spending offsets any expansionary gain from evasion; strong negative effects as per earlier discussion.
  - Additional tax measures (increase effective tax rate):
    - Will tend to offset the effect of evasion; because the initial evasion-induced effect is expansionary, the necessary increase in the rate need not match the initial decline in magnitude to fully reverse the expansion.
- Summary judgment:
  - Debt financing and revenue measures are superior to cuts in public investment in this experiment.
  - Optimality of increased public borrowing depends on shock magnitude and fiscal sustainability.

### C. Results discussion and robustness considerations
- General results:
  - Expenditure cuts in the form of lower public investment are the least preferred option due to amplified negative effects from strong positive externalities of public goods.
  - Domestic revenue mobilization (broadening tax base, VAT, excise duties, mining, reducing tax evasion via admin improvements) is the most preferred option, subject to feasibility.
- Feasibility caveats:
  - In the donor aid fall-by-50-percent experiment, the effective tax rate would need to increase by 13 percentage points to 23 percent within a decade (more than doubling the current rate).
  - Success depends on improvements in revenue administration given Afghanistan’s low revenue-to-GDP ratio and poor revenue administrations.
- Model limitations and extensions:
  - Experiments did not consider cutting recurrent spending (wages), which could have lower negative effects than cutting investment but would require unrealistic wage cuts or retrenchment in security sector.
  - Framework abstracts from other characteristics:
    - Evasion likely a function of tax rate in a poorly administered country (not modeled).
    - Uncertainty about domestic and global market tolerance for debt when starting from zero debt.
    - Partial equilibrium nature of analysis; political stability is a key prerequisite for effective economic policy.
- On borrowing:
  - Public borrowing on world capital markets is not a sustainable option for permanent revenue shortfalls given limited Afghan capacity to carry public debt.
  - Some scope exists for domestic issuance to promote market development, but without a large growth dividend debt servicing would crowd out other spending and propel debt onto an explosive path.
- Downside risks:
  - Worsening security situation would redirect resources from development to security, reducing improvements in living standards.
  - Shortfalls or volatility in donor support will trigger expenditure cuts and sacrifice future development.
  - Failure to achieve targeted revenue gains will entail expenditure cuts and lower growth.
  - Current pecking order: security expenditure takes primacy.

### Conclusion and research avenues
- Main policy message:
  - Public investment in security and development, together with sustained domestic revenue efforts, reinforce one another in supporting growth.
  - Government needs to balance security and development spending as complements in raising living standards.
- Additional points:
  - Combinations of policy alternatives might be warranted rather than isolated responses.
  - Allocation of any public investment cuts should depend on returns to production of public services; current calibration gives predominance to security investment over infrastructure.
- Suggested avenues for future research:
  - Interaction between formal and informal economy and role of informal sector in financing current account and linking tax effort to informal sector size.
  - Impact of financial intermediaries (provision of credit).
  - Extending the framework for endogenous growth to analyze long-term growth effects of public investment in security and infrastructure.

*https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2013/_wp13133.pdf*

### REFERENCES

### _wp13133 - REFERENCES

### References
- Baldwin, J., G. Gellatly, M. Tanguay, and A. Patry, 2007, “Estimating Depreciation Rates for the Productivity Accounts,” Canadian Productivity Review, Statistics Canada, Catalogue no. 15-206-XIE No. 005,
- Barro, R. J., 1990, “Government Spending in a Simple Model of Endogenous Growth,” Journal of Political Economy, Vol. 98(5), part two, S103-S125.
- Beath, A., F. Christia, and R. Enikolopov, 2012, “Winning Hearts and Minds? Evidence from a Field Experiment in Afghanistan,” MIT Political Science Department Research Paper No. 2011-14,
- Berman, E., J. N. Shapiro, and J.H. Felter, “Can Hearts and Minds Be Bought? The Economics of Counterinsurgency in Iraq,” Journal of Political Economy, Vol. 119(4), pp. 766-819.
- Buffie, E.E., A. Berg, C. Pattillo, R. Portillo and L.-F. Zanna, 2012, “Public Investment, Growth, and Debt Sustainability: Putting Together the Pieces,” IMF Working Paper No. WP/12/144.
- Chou T., 2012, “Does development assistance reduce violence? Evidence from Afghanistan,” The Economics of Peace and Security Journal, Vol. 7(2).
- Gali, J., J. D. Lopez-Salido, and J. Valles, 2007, “Understanding the Effects of Government Spending on Consumption,” Journal of the European Economic Association, Vol. 5(1), pp. 227-270.
- Nadari M.I. and I.R Prucha, 1996, “Estimation of the Depreciation rate of Physical and R&D Capital in the U.S. Total Manufacturing Sector,” Economic Enquiry, Vol. XXXIV, pp. 43-56.
- Schmitt-Grohe, S. and M. Uribe, 2003, “Closing Small Open Economy Models,” Journal of International Economics, Vol. 61(1), pp. 163-185.
- IMF Country Report, 2011, Islamic Republic of Afghanistan: 2011 Article IV Consultation and Request for a Three-Year Arrangement under the Extended Credit Facility, Country Report No. 11/330 (http://www.imf.org/external/pubs/ft/scr/2011/cr11330.pdf)
- IMF Country Report, 2012, Islamic Republic of Afghanistan: First Review Under the Extended Credit Facility, Country Report No. 12/245. (http://www.imf.org/external/pubs/ft/scr/2012/cr12245.pdf)
- Depretiation of Infrastructure Assets, South Australia Local Government, Valuers and Asset Management, July 2008 (http://www.lga.sa.gov.au/webdata/resources/files/DepreciationPaperv3.pdf)
- World Bank, 2012, “Transition in Afghanistan: Looking beyond 2014”, prepared for the IMF-WB Annual meeting in Tokyo, (http://documents.worldbank.org/curated/en/2013/02/17423299/afghanistan-transition-looking-beyond-2014).

### Baseline calibration (Table 1)
- α n: 0.8 — Labor’s share in domestic production
- α k: 0.1 — Physical capital’s share in domestic production
- β: 1/1.1 — Time preference factor
- η: 0.2 — Labor supply elasticity
- δ (physical capital): 0.03 — Physical capital depreciation rate
- δ z (infrastructure): 0.3 — Infrastructure depreciation rate
- δ d (security capital): 0.2 — Security capital depreciation rate
- χ: 0.8 — Consumption habit persistence
- φ: 0.9 — Security’s share in public services production
- ̄τ: 0.14 — Average tax rate
- ψ: 0.27 — Weight of public services in private production
- ρ d: 0.9 — Autocorrelation in foreign aid
- f: 0.6 — Share of hand-to-mouth consumers
- ω: 0.2 — Weight of domestic goods in consumption basket
- ǫ x: 2 — Price elasticity of export demand
- ̄R w: 1.06 1/4 — Foreign gross interest rate
- LV R: 0.02 — Risk free loan-to-value ratio
- prem: 0.1 — Private debt risk premium
- φ π: 1.5 — Monetary policy weigh on inflation stabilization at the target
- π ∗: 0 — Long-run inflation target
- ξ I: 20 — Adjustment costs for private investment
- s: 0.6 — Public investment efficiency

### Baseline GDP ratios (Table 2) (in percent)
Public finance:
- Overall fiscal deficit: 0
- Tax revenues: 11
- Donors’ aid: 34

Aggregate economy:
- Private consumption expenditures: 75
- Domestic goods: 30
- Foreign goods: 45
- Private fixed investment: 14
- Government expenditures: 45
- Infrastructure: 5
- Security: 40
- Trade deficit: 34

### Selected fiscally relevant long-run multipliers (Table 3)
One dollar of donors’ aid, security investment, infrastructure investment, sales tax revenues (columns correspond to donors’ aid, security investment, infrastructure investment, sales tax revenues):
- Gross domestic product: 1.4 0.1 0.8 0
- Private consumption expenditures: 0.4 0.1 0.9 -0.7
- Private fixed investment: 0.1 -0.2 0
- Public investment: 1.1 0.4 0.1

Note:
- All simulations assume that the government runs a balanced budget and that the budget is balanced by adjusting the effective tax rate.
- It is assumed that the inflow of foreign aid in foreign currency is fully sterilized and therefore has no effect on domestic real prices and allocation of resources in the steady state.

### Chart captions and thematic summaries
- Chart 1. Model schematics
  - Elements listed: Firms; Exporters; Non-tradables; Rest of the World; Capital; Trade; Government; Households; Public Good; Security; Infrastructure; Foreign borrowing; Labor; Capital; Taxes: VAT (domestic/imports); Government sukuks; Investment goods / raw materials; Imported consumer goods; Domestic consumer goods; Savers; Hand-to-mouth; Donors; Monetary Policy; Inflation targeting

- Chart 2. Importance of security, output and consumption
  - Horizontal axis: Security share in the production of public services (φ) values from 0 to 0.9
  - Vertical axis: Relative steady state (Output, Consumption) values from 1 to 1.1 shown for Baseline calibration

- Chart 3. The effects of changing structure of public services
  - Horizontal axis label: δ z % of baseline with sample values 0.15 0.20 0.25 0.30 0.35
  - Panels and series include Gross Domestic Product (delta % of baseline), Public services (% share of GDP) for φ = 0.6, φ = 0.7 (base.), φ = 0.8, Infrastructure (% share of GDP), Domestic security forces (% share of GDP)

- Chart 4. The effects of depreciation on the supply of public services
  - Horizontal axis: δ z % of baseline with sample values 0.15 0.20 0.25 0.30 0.35
  - Panels and series include Gross Domestic Product (delta % of baseline), Public services (% share of GDP) for δ d = 0.15, δ d = 0.2 (base.), δ d = 0.25, Infrastructure (% share of GDP), Domestic security forces (% share of GDP)

- Chart 5. Impact of government spending shock
  - Horizontal axis: [ Quarters ] with sample range 0–10
  - Panels show Government spending and taxes (Spending, Taxes) [ percent ], Output [ percent ], Consumption [ percent ], Investment [ percent ], Hours worked [ percent ], Real wage [ percent ]

- Chart 6. Fiscal response to consumption shock
  - Horizontal axis: [ Quarters ] with sample range 0–12
  - Panels show Consumption [ percent ], Public capital components: Security/Law enforcement, Infrastructure [ percent ], Aggregate supply [ percent ], Public services [ percent ], Output [ percent ]

- Chart 7. Public finance response to a permanent 50 percent cut in foreign aid
  - Horizontal axis: [ Quarters ] with sample range 0–40 depending on panel
  - Panels show Infrastructure investment [ ppt dev. from steady state ], Security investment [ ppt dev. from steady state ], and Deficit (share of GDP) [ ppt dev. from steady state ] under Debt financing policy, Tax rate policy, Expenditure policy

- Chart 8. Real economy response to a permanent 50 percent cut in foreign aid
  - Horizontal axis: [ Quarters ] with sample range 0–40 depending on panel
  - Panels show Gross Domestic Product [ ppt dev. from steady state ], Private consumption expenditures [ ppt dev. from steady state ], Private fixed investment [ ppt dev. from steady state ], Trade deficit (GDP share) [ ppt dev. from steady state ] under Debt financing policy, Tax rate policy, Expenditure policy

- Chart 9. Public finance response to a permanent decline in tax revenues
  - Horizontal axis: [ Quarters ] with sample range 0–40
  - Panels show Infrastructure investment [ ppt dev. from steady state ], Security investment [ ppt dev. from steady state ], and Deficit (share of GDP) [ ppt dev. from steady state ] under Debt financing policy, Tax rate policy, Expenditure policy

- Chart 10. Real economy response to a permanent decline in tax revenues
  - Horizontal axis: [ Quarters ] with sample range 0–20 depending on panel
  - Panels show Gross domestic product [ ppt dev. from steady state ], Private consumption expenditures [ ppt dev. from steady state ], Private fixed investment [ ppt dev. from steady state ], Trade deficit (GDP share) [ ppt dev. from steady state ] under Debt financing policy, Tax rate policy, Expenditure policy

*Source: _wp13133 - REFERENCES*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2013/_wp13133.pdf_