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DDTC Working Paper 1315

                   2. Tax Policies during Economic Crisis:                policy and a relaxed fiscal policy; and tight
                   Literature Review                                      fiscal policy and expansive monetary policy.
                                                                          However, in the long  run the combination
                            whIle a decrease In complIance                of expansive monetary policy (e.g. lowering
                            durInG The slowdown may have                  BI  rate  to  spur  credit  growth)  and  tight
                             some counTercyclIcal effecTs                 fiscal policy (e.g. increase effort to increase
                                on The economy, ToleraTInG                and improve tax collection) has a healthier
                                   noncomplIance Is noT an                outcome  in comparison  to  tight monetary
                                approprIaTe response To The               policy  combined  with  relaxed  fiscal  policy.
                          crIsIs because IT Is dIsTorTIonary,             This is because the policy leads to crowding
                             InequITable, and perhaps mosT                in of investment from the private sector and
                                   ImporTanTly, hampers The               possibility to generate more outputs  (see
                                                                          Figure 1 below).
                           rebuIldInG of Tax bases over The
                                               medIum-Term.                  To understand the conclusion from the
                                                                          matrix, one  should  also take into  account
                      2.1 Fiscal and Monetary Policy-Mix                  timing of  policy execution and stage of
                                                                          the economy. Although from the model, a
                            Disbursement  in  total  government           combination of  expansive monetary policy
                         spending has been pro-cyclical to economic       and tight fiscal policy is the right option, it
                         growth.  The  effectiveness  of  fiscal  policy   applies only in the long run. In the short and
                         will depend on the pace of the disbursement      medium  terms, the government might use
                         of discreationary spending and macro             expansive fiscal policy to bring the economy
                         prudential  policies  taken by the monetary      to its potential level; and maintain sizeable
                         authority.  Several  empirical  studies  have    monetary  policy  to  stabilize  inflation  and
                         been conducted to determine the impact of        currency fluctuation.
                         monetary and fiscal coordination. A popular
                         method involves game theory  approach in               Figure 1 - Sustainable Policy Mix
                         ascertaining the absence of monetary and                     in the Long-Run
                         fiscal policy coordination.
                          Table 1 - Monetary and Fiscal Game Theory                                   LM
                                  Tight Monetary   Monetary                                             LM
                                  Policy                                                                   1
                         Fiscal   Tight Fiscal Policy  Low Inflation
                         Fiscal   Less Employment  Moderate Inflation
                         Policy                                                                  IS 1   IS
                          Source: Bennet, H and Norman Loayza (2002),”Policy Biases When
                          the Monetary and Fiscal Authorities Have Different Objectives”, in the            y
                          book Monetary Policy: Rules and Transmission Mechanism, Norman
                          Loayza and Klaus Shmidt-Hebbel (ed.). Santiago, Chile, Central Bank
                          of Chile.
                                                                           Note: IS stands for Investment and Saving (Fiscal Policy); whereas
                                                                           LM is Liquidity of Money (Monetary policy). r is real interest rate and
                                                                           y is GDP (Gross Domestic Product). Theoretically,  as  real interest
                                                                           rate decrease, private investment will increase as the cost of fund of
                            Bennet  and  Loayza  assumed  that  there      borrowing will be lower.
                         are two policy options in each policy
                         authority, namely tight  and expansive
                         policy. If both authorities opt for tight policy,   Based  on  the  Marginal  Efficiency  of
                         inflation  will  low  but  with  fewer  jobs  for   Investment (MEI), a decline of real interest
                         the workforce. If both authorities  decide       rate will spur more credit growth by enticing
                         on relaxed policy, inflation will be high and    more firms to borrow and generating their
                         unemployment low. Additionally, if one of        investments for  further  economic  growth.
                         the policies is tight and other is expansive,    This  is what  famously known  as “private
                         both inflation and unemployment will tend        sector  crowding-in’.  In  addition,  degree
                         to be moderate. The Nash Equilibrium in this     of  capital  mobility  affects  monetary-fiscal
                         game, therefore, consists of a tight monetary    policy effectiveness. Private and bank flows
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