A presentation by Konstantīns Beņkovskis, Oļegs Tkačevs and Eduards Goluzins (Latvijas Banka) at the Workshop on Public Finances in Riga on 21 June 2016

1. LATVIA'S FIRST CGE MODEL WITH FISCAL
SECTOR
Konstantīns Beņkovskis
Eduards Goluzins
Oļegs Tkačevs
June 21, 2016

2. MOTIVATION
• CGE models can quantify various effects of economic
policies and other shocks on
o individual industries
o regions
o socioeconomic groups
• This type of models perfectly fit for answering the policy
questions that require going beneath the aggregate
macroeconomic surface
o which makes it especially useful for structural and fiscal policy
questions
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3. MODEL’S BASIC ASSUMPTIONS
• Perfect competition assumption:
o unit cost of production = unit price of commodity
o zero economic profits
• Current input-output data represent equilibrium point of
economy
• Labour is perfectly mobile across industries
3

4. DATABASE: INPUT-OUTPUT DATA
National Supply-Use table from www.wiod.org
o 35 domestic industries (reduced to 32 in the model)
o 59 + 59 domestic and imported commodities (reduced to 55 + 55
in the model)
o 35 + 5 users (modified to 32 + 7 in the model);
• industries
• private consumption
• VAT taxable government consumption, VAT exempt government consumption
• government investments, private investments, housing investments
• exports
Year 2011 is used for simulation purposes (latest available in
WIOD)
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Source: http://www.wiod.org/new_site/database/nat_suts.htm

5. DATABASE: SOCIO ECONOMIC ACCOUNTS (SEA) AND FISCAL
DATA
• Data on employment, labour compensation and capital
compensation was taken from WIOD SEA
• Data on VAT, excise tax and labour tax revenues were obtained
from State Revenue Service
• Data on government expenditure were obtained from the
Statistical Office
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6. INPUT DATA: USE TABLE (MODIFIED)
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7. INPUT DATA: SUPPLY TABLE
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8. MODEL COMPLEXITY
• Latvia's CGE model with fiscal sector includes 11'358
variables.
• The number of equations varies depending on the fiscal
rule:
o model with endogenous fiscal policy contains 11'010 equations
o model with exogenous fiscal policy contains 10'843 equations.
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9. DESCRIPTION OF THE MODEL: STRUCTURE OF PRODUCTION
1. Factors of production are
demanded in direct
proportion to output
2. Domestic/import shares of
factors of production depend
on relative prices
3. Oil (Refined petroleum
products) may only be
imported
4. Two primary factors are used
in production. Shares depend
on relative prices
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1
3
2 2 4

10. DESCRIPTION OF THE MODEL: REPRESENTITIVE HOUSEHOLD
1. Initial fraction of household
budget is used to purchase
subsistence goods
2. Rest of the budget is distributed
according to CES structure (shares
of budget devoted to particular
good remain constant)
3. Domestic/import shares of goods
depend on relative prices
4. Consumers choose between
different suppliers of the same
commodity based on supplier
relative prices
10
1., 2
4
33
4

11. DESCRIPTION OF THE MODEL: GOVERNMENT CONSUMPTION
1. Shares of budget devoted to
particular good are constant
2. Domestic/import shares of factors
of production depend on relative
prices
11
1
2 2

12. DESCRIPTION OF THE MODEL: INVESTMENT (PRIVATE NON-HOUSING AND
GOVERNMENT) DEMAND STRUCTURE
1. Factors of production of capital
are demanded in direct
proportion to output
2. Investment is determined in a way
to keep the desired aggregate real
capital level unchanged
(=depreciation rate)
3. Domestic/import shares of factors
of production depend on relative
prices
12
1
2
3 3

13. DESCRIPTION OF THE MODEL: EXPORT DEMAND STRUCTURE
1. Non-residents choose between domestic and
foreign commodities,
2. Demand for domestic good depends on a)
exogenous growth of foreign demand for a
particular good; b) relative price of domestic
good
3. Given changes in the relative prices between
domestic and non-domestic good of the same
type there is an increase or decrease in exports
of that good
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3

14. DESCRIPTION OF THE MODEL: LABOUR MARKET
• Labour is perfectly mobile across industries
• Changes in gross wage are the same across industries
• Changes in employment lead to real wage adjustment:
• Employment above or below it’s natural level forces
adjustment in real wage (γ > 0)
14
0
011
E
EE
w
ww t
r
t
r
t
r
t 

 

gross real wage
growth
deviation of
employment from
natural level

15. GOVERNMENT REVENUES AND EXPENDITURES
Revenues Expenditures
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VAT revenues
SSC revenues
PIT revenues
Excise tax
revenues
Other revenues
Gov.
consumption
Gov. investment
Social transfers
Interest
payments
Other
expenditures

16. LABOUR TAXES AND ENVELOPE WAGES
• Unit cost of labour is comprised of gross wage and employer's social
contributions
• Some firms evade paying labour taxes and the share of enterprises
paying labour taxes is industry specific
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Social security payments of employer
LABSSCERGROSSGROSSLAB stWWP 
Share of labour tax
payers
Gross wage

17. LABOUR TAXES AND ENVELOPE WAGES
• All workers in a particular industry receive equal salaries
• Non-taxable minimum is assumed to be constant for all workers
in all industries
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   PITLABSSCEEGROSSLABSSCEEGROSSGROSSNET tNTMstWstWWW  1
Social security
payments of employee
Personal income tax payments
Non-taxable minimum
Net wage

18. EXCISE TAX
• All users except exports are subject to excise tax
• Excise tax differs by commodity
• We assume that excise tax is a specific tax (proportional to
volume of use)
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EXC
basprod tPP 
Producer
prices
Basic prices

19. VALUE ADDED TAX AND NON-PAYMENT OF VAT
• Three categories of final use are subject to the VAT payments:
o private consumption
o part of government consumption
o housing investments
• VAT rate differs by commodity
• It is assumed that only a fraction of agents pays VAT
19
)1( stPP VAT
prodpur 
Purchaser prices Producer
prices

20. SHADOW ECONOMY PARTIAL ENDOGENIZATION
• Envelope wage rate depends on
o Level of labour taxes
o Level of industry value added
• Rate of payment of VAT depends on
o Level of VAT tax
o Level of real GDP
• Coefficients α and β were calibrated
based on Schneider (2010)
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exo
e
Sh YX


  
1
1

21. SIMULATIONS

22. TWO TYPES OF SIMULATIONS ARE POSSIBLE BASED ON
EXOGENIZED OR ENDOGENIZED GOVERNMENT EXPENDITURE
• Constant ratio of budget balance
to nominal GDP
• Government consumption and
investments move in same
proportion to maintain budget
balance-to-GDP ratio
• Social transfers depend on real
wage and CPI
• Interest payments depend on
interest rate and government debt
• Nominal government expenditures
(exc. transfers and interest
payments) are exogenous
• Social transfers depend on real
wage and CPI
• Interest payments depend on
interest rate and government debt
Endogenized gov. exp. Exogenized gov. exp.
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23. EXOGENOUS VARIABLE LIST
• Import prices
o by commodity
• Productivity
o by industry
• Export demand shift
o by commodity
• Social security tax, employer and
employee
• Personal income tax
• Non-taxable minimum
• Value added tax
o by commodity
• Excise tax
o by commodity
• Government investment
o by commodity
• Government consumption
o by commodity
• Government pensions
• Envelope wage share
o by industry
• Shares of VAT paying enterprises
o by commodity
OtherFiscal sector related
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24. RUSSIA'S EMBARGO ON FOOD IMPORTS
In August 2014, the Government of Russian
Federation announced an embargo on imports
of various beef, pork, poultry meat, fish, cheese,
milk, vegetables and fruit products from the US
and the EU countries. For Latvia it meant a drop
of around 13% in exports of fish products and a
7.5% decrease in exports of food products
(mainly dairy products).
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25. RUSSIA'S EMBARGO ON FOOD IMPORTS
Exogenous fiscal policy case
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26. RUSSIA'S EMBARGO ON FOOD IMPORTS
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Industry specific response in 2015

27. AN INCREASE IN VAT RATE
This scenario assesses the effect of a permanent VAT rate increase
by 1 percentage point. The simulation is implemented by
assuming that the government raises both standard and reduced
rate of VAT and the pass-through into prices is full
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28. AN INCREASE IN VAT RATE
Exogenous fiscal policy case
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29. AN INCREASE IN VAT RATE
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Exogenous fiscal policy case

30. AN INCREASE IN VAT RATE
Endogenous fiscal policy case
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31. DECREASE IN PERSONAL INCOME TAX
RATE
This scenario assesses the effect of a permanent decrease in PIT
rate by 1 percentage point. The tax reform helps boosting
households' real disposable income and therefore provides an
incentive to spend more
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32. DECREASE IN PERSONAL INCOME TAX
RATE
Exogenous fiscal policy case
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33. DECREASE IN PERSONAL INCOME TAX
RATE
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Exogenous fiscal policy case

34. DECREASE IN PERSONAL INCOME TAX
RATE
Endogenous fiscal policy case
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35. POSSIBLE WAYS FORWARD
• Better modelling of the labour market
o disaggregating into high/medium/low skilled workers
o imperfect mobility of labour
o overlapping generations
• Expanding to global model
• Incorporation of profit margins (corporate income tax)
• Strategically – introducing elements of agent-based
model
o using micro level data for Latvia
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