Imf Chief Urges Tax Rises to Tackle Us Deficit

1- Mr. Rato posits that by increasing taxes (T) the U.S. would see an improvement (decrease in the deficit) of the U.S. current account deficit. He makes this statement in light of the worsening deficit which jumped to $66.1bn last month. He strongly advocates raising taxes as a means of increasing government revenue to improve the current account. Mr. Rato presupposes that without such a drastic change in fiscal policy the U.S., and the world at large, will be confronted with higher interest rates, more expensive goods, and instability in global financial markets. He calls for similar measures for Asian and European markets stating that domestic governments need to be more proactive in order to correct problems affecting their respective current accounts. Mr. Rato calls for immediate domestic action. He argues that in the long run severe fissures in the U.S. economy will surface if the current account deficit is left unchecked. Mr. Rato does not believe that a decrease in government spending (G) alone will improve the current account. He underscores the fact that the Bush administration's pledge to halve the fiscal deficit has not come to fruition. Conversely, high defense spending and emergency aid have led to a deterioration of the fiscal deficit. Thus, according to Mr. Rato, an increase in taxes is what is needed.

2- Our Models:

Asset Market (AA Curve)

FX : i= i* + (E(s) - S)/ S = β ( S; i*, E(s))

Home Money Market: M/P = L (i; y, other)

Foreign Money Market: M*/P* = L (i*; y*, other*)

Goods Market (DD Curve)

where Y=AD= C+I+G+ (X-M) --- CA = (X-M)

where Y= AD' + βY + γ(SP*/P)

where AD'= C'+I'+G'+ X'+M' - βT

The NIPA identity and our aforementioned models and will allow us to evaluate Mr. Rato's recommendation to the U.S. government to institute a contractionary fiscal policy by increasing taxes. We will analyze the effects of Mr. Rato's call for a tax increase would have on government revenue by looking at the U.S. current account through the accounting identity which relates the current account and the government budget. It states: CA = Sp - Ip + (T-Cg-Ig) and portrays the current account as the difference between a nation's saving and its investment. We will develop this analysis later on in the paper. In addition, with this contractionary fiscal policy we have the condition where, ceteris paribus, a rise in taxes will reduce the level of aggregate demand and economic activity through changes in the components of AD. We will analyze this with the help of our Keynesian Cross model. A rise in U.S. taxes will also have effects on the exchange rate and domestic interest rates. We will see these effects in the foreign exchange market and the domestic money market.

3- In order for us to evaluate Mr. Rato's statements we must recall that there are several different approaches to characterizing the current account balance. In this analysis we will focus on two; the current account balance defined as the difference between a nation's saving and its investment, and the current account balance defined as the difference between a nation's exports and its imports.

Firstly, by following Mr. Rato's call for "bold action" to stabilize the U.S. current account deficit, we see that an increase in taxes will affect the government budget. By looking at the accounting identity which relates the current account and the government budget we see that CA= Sp - Ip + (T-Cg-Ig), where the government budget is equal to T-Cg-Ig. If we suppose that Private Savings, Private Investment, and Government Expenditures (Cg+Ig=G) remain constant, and following Mr. Rato's reasoning taxes are increased, then we shall see an improvement in the current account. In the later part of the article Mr. Rato refers to the Bush administration's failed attempt at restraining government spending. In doing so, the administration hoped to raise revenue without increasing taxes. We see from the government budget (T-G) that if government spending decreased, keeping taxes at there present level, government revenue would increase and help to lower the fiscal deficit. However, government spending has significantly increased, as Mr. Rato points out, due to increased defense spending, reconstruction efforts in the Gulf Coast, and emergency aid for Hurricane Katrina relief efforts. Therefore, Mr. Rato calls for increased taxes to ameliorate the U.S. fiscal deficit and thus the current account deficit. Looking at the current account deficit as arising from the widening U.S. budget deficit might a bit too simple, however, as it assumes that private saving and investment remain constant, whereas in reality these quantities can and probably will change in response to a change in the fiscal balance.

Alternatively, we can look at the U.S. current account deficit defined as the difference between U.S. exports and its imports. By using this second approach to characterize the current account deficit we will look at the ability of fiscal policy to affect output by affecting aggregate demand. Mr. Rato's call for higher taxes would act as a shock to our AA-DD model in the short run. Mr. Rato warns against higher interest rates as a result of increase in Y. He assumes that as national income rises, the demand for money would increase, ceteris paribus, thereby causing an increase in domestic interest rates. When Mr. Rato warns against higher interest rates he is also referring to the worsening of the current account deficit as a result of the increased demand for imports coupled with a decrease in exports. Therefore, he recommends increasing taxes to, in part, slow down consumption patterns. If we assume that all markets are in initial short run equilibrium this disturbance, higher taxes, would lower aggregate demand for domestic output and would shift the DD curve to the left. Our DD curve will shift by a factor of the percentage increase in taxes. This is represented by (1/1-β)*(Δ T'). If we assume that this increase in taxes is a temporary fiscal policy then we would see a fall in U.S. output (Y1 - Y2) causing a depreciation of the U.S. dollar (S1 - S2). We would not see a change in the expected spot rate because it is only a temporary fiscal contraction. This fall in U.S. income will have an affect on the components of