Fiscal policies in the Federation of Bosnia and Herzegovina: are spending or revenue measures more effective?

Abstract

We examine the effectiveness of different fiscal policies in the Federation of Bosnia and Herzegovina (FBiH). For this purpose, we use a structural macroeconomic model for the FBiH. In this model, GDP in the Federation is influenced by world demand and by domestic demand in the Federation. Domestic demand comprises consumption of private households, public consumption, and gross fixed capital formation. Employment depends positively on GDP and negatively on the tax wedge, i.e., the net wage plus social security contribution rates (including the unemployment insurance), and the personal income tax rate in the Federation. The latter allows the analysis of the impact of changes in social security contribution rates or in the income tax rate in the Federation of Bosnia and Herzegovina. The following Federation-specific policy instruments are implemented in the model for the FBiH: Pension funds contribution rate in FBiH; contribution rate for health insurance in FBiH; contribution rate for the unemployment insurance in FBiH; benefits from social security; direct tax rates (income tax rate, corporate tax rate); public consumption in FBiH. Our results show that policy measures that reduce the tax wedge on labour income are highly effective in stimulating employment. Due to the large elasticity of imports with respect to demand, pure demand-side measures have little impact on real variables, indicating that a small open economy like the Federation of Bosnia and Herzegovina has only little scope for influencing macroeconomic developments with pure demand management policies. Our results confirm earlier theoretical and empirical studies showing that the labour market can best be influenced positively by reducing the tax wedge. The multipliers of income tax reductions are larger and oscillate more than the effects of the other fiscal policy measures.