Who bears the burden? Tax Strategies to Reduce Long-term Debt in Italy: An overlapping generations model approach

Since the financial crisis, many countries have particularly high public debt-to-GDP ratios. This imposes constraints on the public finances over the long run, which will have broad macroeconomic implications. Barring exceptional growth rates, financing and reducing these debts will likely involve some kind of fiscal squeeze, meaning some combination of higher taxes and/or lower public expenditure. The policy choices made will have consequences for the incentives to work and invest, and will have differing impacts across generations. In this paper, we present an overlapping generations model calibrated for Italy, which currently has a debt-to-GDP ratio above 130%. We model a steady reduction in the debt level, during which time the outstanding debt must continue to be serviced. Our model incorporates seven adult generations (representing individuals aged 20-29 years old up to 80-89 years old), each of whom has a known earnings profile. The individual agents choose their levels of labour, consumption and savings so as optimise their lifetime utility. Data on labour is calibrated using the EUROMOD microsimulation model. We match the labour elasticities estimated using micro-data, to the more aggregated individual agents of our OLG model, producing our labour supply curve. This is one of the mechanisms through which a change in fiscal policy also changes incentives for the individuals. On the supply side, firms maximise profits generated from the production of a single good. Investment is determined by the availability of savings and by the demand for capital in the production function. Government collects revenues from consumption taxes, labour taxes and capital taxes and issues debt, which are used to finance spending on public consumption and transfer payments to the different generations. As a policy simulation, we evaluate the reduction of the debt-to-GDP ratio to 60%, which is the upper limit set in the Stability and Growth Pact of the European Union. The reduction is achieved either through an increase in value-added tax or an increase in personal income tax, with the full reduction of the public debt-to-GDP ratio being achieved either in 20 or 40 years (four main simulations). These simulations are first entered into EUROMOD to gauge carefully the impact by age group, which are then introduced into the OLG model. Our model estimates the key macro-variables including employment, investment and GDP over time. Crucially, it also estimates how income and wealth are affected across the generations. Sensitivity analysis addresses the possible range of interest rate values, with higher rates influencing savings decisions (positively through substitution effects and negatively through income effects) and also raising the cost of holding large debt stocks. Preliminary results from our stylised model show that the older generations are particularly negatively impacted by a rise in value-added tax, which reduces their real wealth. This effect is stronger when the public debt is reduced over 20 years, because with a 40-year reduction less of the reduction occurs during their lifetime. The youngest (adult) generations are heavily impacted by the rise in personal income tax, which they pay for fully and which introduces disincentives to work. The middle generations, who are closer to retirement, may bear more of the burden from personal income tax when the debt is reduced more quickly (over 20 years), whereas the slower debt reduction (over 40 years) allows them to avoid some of the burden as they pay less during retirement.