Evaluating the Social Impact of Economy-Wide Policies B. Essama-Nssah World Bank Poverty Reduction Group (PRMPR) April 2007.

Evaluating the Social Impact of Economy-Wide Policies

B. Essama-NssahWorld Bank Poverty Reduction

Group (PRMPR)April 2007

2

Introduction Impact Analysis

An assessment of variations in individual and social welfare attributable to an exogenous shock or implementation of a policy.

Attribution based on a comparison of the policy state and the counterfactual, ceteris paribus.

3

Introduction Economy-Wide Shocks and Policies

Affect potentially the whole population Are bound to have both macroeconomic,

structural and distributional effects that work through a number of flow-of-fund variables and individual good or factor markets.

Need for an analytical framework that accounts for interdependence between stabilization, structural and distributional issues.

General equilibrium analysis offers such a framework.

4

Introduction Approaches

Standard Representative Household (RH) Impact on functional distribution of income, mean

welfare within a few representative socioeconomic groups, and between-group inequality, but not on poverty.

Extended Representative Household Extends the RH approach by modeling the size

distribution within group, hence allowing poverty analysis in addition to what RH allows. e.g. Lognormal (Dervis, de Melo and Robinson 1982) or Beta

(Decaluwé, Savard and Thorbecke 2005) or Parameterized Lorenz (Essama-Nssah 2005)

5

Introduction Approaches, continued

CGE-Micro-Simulation Use unit record data from household survey to

build a household model of expenditure, or income generation to allow a rich analysis of poverty and inequality.

Focus of Presentation A Stylized ERH Framework

Positive component: a two-sector model of an open economy

Structure Specification

6

Introduction

Stylized ERH, continued Normative component: the Lorenz model of

income distribution Structure Parameterization Recovering Inequality and Poverty Measures

Numerical Implementation Impact of Budgetary Policy

Policy Options Outcomes

7

A Two-Sector Model of an Open Economy

Structure A logical representation of a

socioeconomic system wherein the behavior of all participants is compatible.

Organized around the standard Walrasian template.

8

Structure, continued Two categories of agents: producers and

consumers, or firms and households. Supply and demand behavior: an observable

consequence of the optimization assumption. Market interaction: method of social

coordination by mutual adjustment among participants based on “quid pro quo” (Lindblom 2001).

Behavioral compatibility entails equilibrium on all markets.

9

Structure, continued

Comparative statics entails comparison of equilibrium states associated with changes in the socioeconomic environment.

Social desirability depends on chosen criterion Pareto efficiency focuses on how well the system

promotes individual objectives: efficiency implies no other situation is unanimously preferred by all participants.

Poverty-focused criterion: less poverty is preferred to more.

10

Structure, continued Incentives configuration such that

amount of effective demand equals amount supplied.

Alternatively: No feasible change in individual behavior is

worthwhile. No desirable change in individual behavior is

feasible.

11

Producers

Factor markets

Intermediate goods

ImportsExports

Factor services

Final goods

Circular Flow Chart for an Open Economy

Rest ofthe world

Households

Factor markets

Product markets

12

Structure of a SAM for a Basic Model of an Open Economy

Activity Commodity Household Rest of

World Total

Activity Domestic Sales Exports Total Sales Commodity Intermediate

Consumption Household

Consumption Total Absorption

Household Payments to Factors of Production

Balance of Trade

Total Household Income

Rest of World Imports Total Earnings of Rest of the

World Total Total Factor

Payments Total Supply of Consumption

Goods

Total Household

Expenditure

Total Expenditure by Rest of

World

13

Structure, continued Social Accounting Matrix (SAM)

An accounting framework that reflects the circular flow of economic activity.

A square matrix: dimension based on the number of sectors and agents considered.

Each entry represents a payment to a row-account by a column-account.

Consistency implies that row total must equal corresponding column total.

Also, if all but one accounts balance, the last one must balance as well (Walras’ law).

14

Specification Based on Devarajan, Lewis and

Robinson (1990) Two sectors of production:

Export good not sold domestically. Home good used for both intermediate and final

consumption Imported and domestic intermediate goods

enter the production process. Production process in each sector

represented by a Cobb-Douglas function

.,;1; deiLKAX likiiiiiliki

15

Specification, continued The demand for labor is derived from first

order conditions for profit maximization

Similarly for capital [capital is mobile in the long run]

.,;)(

deiw

XPVAL iilii

.,;)(

deir

XPVAK iiki

i

16

Specification, continued The net price in sector i is given by

a2i is the amount of aggregate intermediate good (Q2) per unit of output in sector i.

.,,22 deiPQaPXPVA iii

17

Specification, continued Producer price of exports

Two aggregate commodities for final (j=1) and intermediate consumption (j=2)

eee tRPX )1(

2,1;)1(1

jDMBQ j

jj

jjjjjj

18

Specification, continued Import demand functions derived from cost

minimization.

Demand for domestic components of aggregate goods (implication off cost minimization).

2,1;)1( )1(

1)1()1(1 jQPMPDPMBM s

jjjjjjjjjjj

jjjjj

2,1;)1( )1(

1)1()1(1 jQPDPDPMBD s

jjjjjjjjjjj

jjjjj

19

Specification, continued

Domestic price of imports inclusive of tariffs

Price of domestic sales includes a sales tax

2,1;)1( jtmRPM mjjj

2,1);1( jtxPXPD ddj

20

Specification, continued Producer price of the domestic good

Price of composite goods

2,1;)1(2

2

1

jtxX

DPD

PXd

jjj

e

2,1);( jMPMDPDPQ jjjjj

21

Specification, continued Rural household represents 60 percent

of the population, and owns a fraction RL of labor and a fraction RK of capital (to be determined by data in SAM).

Urban household represents 40 percent of the population, and owns a fraction (1- RK ) of capital and a fraction (1- RL) of labor.

22

Specification, continued Household income

Household demand for final good (no savings)

Government fiscal revenue

2

1

)(j

ddjmjjG XtxMRtmY

urhRSYrKSwLSY fhfGhghkhlh ,;)()(

h

dh

dhdh QQurh

PQ

YQ 11

11 ;,;

23

Specification, continued

Total demand for intermediate good

Equilibrium in the home good market

Material balance for composite goods

.,;22 deiXaQi

iid

2

1

2,1;j

jd jDX

2,1; jQQ dj

sj

24

Specification, continued Equilibrium condition for each factor market

under full employment of given amounts of capital and labor.

i i

ii deiKKSLLS .,;;

25

Specification, continued Government budget balance

Trade balance

urhYY Gh

Ghg ,;

jj

mjfee MSX

2

1

26

The Lorenz Model of Income Distribution

Structure A flexible statistical model of the

distribution of some welfare indicator, x, among the population.

The Lorenz curve maps the cumulative proportion of the population (horizontal axis) against the cumulative share of welfare (vertical axis), where individuals have been ranked in ascending order of x.

x dtttf

pLxFp0

)()()(

27

Structure, continued

Alternative Expression based on : dp=f(x)dx

First-order derivative

dq

qxpL

p

0

)()(

)(

)(px

pL

28

Structure, continued

Second-order derivative

Parameterization Based on General Quadratic (Datt 1992,

1998) Lorenz

)(

111)(

xfdx

dpdp

dxpL

2

122

2 )(2

1)( enpmpeppL

29

Quadratic model, continued

First Derivative

Second derivative

)(4

2

2)(

22

2

enpmp

nmppL

8

)()(

2

3222

enpmprpL

30

Recovering Inequality and Poverty Measures From a parameterized Lorenz model and the

mean of x, we can recover the following: X: based on the mean and the first order derivative of

the Lorenz function. Density function of x, f(x): based on the mean and

the second order derivative of the Lorenz function.

This is all we need to compute all inequality and poverty measures.

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Numerical Implementation Data

Base Year SAM

Export Domestic Final Intermediate Labor Capital Rural Urban World Total

Export 30.00 30.00 Domestic 73.00 2.00 75.00 Final 40.00 60.00 100.00 Intermediate 5.00 5.00 Labor 20.00 30.00 50.00 Capital 5.00 45.00 50.00 Rural Household 35.00 5.00 40.00 Urban Household 15.00 45.00 60.00 World 27.00 3.00 30.00 Total 30.00 75.00 100.00 5.00 50.00 50.00 40.00 60.00 30.00

Source: Adapted from Devarajan, Lewis and Robinson (1990)

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Data, continued

Calibrated Parameters

Calibrated Parameters f or the Two-Sector Model

L K A M D B

Export 0.80 0.20 1.98 Domestic 0.40 0.60 1.98 Final 0.38 0.62 1.89 I ntermediate 0.69 0.31 1.92

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Data, continued A is tfp (total factor productivity) parameter in

the Cobb-Douglas production function ’s are factor shares (exponents in the

production function). ’s are shares in the Armington aggregation

function and B is a scale factor. Distribution of factor income in base year SAM:

RL=0.70, UL=0.30, RK=0.10, and UK=0.90 Distribution of government transfers: RG=0.60

and UG=0.40

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Data, continued Distribution of foreign transfers: RF=0.20 and

UF=0.80 Base Year Income Distribution

Size Distribution of Income within the Two Socioeconomic Groups

Group Mean Poorest

Decile

2nd 3rd 4th 5th 6th 7th 8th 9th 10th

National 1.00 0.01 0.03 0.04 0.06 0.07 0.09 0.11 0.14 0.18 0.28

Rural 0.66 0.02 0.03 0.05 0.07 0.08 0.10 0.12 0.14 0.17 0.21

Urban 1.50 0.00 0.04 0.06 0.07 0.09 0.10 0.12 0.14 0.16 0.23

Source: Author’s calculations

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Data, continued

Baseline Inequality (Extended Gini)

Focus National Rural Urban 1 0.00 0.00 0.00 2 0.41 0.32 0.32 3 0.57 0.47 0.47 4 0.65 0.56 0.57 5 0.71 0.62 0.64 6 0.74 0.66 0.69

Source: Author’s Calculations

36

Data, continued Parameters underlying the General Quadratic

Lorenz ModelParameterization of the Lorenz Model

Parameter National Rural Urban

1 1.52 2.16 1.46

2 -0.89 -1.42 -1.83

3 0.02 0.08 -0.15

e -1.65 -1.82 -0.48

m -5.29 -6.60 -2.51

n 2.86 4.84 2.37

r 8.11 10.50 2.82

Source: Author’s calculations

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Policy Options Case 1: Reference

Tax on domestic sales: 15.4 percent Tariff on imports of final and intermediate

goods: 12.5 percent Case 2: Reform Option A

Increase domestic sales tax by 5% (from reference)

Lower tariff on final import by 17.6% Increase tariff on intermediate by 46.4 %

38

Policy Options, continued

Case 3: Reform Option B Lower sales tax by 5% Increase tariff on final goods by

18.4% Lower tariff on intermediate by 44%

39

Policy Options, continued

Tax Rates (percentage)

Case Domestic Good Final I mports I ntermediate I mports

1 15.4 12.50 12.50

2 16.17 10.3 18.30

3 14.63 14.80 7.00

40

Social Impact of Budgetary Policy

Base Case 1 Case 2 Case 3

Exports 30.0 100.0 102.2 97.7 Domestic Good 75.0 100.0 99.3 100.8 Final I mports 27.0 100.0 102.3 97.6 I ntermediate I mports 3.0 100.0 101.1 98.8 Total Consumption 100.0 100.0 100.0 100.0 Rural Consumption 40.0 106.7 107.1 106.3 Urban consumption 60.0 95.6 95.3 95.8 Total Poverty I ncidence 59.2 97.5 97.3 97.6 Rural Poverty I ncidence 78.3 95.2 94.9 95.5 Urban Poverty I ncidence 30.5 106.4 106.8 106.0 Overall Poverty Gap 29.7 95.8 95.6 96.1 Rural Poverty Gap 38.7 93.5 93.1 93.9 Urban Poverty Gap 16.3 104.1 104.4 103.9

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Outcomes, continued

Case 1: Pattern of production and imports unchanged from

the base case where there is no government intervention.

Optimal configuration of taxes to the extent that they do not distort private production decisions.

The redistributive policy associated transfers to households causes an increase in rural consumption and a decrease in urban consumption.

As a consequence overall poverty incidence decline by about 2.5 percent.

Rural poverty decreases by 5 percent while urban poverty increase by more than 6 percent.

42

Outcomes, continued Case 2:

Production of exports increases, that of the domestic good declines. Both categories of imports increase.

Pattern of change in poverty incidence is similar to the reference case, but reduction in rural poverty and increase in rural poverty are a bit higher than in the reference case.

Case 3: Production of exports and all imports fall while

production of domestic good increases. Change in poverty similar to previous cases.

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Conclusion Evaluating the social impact of economy-wide policies

requires a social policy model framed within the logic of general equilibrium analysis.

Such a model has two basic components A structural representation of individual behavior and social

interaction based on the principles of optimization and quid pro quo.

A social evaluation function reflecting a chosen set of value judgments (e.g. efficiency and fairness).

A stylized analysis of the social impact of budgetary policy revealed the following:

The outcome hinges crucially on the underlying mechanisms allocating burdens and advantages among individuals.

Aggregate welfare effects may be negligible while structural and distributional impacts are significant.

the latter drive the political economy of policy-making.

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References

De Melo Jaime and Robinson Sherman. 1989. Product Differentiation and the Treatment of Foreign Trade in Computable General Equilibrium Models of Small Economies. Journal of International Economics, Vol. 27:47-67.

Devarajan, Shantayanan, Jeffrey D. Lewis, and Sherman Robinson. 1990. Policy Lessons From Two-sector Models. Journal of Policy Modeling 12 (4): 625-657.

Dervis, Kemal, de Melo, Jaime, and Robinson, Sherman. 1982. General Equilkibrium Models for Development Policy. Washington, D.C.: the World Bank.

Decaluwé, B., Savard. L. and Thorbecke, E. 2005. General Equilibrium Approach for Poverty Analysis: With an Application to Cameroon. African Development Review, Vol. 17, No.2: 213-243.

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Dinwiddy, C.L. and F.J. Teal. 1988. The Two-Sector General Equilibrium Model: A new Approach. Oxford: Philip Allan.

Essama-Nssah, B. 2006. Macroeconomic Shocks and Policies. In Aline Couduel and Stefano Paternostro (eds) Analyzing the Distributional Impact of Reforms. Washington, D.C.: The World Bank.

Essama-Nssah, B. 2005. Simulating the Poverty Impact of Macroeconomic Shocks and Policies. World Bank Research Working Paper No. 3788. Washington, D.C.: The World Bank.

Lindblom Charles E. 2001. The Market System: What Is It, How It Works and What to Make of It. New Haven: Yale University Press.

Varian Hal R. 1984. Microeconomic Analysis (Second Edition) New York: Norton & Company.

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THE END