How Costly Are Borrowing Costs?: An Analysis of Fiscal Policy Changes During Crises

Abstract Financial crises lead to substantial declines in output and consumption in emerging market economies. The fact that …scal policy is procyclical in these countries shows that the e¤ects of a crisis are exacerbated by spending cuts and tax increases, which are usually attributed to borrowing constraints that they face in bad times. This paper quantitatively analyzes the costs of reduced borrowing in crisis episodes, by studying the e¤ects of expansionary …scal policies that would have been possible to implement, had the government been able to borrow more. For additional borrowing that keeps the debt-to-GDP ratio of the government at its pre-crisis level, the model with a proportional reduction of taxes on labor income, capital income and consumption reduces output and consumption decline almost by half during the 1997 Korean crisis. When the e¤ects of each tax rate are analyzed separately, labor income tax reduction turns out to be more e¤ective than the other policies, including the proportional tax reduction. JEL Classi…cation: E32; E62; F32; F4