Stochastic Fiscal Gap and Debt Dynamics: The Case for the Colombian Economy

Traditional fiscal gap analysis is only based on assumptions about discount and interest rates supplemented by demographic projections to value future government revenues required to cover the current and future obligations to honor the debt. In this paper, we offer an alternative approach. By employing a macroeconometric model, we mimic the empirical functioning of the Colombian economy traced back over the last 40 years. Then, we developed a computer program embodying all the equations describing the economy and used it to simulate the stochastic process for the period 2023–2070 with 100 replications. (For us, simulating the model for more than 100 replications was computationally costly.) The main result was the finding of an optimal path scenario for government spending that maximizes long-term growth. This scenario implies reaching a debt-to-gross domestic product (GDP) ratio between 46 and 48 percent in the long run. Having established this optimal government-spending path, we simulated three alternative path scenarios for government spending and then measured the corresponding fiscal gaps for (i) an optimal path, (ii) a fiscal rule path (where hitting the ceiling debt-to-GDP ratio is fixed by the fiscal rule), and (iii) a fully expansive path scenario. Under the latter two, we found fiscal gaps of 19 and 66 percent higher, respectively, compared to the optimal path gap. The fully expansionary fiscal path is probably the most likely scenario to take place in the next several years, as government spending will continue to grow for many reasons, including the phenomena of population aging and economic development that the country is experiencing. Our findings suggest that adhering to the expansive fiscal policy scenario would significantly increase interest rates and debt service payments, resulting in an average annual economic growth slowdown of 0.86 percent over the next 48 years, which translates to a loss of wealth of $10,511 (USD Purchasing Power Parity (PPP)) per person by 2070.