The (Intertemporal) Equity-Efficiency Trade-Off of Fiscal Consolidation

Abstract

We build a dynamic general equilibrium model with heterogeneous households and capitalskill complementarity in the production function to study aggregate and distributional e¤ects of …scal consolidation policies when government uses a rich set of productivity-enhancing spending instruments along with utility-enhancing spending and tax …scal instruments. Fiscal policy is conducted through simple …scal rules. We study both ad-hoc and optimized …scal rules. Our main results indicate that ad-hoc …scal consolidation policies, either through spending cuts or tax increases, are recessionary and entail an equity-e¢ciency trade-o¤ in the short-and medium-run. That is spending-based consolidation policies are less recessionary but come at a higher distributional cost; whereas tax-based consolidation policies result in sharper output losses but have smoother distributional e¤ects. In addition, …scal consolidation policies through optimized …scal rules can be expansionary and social welfare enhancing while at the same time balance the equity-e¢ciency trade-o¤.

Public Debt Consolidation and its Distributional Effects

“…1 In an earlier version of this paper we show that income inequality can increase in the short run under an ad hoc (non optimized) spending based …scal consolidation policy see inSakkas and Varthalitis (2018).4 2 Although government imposes identical tax rates to both households, distortionary taxes are analogous to income. This implies that a relatively higher income increase is accompanied with higher taxes.…”