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Macroeconomic Effects of Fiscal Consolidation : A General Equilibrium Approach .

In contrast to many (partial) econometric studies, only a few papers have analyzed the effects of fiscal consolidation within a general equilibrium model. This paper uses a computable overlapping-generations model to analyze how different fiscal consolidation policies contribute to public debt reduction, taking into account these policies’ influence on the employment rate of different age groups, the schooling decision of young people, and aggregate per capita output and growth. We model eight different consolidation scenarios; three of them resort to capital, labor or consumption tax hikes, while the other implement cuts in different public expenditures (wage consumption, nonwage consumption, nonemployment benefits, and investment and education expenditures). We contribute to the literature in two important ways: (i) we endogenously explain individual decisions of time allocation between education, working and leisure and (ii) we model two ability groups. The first extension is crucial given the importance of education for growth (and of growth for a reduction of the debt ratio). The second extension allows to assess the (possibly different) impact of fiscal tightening on welfare of lowand highskilled individuals. Our simulations show that consolidation is most harmful for medium-run output when it resorts to hikes in the labor or capital tax or when efficiently used public employment is reduced. Lowering nonemployment benefits, on the other hand, has the opposite effects. In the long run, per capita growth benefits more from fiscal consolidation when budgetary savings are used to increase productive expenditures; labor supply increases most when labor taxes are reduced. Higher public employment also stimulates growth and labor supply. Our results underscore the importance of modeling the individual’s education decision; something which is often neglected in this literature. Finally, our model confirms earlier findings that interrather than intra-generational equity is most likely to pose the greatest obstacle to fiscal tightening.