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Leaving the empirical (battle)ground: Output and welfare effects of fiscal consolidation in general equilibrium

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  • T. BUYSE
  • F. HEYLEN
Abstract
We study the effects of fiscal consolidation within a dynamic general equilibrium model with overlapping generations. Our contribution to the theoretical consolidation literature is threefold. (i) Individual decisions of time allocation between work, leisure and education are fully endogenous in our model. (ii) We pay particular attention to also modeling public employment and production. We distinguish public employees in the construction of infrastructure, in education, and in the production of useful public consumption goods. (iii) We go beyond the analysis of the usual economic aggregates (such as GDP) and also look at the welfare impact of different fiscal consolidation strategies on current and future generations of both high and low-ability individuals. Our main findings are as follows. As to output effects, we confirm that expenditure based consolidation is better than labor or capital tax based consolidation. Truly expansionary output effects after spending cuts, however, can only be observed for private output. We do generally not observe them when we consider GDP and include the value added produced by public employees. Our results for welfare bring even more nuance on the possibility of expansionary fiscal consolidation. When aggregated over all generations that are alive at the time consolidation is started, almost all consolidation strategies bring about net negative welfare effects. Only the youngest and future generations experience positive welfare effects. Interestingly, the positive effects for these generations are smaller under spending based adjustments in the area of education, investment, and overall public employment, than under tax based adjustments. Robustness tests by changing key assumptions of our model never imply changes of these conclusions, quite on the contrary.

Suggested Citation

  • T. Buyse & F. Heylen, 2012. "Leaving the empirical (battle)ground: Output and welfare effects of fiscal consolidation in general equilibrium," Working Papers of Faculty of Economics and Business Administration, Ghent University, Belgium 12/826, Ghent University, Faculty of Economics and Business Administration.
    • Handle: RePEc:rug:rugwps:12/826
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    More about this item

    Keywords

    Employment by age; Endogeous growth; Fiscal consolidation; Overlapping generations;
    All these keywords.

    JEL classification:

    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt
    • J22 - Labor and Demographic Economics - - Demand and Supply of Labor - - - Time Allocation and Labor Supply
    • O41 - Economic Development, Innovation, Technological Change, and Growth - - Economic Growth and Aggregate Productivity - - - One, Two, and Multisector Growth Models

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