Fiscal Consolidation in Heavily indebted Economies

Abstract

In this paper, I build a dynamic general equilibrium model calibrated to the U.S. economy to study the macroeconomic e ects of alternative scal consolidation strategies in a context where the private sector is heavily indebted. Fiscal consolidation is de ned as a permanent reduction of the public debt-to-GDP ratio through government spending cuts or tax hikes. I show that in the long run, scal consolidation entails output bene ts that are dampened when private debt is high. This e ect occurs independently of the scal instrument used to stabilize the debt. In the short run, I nd that a scal policy that rises labor or capital tax rates induces deleveraging in the private sector, which ampli es temporary output losses due to scal consolidation policies. By contrast, a scal consolidation achieved by government spending cuts or consumption tax hikes facilitates the repayment of private debt, thereby mitigating the negative output e ect associated with a public debt reduction. Finally, regarding social welfare, I nd that a scal consolidation brings higher welfare gains when government spending or consumption tax rates adjust in an environment of high private debt. However, it increases the social welfare loss when capital or labor tax rates adjust to meet the public debt target.