Fiscal Consolidations: A Theoretical Essay with a Heterogeneous-Agent Model

ABSTRACT

Since the emergence of the financial crisis, most of the EU countries have promoted impressive public interventions to support financial institutions, contributing to a significant rise in general government gross debt-to-GDP ratios. As such, the issue of how to best pursue a fiscal consolidation will become crucial regarding the fiscal policy stance. This paper aims at characterizing four different stylized debt consolidation strategies extensively identified in the literature (one pure revenue-based and three expenditure-based) in order to assess welfare affects and, in particular, the inequality effects involved. For this purpose, we built a general equilibrium heterogeneous-agent model capable of exploring the relationship between fiscal policy and the endogenous cross-section distribution of income and wealth. Moreover, we decompose the impacts on welfare criteria in order to distinguish pure efficiency effects from insurance and inequality effects. According to our simulations, the adjustment based on the reduction of unproductive expenditures came out to be the most welfare-enhancing compared to those based on tax increases or on social transfer reductions.

KEYWORDS:

• Fiscal consolidation
• heterogeneous-agent model
• inequality
• transition costs
• welfare

JEL Classification:

• E17
• E60
• H60
• I30

Disclosure statement

No potential conflict of interest was reported by the authors.

ORCID

M. Viegas  http://orcid.org/0000-0003-1390-4992

Notes on contributors

Miguel Viegas currently lectures as an invited PhD professor at the Department of Economic and Management of the Aveiro University (Portugal). He is also a member of the GOVCOPP investigation unit (governance, competitiveness and public policies). He graduated in economics from the Universidade de Aveiro in 2004 and completed a doctoral program in economics in 2010 at Porto University with the thesis “Debt, Government Size and Public Expenditure in a Heterogeneous-agent framework”. His main investigation concerns fiscal policy and consolidation processes.

Ana Paula Ribeiro is currently a professor at the Faculty of Economics, Porto University and an investigator of CEF.UP. She completed her PhD thesis in 2005 at Porto University. She currently lectures undergraduates and PhD students. Her investigation field includes the labour market, monetary policies and fiscal consolidation processes. She has published in the Journal of Macroeconomics and, as a co-author, has published several book chapters.

Notes

1 For a complete historical perspective we recommend Tanzi and Schuknecht (2000) and Tanzi (1997).

2 In order to stabilize the model some variables have to be defined as a percentage of output (Y ), namely,

3 In a seminal paper, Barro (1990) incorporates a public sector into a simple, constant return, model of economic growth. The ratio of real public gross investment to real GDP is assumed to correspond to a flow of services identified as the measure of infrastructure services and enters directly in the production function.

4 We regress the differential of the real long-term interest rate between seven European countries (Portugal, Greece, Italy, Ireland, Spain, Denmark and Belgium), which have experimented significant debt reductions, and Germany between 1991 and 2009. On average, an increase of one percentage point in debt-to-output ratio contributes, ceteris paribus to an increase of 0.04 percentage points of the real long-term interest rate bet. For a comprehensive discussion about sovereign risk, see Corsetti, Kuester, Meier, and Müller (2013).

5 Remember that must be common to both regions.

6 The solution is represented by an optimal sequence of consumption and leisure to infinity, .

7 Models including as an argument in the household's utility function are scarce. In such models, there is no homogeneous value used for calibration. Most of the values in use are rather small, eventually up to 0.4 (see, among others, Ni (1995), Domanech and Garciá (2002) and Ganelli and Tervala (2010)). Moreover, this value makes the model outcomes, in terms of steady-state optimal debt (results not reported), compatible with the average European values, given actual data on fiscal policy variables.)

8 In a recent paper, D'Auria et al. (2010) estimated for the EU15 over the period 1960–2003.

9 Source: AMECO database, k=2.85 for the EU15.

10 Davies, Sandström, Shorrocks, and Wolff (2008) estimate a wealth Gini index of 0.62.

11 Decreasing (increasing) υ by 100%, from 0.1 to 0 (0.2) induces an augmentation (diminution) in welfare gain of 12.5%.

12 For the weight of each welfare decomposition effect in the overall welfare, see the discussion in Viegas and Ribeiro (2013).

13 Welfare expression (1(1) ) provides three utility sources: consumption, leisure and public services (). The global effect on welfare distribution results from the dynamics of all these individual variables.