Dynamic analysis of budget policy rules in Japan

Abstract

We construct an endogenous growth model with public capital and endogenous labor supply and examine quantitatively the welfare effects of fiscal consolidation on the Japanese economy. We consider two modes of fiscal consolidation: the adjustment to a new lower target of the debt-to-GDP and deficit-to-GDP ratios. We find that the debt and deficit reduction rules based only on government consumption and investment expenditure cuts improve households’ welfare. This improvement in households’ welfare becomes large as the speed of fiscal consolidation rises. Further, reductions in the target debt-to-GDP or deficit-to-GDP ratio generate larger welfare gains. We also discuss the welfare effects of fiscal consolidation with tax increases and transfer payment decreases.