Fiscal Consolidation in the Euro Area: How Much Can Structural Reforms Ease the Pain?

Abstract

Derek Anderson - Graduate Student, Department of Economics, University of Virginia; 248 McCormick Rd,22903, Charlottesville, VA, USA; E-mail: dta7dk@virginia.eduBen Hunt - Advisor in the Research Department, The International Monetary Fund; 700, 19th St., 20431, N.W.,Washington, D.C., USA; E-mail: bhunt@imf.orgStephen Snudden - Project Officer in the Research Department, The International Monetary Fund; 700, 19th St.,20431, N.W., Washington, D.C., USA; E-mail: ssnudden@imf.orgSeveral euro area countries must implement substantial fiscal consolidation to put public finances back on a sustainable path. Although this required consolidation will improve long-run output prospects, in the short run, the impact on activity is likely to be negative. Simultaneously implementing structural reforms to raise growth could be one way to help mitigate the short-run negative impact on GDP. This paper uses the IMF’s Global Integrated Monetary and Fiscal Model (GIMF) to provide some estimates of how effective structural reforms might be in softening the near-term contractionary effects of euro area fiscal consolidation. For the analysis, the euro area is divided into two regions, one with acute fiscal sustainability issues, referred to as the periphery, and one with less acute sustainability issues, referred as the core. The magnitudes and the timing of the required consolidation are stylized, but loosely based on the consolidations contained in the April 2013 World Economic Outlook. Although the macroeconomic impacts of consolidations in the two regions that are achieved by reducing transfers are presented, it is highly unlikely that the consolidations can be achieved in such a growth-friendly fashion. Therefore, results are also presented for consolidations of identical magnitudes that are achieved by using a mix of public absorption expenditure (30 percent), consumption taxes (30 percent), labor income taxes (30 percent) and capital income taxes (10 percent). This more plausible mix of fiscal instruments reduces GDP below its reconsolidation level in both the periphery and core for an extended period. GIMF is then used to estimate the scope for offsetting that impact on activity through implementing wide-ranging structural reforms. The GIMF analysis relies on OECD estimates of the distance from best practice in product and labor market polices in each euro area country along with estimates of the impact on productivity and employment of closing those gaps. The impact on output is estimated under two alternative assumptions about how much of the best-practice gap is closed, a lower bound of 25 percent and an upper bound of 75 percent. The results suggest that for the core, it is quite feasible that structural reforms can offset even the near-term negative impact of consolidation on activity. However, for the periphery, even under the case where 75 percent of the best-practice gap is closed, it takes several years before GDP is restored to its pre-consolidation level. In the medium and longer term, however, the estimates suggests that structural reforms can make a substantial contribution to raising output in both the core and periphery.