Fiscal consolidations and distributional effects: which form of fiscal austerity is least harmful?

Abstract

Abstract Distributional consequences of fiscal austerity, while being increasingly recognized in the policy debate, have received little attention in the existing formal work. This paper proposes a medium-scale New Keynesian dynamic stochastic general equilibrium model incorporating an appropriate dimension of household heterogeneity and a well-specified fiscal structure, allowing for a comprehensive analysis of losers and winners from austerity. We find, first, that cutting transfers and public employment, and raising labour income taxes are the most regressive forms of austerity, greatly raising income inequality. In contrast, raising capital income taxes is progressive—the only such policy in our analysis—and entails the smallest output losses in the short term. Second, the speed of austerity emerges as a potential tool in fiscal adjustment. Indeed, speedy austerity yields the worst distributive and output effects irrespective of its composition. Finally, fiscal consolidation is particularly damaging in downturns where distributional effects are substantially more unfavourable than in normal times.