Fiscal stabilization in high-debt economies without monetary independence

Fiscal stabilization without monetary autonomy can be challenging, especially in high-debt economies. This paper studies the welfare outcomes of six fiscal stabilization rules in Greece, a highly indebted country in a monetary union. We introduce rich fiscal policy instruments into a small open economy dynamic stochastic general equilibrium model and estimate it using Bayesian methods. Four results emerge. First, the estimated fiscal policy rules show a lack of fiscal stabilization, which contributes to rising public debt. Second, productive spending-based policy rules dominate the tax-based rules in welfare terms. Welfare gains are mainly driven by agents’ expectations of the future fiscal policy stance. Third, the optimal stabilization policy features a simultaneous adjustment of all spending and taxes. In the case of negative productivity shocks, the optimal response is to expand public consumption and employment, raise the labor tax rate, and reduce public investment and tax rates on consumption and capital. Fourth, sizable distributional effects are found across savers and hand-to-mouth households, with savers’ welfare gains being quantitatively greater than those of hand-to-mouth agents.