Fiscal policy reforms in a general equilibrium model with imperfections

The debate on the way of stabilizing the economy, through cuts in public spending or rises in taxes, has been intensified after the crisis in 2008. This holds primarily for the Eurozone periphery countries. In view of high public debts, these countries have been urged to adopt restrictive fiscal policies which have further dampened demand and have worse- ned the recession, at least in the short term. It is known that within a dynamic general equilibrium (DGE) model with a representative agent a reduction of capital tax rates and the move of the tax burden to labour taxes produces social welfare benefits. However, one should not neglect the resulting distributional implications, which may favour some social groups vis-a-vis others. Such distributional implications are significantly influenced by imperfections in product and labour markets. Thus, this paper employs a DGE model that in- corporates heterogeneous agents (entrepreneurs and workers) and imperfectly competitive product and labour markets, augmented with a relatively rich public sector, to quantify the macroeconomic and distributional implications of fiscal reforms like the above in the euro area. Our main results are as follows: First, the most effective policy for the gover- nment to boost output is to reduce the capital tax rate, regardless the policy instrument that adjusts. In addition, if the goal of tax-spending policy is to promote welfare, then it should decrease the tax rate on labour and increase the consumption tax rate. Finally, a reduction in any of the tax rates, financed by an increase in capital tax rate, leads to a fall of inequality between the two social groups.