Fiscal consolidation in an open economy with sovereign premia and without monetary policy independence

We welfare rank various tax-spending-debt policies in a New Keynesian model of a small open economy featuring sovereign interest-rate premia and loss of monetary policy independence. When we compute optimized state-contingent policy rules, our results are: (a) Debt consolidation comes at a short-term pain but the medium- and long-term gains can be substantial. (b) In the early phase of pain, the best fiscal policy mix is to cut public consumption spending to address the debt problem, and, at the same time, to cut income tax rates to mitigate the recessionary effects of debt consolidation. (c) In the long run, the best way of using the fiscal space created is to reduce capital taxes.