Optimal Fiscal Consolidation in a Currency Union

This paper studies, in the context of a New Keynesian open-economy model, the optimal response of fiscal policy to a risk premium shock for a country in a currency union. First, I show that the planner should not use government spending to stimulate the economy. Instead of distorting the provision of public goods, it is optimal to use simple tax instruments, as consumption, sales, and payroll tax, to achieve stabilization goals. Second, it is optimal to front-load taxes, i.e., the overall level of taxes increase in response to a positive risk premium shock, and it declines over time. The composition of taxes is also time-varying. Consumption tax is increasing, while either VAT or payroll taxes decline over time after an initial increase. Under downward nominal wage rigidities, it is optimal to implement a form of fiscal appreciation, a decline in the VAT accompained by an increase in the payroll tax. Government debt is smaller under the optimal policy than under a passive fiscal policy where the government does not react to the shock. Under some circumstances, it may be optimal to stabilize the government debt at its pre-shock level. Therefore, under the optimal policy, there is no necessary trade off between stabilization policy and fiscal consolidation.