The Modality of Fiscal Consolidation and Current Account Adjustment

In this article, we argue that supply-side adjustments (i.e. the reallocation of productive resources between the traded and non-traded sectors) can be an important determinant of the output costs of current account adjustment. The argument relies on the fact that tax evasion is more prevalent in the non-traded sector, which is dominated by services and the self-employed. Heavy reliance on tax-based fiscal consolidations induces a reallocation of economic activity towards the non-traded sector, thus requiring a larger decline in domestic absorption (and output) per unit of improvement in the current account balance. Using International Monetary Fund data for the period 1980–2011, we find that budget consolidations that relied more on tax increases than on spending decreases were associated with larger output costs per unit of current account improvement.