Fiscal Consolidation - Impact on Labor Market Outcomes

Recent global economic crisis and the concerns about long-term sustainability of public finances have resulted in stronger implementation of fiscal consolidation measures. In this context, consolidation has received a lot of attention in both theoretical and empirical literature with the large number of papers investigating its impact on different aspects of economy. Although fiscal consolidation has long been recognized as a hot issue, the literature does not offer a consensus on the impact of fiscal consolidation. Theoretical considerations offer a rationale for both contractionary and expansionary effect of fiscal consolidation on economic activity. Given this state of theoretical literature and quite ambiguous predictions, it is no wonder that the empirical literature has provided evidence supporting both of these views. At the same time, investigation of fiscal consolidation on labor markets has received relatively little attention (IMF, Fiscal monitor-back to work: How fiscal policy can help, 2014). Given that one of the main goals of economic policy is labor market outcomes, we find this topic extremely relevant. The existing literature indicates that fiscal consolidation can result in long-lasting negative effects on the labor market (IMF, Fiscal monitor-back to work: How fiscal policy can help, 2014). In addition, the literature also recognizes possible positive effects of fiscal consolidation. This paper adds to the literature by tackling the issue of fiscal consolidation through an empirical investigation focusing on labor market. More precisely, it investigates the effects on a set of specific labor market outcomes: employment, unemployment, and activity. Given that the debate on labor market impact of expenditure-based versus revenue-based consolidations is not settled in the literature, the special attention in this paper has been dedicated to the effects of the design of fiscal consolidation on the labor market outcomes. Additional contribution of this paper relates to the usage of the relatively new database on fiscal consolidations (Devries et al., A new action-based dataset of fiscal consolidation (IMF Working Paper No. 11/128). International Monetary Fund, 2011) in 17 OECD countries covering the period 1978–2009. This new approach, following the narrative approach introduced by Romer and Romer (American Economic Review, 100(3), 763–801, 2010), suggests that previous empirical literature has been contaminated by using the indicators for fiscal consolidation which may be subject to serious mismeasurement errors leading to a strong bias toward finding an expansionary effect of fiscal consolidation. Recognizing this as a serious obstacle, the present paper first provides a brief review on the problems in the previous literature and then applies the empirical investigation using the new database which successfully removes most of the problems in providing the representative indicators for fiscal consolidation. Using these new indicators, the paper next provides a thorough empirical investigation through the use of panel data analysis. The findings from this investigation provide novel empirical evidence concerning the effects of fiscal consolidation on labor market outcomes.