Fiscal Austerity Measures: Spending Cuts vs. Tax Increases

We study the macroeconomic and welfare effects of decumulating government debt in an overlapping generations model with skill heterogeneity and productive and non-productive government programs. Our results are: First, in the small open economy model calibrated to Greece, the spending-based austerity reform dominates the tax-based reform with respect to income effects but not with respect to the welfare effect. A mixed reform combining the tax-based and spending-based measures results in the largest welfare effects of up to 1.8 percent of pre-reform consumption. Second, the welfare effects vary significantly along the transition to the post reform steady state, depending not only on fiscal austerity measures, but also on skill types, working sectors and generations. When consumption taxes adjust the aggregate welfare effects are positive but the current old and middle age generations experience welfare losses while current young workers and future generations are beneficiaries. Third, interactions between fiscal distortions and the risk premium as well as accessibility to international capital markets strongly influence the effects of fiscal austerity. Larger growth and welfare effects are observed when the risk premium is larger than zero and when access to international capital markets is restricted.