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Comparing budget repair measures for a small open economy with growing debt

George Kudrna and Chung Tran

Journal of Macroeconomics, 2018, vol. 55, issue C, 162-183

Abstract: We quantify the macroeconomic and welfare effects of alternative fiscal consolidation plans in the context of a small open economy. Using an overlapping generations model tailored to the Australian economy, we examine immediate and gradual eliminations of the existing fiscal deficit with (i) temporary income tax hikes, (ii) temporary consumption tax hikes and (iii) temporary transfer payment cuts. The simulation results indicate that all three fiscal measures result in favourable long-run macroeconomic and welfare outcomes, but have adverse consequences in the short run that are particularly severe under the immediate fiscal consolidation plan. Moreover, our results show that cutting transfer payments leads to the worst welfare outcome for all generations currently alive. Increasing the consumption tax rate results in smaller welfare losses, but compared to raising income taxes, the current poor households pay much larger welfare costs. The adverse effects on wellbeing of current generations highlight political constraints when implementing a fiscal consolidation plan. However, after compensating current generations for all welfare losses, there is still an overall efficiency gain. This implies possibilities to devise a fiscal consolidation plan supported by a compensation scheme to improve wellbeing of future generations.

Keywords: Fiscal deficit; Public debt; Fiscal consolidation; Welfare; Dynamic general equilibrium; Small open economy (search for similar items in EconPapers)
JEL-codes: C68 E21 E63 H31 H60 J26 (search for similar items in EconPapers)
Date: 2018
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