Fiscal Consolidation During Times of High Unemployment: The Role of Productivity Gains and Wage Restraint

Ruy Lama and Juan Medina

No 2015/262, IMF Working Papers from International Monetary Fund

Abstract: This paper studies the Swedish fiscal consolidation episode of the 1990s through the lens of a small open economy model with distortionary taxation and unemployment. We argue that the simultaneous reduction in the fiscal deficit and unemployment rate in this episode stems from two factors: (i) high growth rates of total factor productivity (TFP), experienced after the implementation of structural reforms; and (ii) a sustained wage restraint that occurred during the 1990s. The model simulations show that economic growth, accounted for mostly by TFP gains, improved the fiscal balance by 8 percentage points of GDP through an expansion of the tax base and fiscal revenues. Moreover, the combination of stable wages and higher TFP boosted net exports and led to a reduction in the unemployment rate. A counterfactual simulation assuming stagnant TFP shows that fiscal consolidation measures alone would have generated a double-digit unemployment rate without eliminating the fiscal deficit.

Keywords: WP; business cycle; trade balance; Fiscal Consolidation; Search Models of Unemployment; Small Open Economy; productivity gain; government consumption shock; government transfer; government budget constraint; lumpsum transfer; result wage inflation; business cycle accounting exercise; business cycle accounting decomposition; wage inflation; government lumpsum transfer; accounting exercise; labor productivity gain; Unemployment rate; Productivity; Total factor productivity; Fiscal stance; Global (search for similar items in EconPapers)
Pages: 41
Date: 2015-12-10
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Citations: View citations in EconPapers (1)

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