FISCAL CONSOLIDATION: TEMPORARY COSTS OR LASTING SCARS?

João Tovar Jalles Luiz de Mello

No 2026/0431, Working Papers REM from ISEG - Lisbon School of Economics and Management, REM, Universidade de Lisboa

Abstract: This paper studies how fiscal consolidation affects economic activity in both the short and long run, with particular attention to supply-side channels and the risk of self-defeating austerity. Using a broad cross-country panel covering 1970–2024, we find that fiscal consolidations reduce output only modestly in the short run but may generate mild scarring effects over longer horizons. Consolidation episodes are identified using a combination of cyclically adjusted primary balances, residual-based fiscal shocks, and Bai-Perron structural break detection. Local projection estimates show that output losses are concentrated around the implementation period and dissipate thereafter, while Dynamic OLS and error-correction estimates point to a small but persistent negative long-run association between consolidation and output. Although fiscal consolidation is, on average, associated with lower public debt ratios, the estimated effects are imprecise, and more than half of identified episodes can be classified as self-defeating, because debt ratios increase within three years of adjustment. The effects are state-dependent and vary systematically with initial debt conditions, macroeconomic environments, and the composition of adjustment measures.

Keywords: Fiscal consolidation; Fiscal adjustment; Debt sustainability; Self-defeating austerity; Fiscal shocks; Supply-side effects; State dependence; Local projections. (search for similar items in EconPapers)
JEL-codes: C23 E62 H30 H50 H60 H63 (search for similar items in EconPapers)
Date: 2026-09
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