Fiscal Consolidation Strategy

Transcription

1 JOHN F. COGAN JOHN B. TAYLOR VOLKER WIELAND MAIK WOLTERS Fscal Consoldaon Sraegy Insue for Moneary and Fnancal Sably GOETHE UNIVERSITY FRANKFURT AM MAIN WORKING PAPER SERIES NO. 6 ()

2 Insue for Moneary and Fnancal Sably Goehe Unversy Frankfur House of Fnance Grüneburgplaz D-633 Frankfur am Man

3 Fscal Consoldaon Sraegy John F. Cogan John B. Taylor Volker Weland Mak Wolers * Sepember Absrac In he afermah of he global fnancal crss and grea recesson many counres face subsanal defcs and growng debs. In he Uned Saes federal governmen oulays as a rao o GDP rose subsanally from abou 9.5 percen before he crss o over 4 percen afer he crss. In hs paper we consder a fscal consoldaon sraegy ha brngs he budge o balance by gradually reducng hs spendng rao over me o he level ha prevaled pror o he crss. A crucal ssue s he mpac of such a consoldaon sraegy on he economy. We use srucural macroeconomc models o esmae hs mpac focussng prmarly on a dynamc sochasc general equlbrum model wh prce and wage rgdes and adjusmen coss. We separae ou he mpac of reducons n governmen purchases and ransfers and we allow for a reducon n boh dsoronary axes and governmen deb relave o he baselne of no consoldaon. Accordng o he model smulaons GDP rses n he shor run upon announcemen and mplemenaon of hs fscal consoldaon sraegy and remans hgher han he baselne n he long run. We explore he role of he mx of expendure cus and ax reducons as well as gradualsm n achevng hs polcy oucome. Fnally we conduc sensvy sudes regardng he ype of model used and s parameerzaon. * John F. Cogan s he Leonard and Shrley Ely Senor Fellow a he Hoover Insuon and a professor n he Publc Polcy Program a Sanford Unversy. John B. Taylor s he George P. Shulz Senor Fellow n Economcs a he Hoover Insuon and Mary and Rober Raymond Professor of Economcs a Sanford Unversy. Volker Weland s Professor of Moneary Economcs a he Insue for Moneary and Fnancal Sably (IMFS) a Goehe Unversy of Frankfur. Mak Wolers s a Pos-Docoral Researcher a he IMFS. Helpful commens by wo anonymous referees he edors Rober Kollmann Erc Leeper Chrs Orok and Werner Roeger and by parcpans of he Fscal Polcy n he Afermah of he Fnancal Crss Conference a he European Commsson n Brussels March -3 ncludng Güner Coenen Jan n Veld Roland Sraub and Harald Uhlg are graefully acknowledged. All remanng errors are he auhors sole responsbly.

4 . Inroducon As a consequence of he fnancal crss and grea recesson governmen defcs have rsen subsanally creang he need for a fscal consoldaon sraegy o reduce he defcs and sop he growng deb. Ths ncrease n budge defcs resuled parly from greaer spendng and ransfers and parly from lower ax receps durng he recesson. Lookng forward susaned spendng ncreases are parcularly worrsome because hey ulmaely requre rasng ax raes beyond pre-crss levels even afer he economc recovery. Hgher dsoronary axes may hen dampen he economy s rend growh for a long me. Fgure summarzes he federal governmen spendng suaon n he Uned Saes n. I shows U.S. federal governmen oulays excludng neres paymens relave o GDP. Governmen oulays (or governmen spendng) nclude boh governmen ransfers and governmen purchases of goods and servces. The hsory lne shows he rapd ncrease n spendng durng he crss. The - baselne s derved from he Congressonal Budge Offce s (CBO) Alernave Fscal Scenaro whch projecs he hgh spendng levels o connue n he absence of a polcy change. The neres paymens on federal deb ha s Percen 4 Fgure. U.S. Federal Oulays as a Percen of GDP (excludng neres) 3 Baselne Hsory Fscal Consoldaon Sraegy Year expeced o be ssued o fnance hs hgh level of spendng (no shown n he char) wll add ncreasngly larger amouns o oal federal spendng. Under he baselne assumpons neres Congressonal Budge Offce The Long-Term Budge Oulook June. Ths baselne assumes ha curren federal expendure polces wll reman n place for he nex decade. Durng hs perod accordng o CBO dscreonary programs grow a a rae approxmaed by he rae of nflaon. Mandaory programs whch are drven by hree large enlemens; Socal Secury Medcare and Medcad grow faser han GDP over he perod 3- manly as a resul of an ncrease n he number of workers reachng reremen age and a connuaon of rapdly rsng healh care coss. Under hs baselne non-neres federal spendng gradually declnes by one percen of GDP beween 3 and.

5 paymens rse from.4 percen of GDP n o 3.7 percen n. Implc n hs baselne s a long-run ncrease n ax raes needed o reduce he defc and hereby preven he naonal deb from growng o economcally dangerous levels. However hgher ax raes hemselves wll dsor prvae ncenves for savng nvesmen and capal accumulaon o he dermen of economc growh and welfare. Fgure also shows he pah of federal governmen spendng under a fscal consoldaon sraegy ha gradually reurns spendng o he pre-fnancal crss level as a share of GDP. I s modelled on he 3 Budge Resoluon passed n March by he U.S. House of Represenaves. Ths plan whch conans reducons n boh governmen purchases and ransfer paymens from her curren rajecory or baselne mgh realscally be employed o reduce federal spendng and hereby brng he U.S. federal budge defc down from s curren level of 9 percen of GDP. Because he U.S. federal budge was close o balance before he crss (he federal defc was only.3 percen of GDP n 7) hs sraegy would mgae he sze of any ax rae ncrease. Hence relave o he polcy baselne long-run ax raes would be lower under hs alernave sraegy. The purpose of hs paper s o evaluae he mpac of hs fscal consoldaon plan on he U.S. economy ncludng quanfyng s mpac on GDP consumpon and nvesmen. Of course he sze and sgn of hs mpac s a crucal and wdely debaed polcy queson whch s a he hear of he curren ausery debae. We use modern srucural macroeconomc models o assess he mpac. Our prmary ool for evaluang he shor- medum- and long-run mpac of fscal polcy s a modfed verson of Coenen McAdam and Sraub s (8) (CMS) model of he Uned Saes and euro area economes. Is auhors have used o nvesgae he mpac of a reducon n dsoronary axes n he euro area. I s somemes called he New-Area-Wde Model (NAWM) snce a verson of he model has been esmaed and has replaced he socalled Area-Wde-Model (AWM) n European Cenral Bank polcy analyss. 3 The CMS model s a New Keynesan dynamc sochasc general equlbrum (DSGE) model. Thus accouns for he opmzng behavour of forward-lookng households and frms n an envronmen wh shor-erm nomnal rgdes mperfec compeon and a number of addonal real economc frcons and adjusmen coss. I ncludes a dealed fscal secor and accouns for he evoluon of governmen deb. On he expendure sde House Concurren Resoluon h Congress nd Sesson House Repor No. March. 3 We have made our mplemenaons of he AWM NAWM and oher models avalable onlne n a new macroeconomc model archve (see hp://macromodelbase.com.). The model comparson approach s presened n Taylor and Weland () and Weland e al (). 3

6 dsngushes beween governmen purchases and ransfers. Wh regard o axaon consders a varey of dsoronary axes. For he purpose of our sudy of U.S. fscal consoldaon we calbrae he parameers of he U.S. par of he CMS model wh references o emprcally esmaed models ncludng he model of Cogan Cwk Taylor and Weland () (CCTW). The CCTW model s very smlar o he well-known models of Chrsano Echenbaum and Evans (5) and Smes and Wouers (7). I s esmaed on U.S. daa wh Bayesan mehods and useful as an emprcally relevan benchmark hough does no nclude dsoronary axes. To furher help esablsh he robusness of our resuls we also consder a smple neoclasscal growh model wh flexble prces and forward-lookng households whch absracs from all he rgdes and adjusmen coss ncluded n CMS model. Such a model s helpful for clarfyng some of he longer-run mplcaons of changes n governmen spendng and axes. For example n hs model a reducon n fuure governmen spendng allows for lower ax raes relave o baselne ha wll ncrease employmen and GDP; f lower axes are ancpaed hen consumpon wll ncrease n he shor run. The paper s organzed as follows. Frs we dscuss he fscal consoldaon sraegy n more deal and compare wh he baselne assumpon of wha would happen f here were no consoldaon. Then we descrbe he properes of he macroeconomc model ha we manly use o evaluae he economc mpac of he fscal consoldaon: he New Keynesan model of he Uned Saes and euro area economes by Coenen McAdam and Sraub (8). The fourh secon analyses he effec of he consoldaon sraegy on he U.S. economy usng hs model. The consoldaon s found o nduce a hgher level of aggregae oupu hroughou he smulaon. In secons 5 and 6 we proceed o nvesgae he key ngredens of he sraegy ha ensure ha a fscal consoldaon rases GDP even n he shor- and medum-run. Secon 7 provdes addonal sensvy analyss regardng oher ypes of models and parameerzaons. Secon 8 concludes.. Fscal Consoldaon Sraegy We have chosen he House Budge Resoluon o gve our analyss a degree of polcy relevance. Ths budge plan s he only fscal plan o have passed a leas one house of he U.S Congress n recen years. The plan calls for szeable reducons n expendures n boh dscreonary and mandaory program expendures relave o he budge baselne beween 4

7 3 and. Under he plan non-neres federal spendng s projeced o declne o 7.3 of GDP n ; a full.6 percenage pons of GDP below he CBO baselne n ha year. Addonally he Resoluon s fscal plan has wo feaures ha make parcularly well-sued for our purposes. Frs combnes a long-erm permanen reducon n governmen spendng wh near-erm spendng reducons ha are gradually phased-n. Ths allows us o assess he mpac of shor and long run spendng cus n a sngle plan. Second he fscal plan s long-erm spendng reducons are heavly weghed oward ransfers raher han purchases. Snce he fscal problem facng he U.S. and mos of he European counres s prmarly he resul of large and growng ransfer paymen programs he fscal plan aacks he fscal problem faced by each of he counres a s source. Thus he resuls from our chosen fscal consoldaon plan have mplcaons beyond he Uned Saes. The Fscal Consoldaon Sraegy s measured agans he CBO budge baselne hrough he year. Thereafer we assume ha he Sraegy s annual expendure reducon relave o he baselne remans fxed a s level. To esmae s mpac wh srucural macroeconomc models he baselne and House Budge Resoluon esmaes boh of whch are presened on a unfed federal budge bass mus be frs convered o a Naonal Income and Producs Accoun (NIPA) bass. Unforunaely he publcly avalable daa on he CBO baselne and he Resoluon does no conan suffcen deal o perm a precse converson o be made. Neverheless a reasonably accurae converson may be obaned by makng a few smple assumpons. Our NIPA-based expendure projecons are obaned by converng hree large caegores of non-neres federal spendng no federal purchases and ransfer paymens. The frs caegory consss of four man federal enlemens: Socal Secury Medcare Medcad and healh nsurance subsdes under he Affordable Care Ac. These expendures whch accoun for nearly one-half of all federal spendng are reaed as ransfers. 4 The second caegory consss of defense expendures. 5 All of he spendng n hs caegory whch accouns for percen of federal spendng s classfed as purchases. The hrd caegory consss of all oher non-neres expendures. These expendures are allocaed o purchases and ransfers accordng o her share n he laes year for whch we have a dealed converson of federal budge expendures no NIPA expendures. A fnal sep s o conver he annual budge daa seres o quarerly daa. Ths sep was accomplshed by lnearly nerpolang he devaons of purchases and ransfers from he 4 Medcare expendures are gross of Medcare receps manly premum paymens by enrollees. Under NIPA accounng hese receps are recorded as revenues. 5 Defense spendng s measured by dscreonary spendng. 5

8 budge baselne measured as a share of GDP ha s each value n he annual seres was assgned o he las quarerly observaon of he assocaed annual seres. Then nermedae pons were placed on sragh lnes connecng hese pons. Purchases and ransfer paymens under he Fscal Consoldaon Sraegy The budgeary mpac of he Fscal Consoldaon Sraegy shown earler n Fgure s subsanal. By federal expendures relave o GDP are reduced relave o he baselne by 3.4 percenage pons. Fgure shows how hs reducon s dsrbued beween federal governmen purchases and federal governmen ransfer paymens. Fgure : Fscal consoldaon sraegy: percenage devaon of purchases ransfers and oal spendng from baselne as a share of GDP Purchases Transfers Spendng As he char shows he plan s major budgeary mpac s acheved hrough a reducon n ransfer paymens. The plan reduces ransfers relave o he budge baselne by.5 percenage pons. Mos of hs reducon occurs relavely early n he en year perod; by 5. The plan s mpac on federal purchases s n conras relavely modes. Governmen purchases declne relave o GDP by only.6 percenage pons. As was he case wh ransfers mos of he declne n purchases occurs early; by 5. Deb and ax raes under he Fscal Consoldaon Sraegy Because he reform spendng pah s lower han he baselne spendng pah allows for lower ax raes and/or lower levels of governmen deb. We assume a mxure. Under he Fscal Consoldaon Sraegy he funds released from reduced federal spendng are used o reduce he labor ax rae by abou 5 percenage pons relave o baselne wh he remanng 6

9 funds used o reduce he deb o GDP rao as mpled by he budge consran and he model of he economy. To be clear he ax cus are relave o a baselne whch f corresponds o he acual curren oulook for he Uned Saes economy mplcly ncludes ax rae ncreases. Thus n erms of praccal mplemenaon n he Uned Saes our consoldaon sraegy would end o devae from he baselne oulook by avodng ax ncreases raher han requrng acual ax cus. 3. A model for evaluang he shor- medum- and long-run mpac of fscal consoldaon As emphaszed by he well-known Lucas crque polcy evaluaon requres srucural models ha accoun explcly for he decson-makng of raonal forward-lookng households and frms. Furhermore an evaluaon of shor- o medum run changes n governmen expendures should ake no consderaon he exsence of nomnal rgdes ha preven mmedae adjusmen owards marke soluons under fully flexble prces. Such rgdes nduce mporan neracons beween moneary and fscal polcy a leas n he shor-run. Fnally any model used o analyze he mplcaons of changes n he governmen s budge ncludng her effec on fscal susanably needs o ncorporae governmen deb as well as he dsorons n household and frm decsons resulng from axes ha are no colleced lump-sum. The model of Coenen McAdam and Sraub (CMS) (8) sasfes hese condons. I s a modern sae-of-he-ar dynamc sochasc general equlbrum (DSGE) model wh opmzng and forward-lookng households and frms. I s a New-Keynesan model wh nomnal rgdes n prce and wage seng as well as addonal real frcons adjusmen coss and monopolsc compeon. Furhermore akes no accoun dsoronary axes on ncome capal and consumpon as well as he accumulaon of governmen deb. The CMS model covers wo large open economes he Uned Saes and he euro area. Coenen e al (8) calbrae boh economes symmercally usng parameer esmaes for he euro area from Smes and Wouers (3). Insead we calbrae he US par of he model usng parameer values from Cogan e al () who used US daa o esmae a verson of he model by Smes and Wouers (7) exended o nclude rule-of-humb consumers. Under our calbraon he model may be used o analyze fscal consoldaon n he Uned Saes and s spllovers o he euro area. 7

10 Each economy conans households frms a fscal and a moneary auhory. We sar wh a descrpon of he fscal auhory and hen nroduce he opmzaon problems of he households and frms o show how he dfferen fscal varables ener hese decson problems. Fscal auhory To beer undersand he srucure of he fscal secor n he CMS model s useful o revew he governmen budge consran: P G TR B M G C N I J Wh I J W f PC C ( WI N WJ N ) ( WI N WJ N ) WN ( R u ( ( u ) ) P ) K T R B M K K u I () The lef hand sde denoes expendures whle he rgh hand sde denoes revenues. C Wh N W f and K G refer o governmen consumpon ransfers he consumpon ax TR rae he labor ax rae employee and employers socal secury conrbuons and he capal ax rae respecvely. These are all se exogenously. B and M are governmen bonds and money supply. Demands for hese asses are deermned by he household s uly maxmzaon as characerzed by frs order condons. Lump sum axes T are deermned by he followng equaon n whch ransfers as a fracon of seady sae nomnal oupu are adjused accordngly o he gap beween arge and acual deb as a share of nomnal oupu: P T Y Y B Y B PY Y B * () where P Y denoes nomnal GDP and B * denoes he deb-o-gdp arge. Ths equaon s Y used o deermne wha share of he budge defc s pad for by changes n lump-sum axes and wha share s covered by accumulang new deb. The long run sock of deb relave o * GDP s deermned ogeher by he arge B and he endogenous demand for governmen bond holdngs of domesc and foregn households. Households There are wo ypes of households ha are ndexed by I and J. The members of household J can smooh consumpon only va holdng money whle members of household I can addonally buy domesc and foregn bonds and accumulae physcal capal. The 8

11 9 members of household I are ndexed by and he members of household J are ndexed by j. Each member of household I maxmzes he followng uly funcon: k k k I k k N C C E (3) where C denoes consumpon of member of household I I C denoes average consumpon of all members of household I and N denoes hours worked. s he dscoun facor denoes he nverse of he neremporal elascy of subsuon s he nverse of he Frsch labor supply elascy and deermnes he degree of hab formaon. The household maxmzes uly by choosng consumpon C nvesmen I nex perod s capal sock K he nensy wh whch exsng capal s ulsed u nex perod s holdngs of domesc and nernaonally raded bonds B and F B and curren perod s money holdngs M. Household members ake no accoun her budge consran:. F D I K I u K K W N F F F B I C C M B S B T TR D K P K P u u R N W M B S R B B R I P C P h F (4) C P and I P denoe he prces of one un of he consumpon and he nvesmen good respecvely. R and F R are he rsk-less reurns on domesc and nernaonally raded bonds respecvely. Inernaonally raded bonds are denomnaed n foregn currency. To oban he domesc value hey are mulpled wh he nomnal exchange rae S. W denoes he wage K R denoes he renal rae for capal servces ren o frms K u and D denoes dvdend paymens. The budge consran ndcaes some frcons ha he household has o ake no accoun. The purchase of he consumpon good s subjec o a ransacon cos ha depends on he consumpon-based velocy. F B s a fnancal nermedaon premum ha he households mus pay when buyng nernaonally raded bonds. Varyng he nensy

12 of capal ulsaon relave o s seady-sae level s subjec o a cos ). The budge u ( u consran ncludes a number of dfferen ax raes so ha changes n fscal polcy have a drec effec on he consumpon-savngs choce he labor supply nvesmen decsons and he oher varables he household members use o maxmze her expeced lfe-me uly. Households pay axes on consumpon purchases on wage ncome and on capal ncome. Furhermore hey pay socal secury conrbuons a lump-sum ax and receve ransfers. The household members ake her decsons n a forward lookng manner so ha no only changes n fscal polcy oday bu also ancpaed fuure changes can have an mmedae effec on households decsons oday. The capal sock owned by household member evolves accordng o he usual capal accumulaon equaon: I I I I K ( ) K / where I I I (5) / denoes nvesmen adjusmen coss. The members of household I have monopolsc power n he labor marke and herefore some wage-seng power. To acheve scky wages he saggered nomnal wage seng scheme by Calvo (983) s used. In each perod household members can opmally rese her wage wh probably I. All ~ members ha rese her wage opmally se he same wage rae W Those members W I ha canno rese her wage n a specfc perod adjus her wage by ndexng o a geomerc average of las perod s change n he prce of he prvae consumpon good and he seadysae consumer-prce nflaon rae: W I P C I C W PC (6) where denoes he ndexaon parameer. Households ha are allowed o opmally rese I her wage are assumed o maxmze lfeme uly akng no accoun he ndexaon scheme and he demand for her labor servces. Members of household J also maxmze he uly funcon n equaon (3) bu do no have access o he bond marke and canno accumulae physcal capal. Therefore hey

13 choose consumpon C j and money holdngs subjec o he followng budge consran: M j o maxmze her lfeme uly funcon C N Wh j PC C j M j W j N j TR j T j M j j (7) The members of household J also ac as wage-seers n a manner analogous o he members of household I. We devae from Coenen e al (8) by assumng ha ransfer and lump-sum ax paymens are equally dsrbued beween households of ype I and J. Coenen e al (8) nsead consder an unequal dsrbuon whch mples ha changes n ransfer paymens nduce redsrbuon of ransfers and lump-sum axes a feaure no nended o be par of he fscal consoldaon sraegy ha we evaluae. Frms There are wo ypes of frms. Inermedae goods frms ndexed by f produce a radable dfferenaed nermedae good Y. Perfecly compeve fnal goods frms f combne domescally produced goods and mpored nermedae goods no a consumpon good C Q an nvesmen good I Q and a publc consumpon good G Q. Inermedae goods frms produce a sngle radable dfferenaed good usng an ncreasng-reurns-o-scale Cobb-Douglas echnology wh capal servces and labor as npus: Y max z K N (8) f f f where K denoes capal servces rened from household I and f N an ndex of f dfferenaed labour servces provded by members of households I and J. z denoes oalfacor producvy and represens fxed cos of producon ha ensure zero profs n seady sae. The frm akes he renal cos of capal R and he aggregae wage ndex K W as gven and mnmses oal npu coss R Wf K K f ( ) W N whch yelds an equaon for f margnal cos. Margnal coss are dencal across all frms as hey face he same npu prces:

14 MC W f R K z ( ) W ( ). (9) Inermedae goods frms have monopolsc prcng power. In addon prce changes are subjec o saggered prce conracs of he Calvo (983) varey. The frms sell her goods n boh he domesc and foregn marke and charge dfferen prces a home and abroad.e. hey engage n local currency prcng. 6 Each frm can rese domesc prces n perod wh probably H and prces charged abroad wh probably X. Frms ha can opmally rese her domesc and/or foregn prce n perod maxmze he sum of dscouned expeced fuure profs akng as gven domesc and foregn demand H and f X : f E k I k k k P H MC H S P X MC X. () H H f f f X X f f f Frms ha canno rese her prce opmally n perod ndex o a geomerc average of las perod s change n he prce ndexes H and X : P and H P X and he seady sae nflaon raes P P H X P P P P. () H H X X H f H H f X f X X f PH PX The fnal goods frms produce he non-radable fnal prvae consumpon and nvesmen goods by combnng purchases of domescally produced nermedae goods wh purchases of mpored foregn nermedae goods usng a consan-reurns-o-scale CES echnology: Q X X /( X ) / X X / X / X X X X / X X H X IM X IM / Q IM X C I () where denoes he nraemporal elascy of subsuon beween domesc and X foregn nermedae goods and X denoes he home bas. There s also a cos IM X ha he 6 See Cwk Müller and Wolers () for a dealed analyss of dfferences n producer currency prcng and local currency prcng and esmaed shares for each prcng scheme.

15 frm has o pay when varyng he use of he bundle of mpored nermedae goods o make he mpor share relavely unresponsve n he shor run o changes n he relave prce of mpor goods. The publc consumpon good s produced by combnng domesc nermedae goods G G whou any use of mpored nermedae goods: Q H. Cenral bank The moneary auhory ses he neres rae accordng o he followng Taylor-ype rule wh neres rae smoohng where he nomnal neres rae responds o devaons of CPInflaon from he nflaon arge and oupu growh from seady sae oupu growh: R 4 P 4 4 C Y RR ( R ) R g gy. (3) Y PC 4 Y Parameerzaon The counres dffer wh respec o her populaon sze. Oherwse Coenen e al (8) have parameerzed he wo economes symmercally usng values esmaed by Smes and Wouers (3) wh euro area daa. By conras we se mos of he parameer values of he U.S. par of he model along he lnes of Cogan e al s () medum-scale DSGE model esmaed wh U.S. daa. Table repors chosen parameer values. The labor supply elascy equals /. 5 n boh counres and s conssen wh mcroeconomc esmaes (see Chey e al ). Snce s a key parameer deermnng he effecs of fscal polcy we wll examne he sensvy of he smulaon resuls o varaons n hs parameer n secon 7. We devae from Coenen e al (8) wh respec o he calbraon of he neremporal elascy of subsuon. Insead of a value of / we use / for boh economes. Ths value mples log uly and s conssen wh a balanced-growh pah. Though he model s smulaed whou rend growh s advsable o use growh-conssen preferences n order o render fndngs from model smulaons meanngful o baselne scenaros wh balanced growh. 3

16 Table : Parameer choces Parameer Symbol U.S. Euro zone Labor supply elascy Ineremporal elascy of subsuon Share of consraned households J Calvo prce sckness domesc marke Calvo prce sckness expors Prce ndexaon parameer Calvo wage sckness Wage ndexaon parameer Home/foregn good subsuon elasces Adjusmen cos conc.mpors n nvesmen /.5.5 / H.3.3 X H I I X.5.5 IM X Consumpon habs parameer.67.7 Tax Raes (n%): Consumpon ax rae Labor ax rae Socal secury conrbuons (employee) Socal secury conrbuons (employer) Capal ax rae C N 5.4. Wh 7..8 W f 7..9 K The oher parameers may be found n he earler equaons and are aken from Cogan e al () or Coenen e al (8). The ax raes are key polcy parameers and all aken from he comparave sudy of U.S. and euro area axes by Coenen e al. Ther values for consumpon ncome and socal secury axes are based on daa for he U.S. and he euro area. The capal ax rae s calbraed o mach he observed nvesmen-o-oupu expendure rao. The governmen consumpon-o-gdp rao s calbraed o G / 6% for he US * * and G / 8% for he euro area. Y The arge for he deb-o-gdp rao s se o B * 6% of annual GDP n boh counres. In Coenen e al (8) ransfers n per capa erms are unevenly dsrbued beween households J and households I n he proporon 3 o. Lump-sum axes n per capa erms 4 Y

17 are colleced n he proporon of o 3 from household J and household I. We devae from hs seng and dsrbue ransfers and lump-sum axes equally beween household J and I. 4. The mpac of he Fscal Consoldaon Sraegy We consder he mpac of he budge reform on he economy by smulang n he CMS model. 7 We assume ha he sraegy s announced and mplemened sarng n he frs quarer of 3 as ndcaed earler n Fgure. Thus households and frms mmedaely ancpae ha he plan s carred ou from 3 onwards. Makng decsons n a forwardlookng manner hey ake no accoun fuure reducons n governmen spendng and axes and expec afer-ax ncome o rse. Gven he planned reducon n he labor ax rae hey also face more favorable condons for prvae secor producon and work effor. Fgures 3 hrough 7 repor on he mpac of he budge reform on key macroeconomc varables. Fgure 3 dsplays he proposed changes n governmen expendures ha s purchases and ransfers and he ax rae on labor ncome. They are exogenous npus o he model smulaons. As explaned prevously expendures are reduced gradually over he course of years up o 3.4 percen of GDP below baselne. The labor ax s lowered gradually over he same perod from 5 o percen. The smulaon s mplemened as a ranson from an nal baselne acually a seady sae o a new sae wh lower governmen purchases and ransfers and a lower labor ax. Ths scenaro s consdered wh reference o he curren suaon n he Uned Saes whch requres reurnng governmen spendng o pre-crss levels n order o avod mpendng ax hkes. Fgure 3: Implcaons for governmen expendures and ax raes Governmen spendng Labor ax rae. - - Governmen purchases Transfers Noes: Expendures are shown n erms of percenage devaons from baselne.the labor ax rae s gven n levels. 7 The model s nonlnear and solved numercally employng he sacked Far-Taylor soluon algorhm as mplemened n Dynare. For furher nformaon on hs mplemenaon see Jullard (996). 5

18 The mpac of he budge reform on GDP consumpon nvesmen and ne expors s shown n Fgure 4. Ineresngly aggregae oupu ncreases hroughou he smulaon. Even n he shor-run he consoldaon of governmen fnances s found o boos economc acvy n he prvae secor suffcenly o overcome he reducon n governmen spendng. Consumpon and oupu ncrease on mpac wh anoher ncrease afer 5 o years. Consumpon even exceeds oupu for several years. Invesmen decreases emporarly bu also rses n he longer run. The reducon n governmen spendng rases permanen ncome of households who hen wsh o consume more goods and o enjoy more lesure. The labor ax cus lower dsorons o he ncenves o work and produce and rgger an ncrease n labor demand and supply. Fgure 4: Impac on GDP and s componens.5.5 Oupu Consumpon Invesmen Ne-expors Noes: Values shown are percenage devaons from baselne. As shown n Fgure 5 hours worked ncrease subsanally parallel wh produced oupu. More work effor also nduces hgher demand for capal servces npu n producon. The CMS model allows for varable capal ulzaon subjec o an adjusmen cos. Inally ncreased npu of capal servces n producon s acheved by greaer capal ulzaon. In fac he nensy of use rses suffcenly o olerae a small emporary declne n he sock of capal. Thus allows nvesmen o declne emporarly so ha consumpon growh can exceed oupu growh for a few years. Over me nvesmen urns posve and capal s accumulaed o reach a hgher level n he long-run seady-sae. 6

19 Fgure 5: Labor and capal servces n producon Hours worked Capal Ulzaon.5 Capal Capal Servces Noes: Values shown are percenage devaons from baselne. The real neres rae s nearly fla hroughou he smulaon (see Fgure 6) ncreasng slghly due o he expeced ncrease n consumpon and oupu growh. The susaned declne n he real wage mrrors he fndng ha he posve labor supply effec of reduced dsorons ouweghs he negave effec from ncreased lfe-me ncome..5% Fgure 6: Ineres rae exchange rae and nflaon Real neres rae Real exchange rae.5%.5% Inflaon.%.%.%.5%.5%.5%.%.%.% Noes: The scale on he vercal axs denoes percenage pon changes. An ncrease n he real exchange rae s a real deprecaon. Furhermore he CMS model shows ha ne expors also conrbue o he ncrease n GDP (dashed-doed lne n Fgure 4). They are smulaed by a real deprecaon of he dollar as ndcaed n Fgure 6. 7

20 Deb-o-GDP rao Fgure 7: Deb and prmary defc prmary defc Noes: The deb-o-gdp rao as well as he prmary defc are shown n levels n erms of percen of oupu. Prmary defc pror o neres payed on exsng deb. A negave prmary defc mples a surplus. Whle some of he governmen savngs acheved by expendure reform are used o lower he labor ax rae he remander s appled o deb reducon. 8 Lower governmen deb ogeher wh he ncrease n GDP mples a declne n he deb o GDP rao from he nal level of 6 percen o abou 48 percen by 3 as shown n Fgure 7. The prmary defc whch nally jus covers neres pad on exsng deb mproves wh he sar of he consoldaon. Ulmaely mples ha he sock of deb s reduced by almos 9 percen. Snce he CMS model covers he U.S. and he euro zone economes allows us o evaluae he foregn mpac of U.S. budge consoldaon. Fgure 8 shows ha spllover effecs o he euro area are relavely moderae. The effec on aggregae euro zone GDP s small bu posve hroughou he smulaon. Whle ne expors decrease due o he real apprecaon of he euro consumpon and wages ncrease on mpac. Invesmen falls for some me before reurns o posve errory. Fgure 8: Spllovers o he euro area.5 EA Oupu EA Consumpon EA Invesmen EA Ne-expors Noes: Values shown are percenage devaons from baselne. 8 The model also conans lump-sum axes. Small flucuaons n hese axes occur due o he dffculy of fndng a pah whch gves boh a smooh reducon n he deb o GDP rao and n he ax rae. 8

21 5. Why ax cus raher han only deb reducon? Lower dsorons rase growh. Our evaluaon ndcaes ha lower axes relave o he baselne are cenral o ensurng a posve mpac of he consoldaon on aggregae GDP and employmen whch suggess ha expendure cus raher han ax hkes should be used o generae governmen savngs. Whle par of hese savngs would be appled o reducng ousandng deb he remander would be used o keep ax raes below wha hey would oherwse have been. Wh regard o he curren oulook for he Uned Saes economy our consoldaon sraegy mples reurnng governmen expendures o pre-crss levels n erms of share of GDP n order o avod an ncrease n dsoronary axes. Thus a hs juncure n he Uned Saes he sraegy would no necessarly requre legslang acual ax reducons bu raher decdng no o le hem rse so as o negae he dsncenves o work and producon arsng from currenly expeced ax hkes. In our model smulaons we explore he role of axes furher by consderng wo addonal scenaros relave o he benchmark consoldaon of secon 4. One addonal scenaro consders he planned reducon n governmen purchases and ransfers bu leaves he labor ax rae unchanged. The oher scenaro consders a mxure of labor and capal ax rae reducons of 3 and percen respecvely. Table : Lowerng ax dsorons rases GDP: long-run effecs Varable Benchmark consoldaon N G TR Labor ax consan G TR Labor&capal ax reduced N G TR Governmen purchases -.5% -.5% -.5% Transfers -.85% -.85% -.85% Labor ax rae -5% % -3% Capal ax rae % % -% Oupu.8% -.5%.% Consumpon.83%.%.4% Invesmen.3% -.%.34% Ne Expors.6% -.%.3% Hours worked.99% -.5%.8% Capal.4% -.48%.54% Deb-o-GDP (nally 6%) 47.87% 4.34% 45.% Noes: Values shown are percenage devaons from baselne excep for changes n ax raes ha are ndcaed n percenage pons and he deb-o-gdp rao ha s gven n levels n erms of percen of oupu. K 9

22 Table repors he long-run effecs under he hree scenaros. GDP ncreases by.8 percen n he benchmark case. If he labor ax rae s kep a he baselne hen he longer run effec of governmen spendng cus on GDP s negave a -.5 percen whle remans posve wh regardng o prvae secor consumpon. In hs case he ncenve o enjoy more lesure n response o an ncrease n lfeme ncome domnaes households labor supply decson and resuls n a reducon n hours worked. Wh he labor and capal ax cus ogeher GDP sll ncreases bu less han n he benchmark case a. percen. In hs scenaro he capal sock s greaer and hours worked smaller han for he benchmark. Fgure 9 dsplays he ranson pahs for oupu consumpon nvesmen ne expors hours and he deb-o-gdp rao under he hree scenaros. Even n he smulaon wh consan labor ax oupu rses nally. The reason s ha governmen spendng s reduced only very gradually bu permanen-ncome households ncrease consumpon on mpac ancpang hgher lfeme ncome. Also nvesmen s up for some me before declnes owards a lower value n he long run. The deb-o-gdp rao however declnes fases and furhes n he smulaon wh consan ax raes. Fgure 9: Benchmark consoldaon vs scenaro whou labor ax reducon and mxure of labor and capal ax reducon Oupu Consumpon Invesmen Ne-Expors Hours worked labor ax reducon no ax reducon capal + labor ax reducon Deb-o-GDP rao Noes: Values shown are percen devaons from baselne excep for he deb-o-gdp rao whch s gven n levels n erms of percen of oupu. Reducon n governmen purchases and ransfers wh ax adjusmen (sold) whou ax adjusmen (dashed) wh labor and capal ax reducon (dashed-doed; labor ax reduced by 3% capal ax reduced by %)

23 6. How does he Fscal Consoldaon Sraegy smulae GDP n he near erm? An mporan fndng of our analyss wh he CMS model s ha he Fscal Consoldaon Sraegy already ncreases GDP n he shor- and medum-run. I s naural o ask o wha exen hs fndng depends on specfc feaures of he sraegy such as he mx of cus n governmen purchases versus ransfers and he degree of gradualsm or on feaures of he economc envronmen such as parcular nomnal rgdes. Fgure repors he oucomes under he wo exreme alernaves regardng he mx of purchases versus ransfer cus whle mananng he benchmark pah for he labor ax rae. In one case he full reducon of 3.4 percen of GDP s acheved by cung governmen purchases and n he oher case by cung ransfers. Varables shown nclude aggregae oupu consumpon nvesmen and hours worked. Fgure : Reducon n governmen purchases and ransfers separaely 3 Oupu 3 Consumpon Invesmen Transfer cu Gov. purchase cu Benchmark consoldaon 3 Hours worked Noes: Values shown are percenage devaons from baselne. All scenaros nclude a reducon of he labor ax rae of 5%. If s all ransfer cus (dashed lne) oupu ncreases even a b more han n he benchmark case. If consoldaon s acheved by reducng governmen purchases only oupu declnes n he medum o longer-erm (doed lne). Alhough household consumpon rses by more han 3 percen due o he ncrease n lfeme ncome wh lower axes and consan ransfers hs ncrease s no suffcen o offse he reducon n drec governmen demand. Hours worked declne n he medum erm because he posve ncenve effecs from lower

24 labor axes are no suffcen o overwhelm he negave labor supply effec of ncreased lfeme ncome and he negave demand effec from governmen purchases cus. Accordng o hs model a mxure of spendng cus ha s more led owards a reducon n ransfers has a greaer o chance o ncrease GDP and employmen n he shor- medum- and longer-run. Transfers affec demand ndrecly hrough household consumpon whle governmen purchases have a drec demand effec. In a model wh only forwardlookng permanen-ncome consumers and lump-sum axes ransfer cus would leave oupu unchanged whle reducons n governmen purchases would reduce because such consumers would only use par of he possble ncrease n ncome o consume goods bu forego he res o enjoy more lesure. Ths negave labor supply effec of he reducon n governmen purchases would reduce oupu. Wh dsoronary axaon ransfer cus would reduce dsorons and herefore ncrease oupu. The GDP mpac of purchases cus n such a model could be negave or posve dependng on wheher he effec of lowerng dsorons s suffcenly large o overcome he drec demand effec. Gradualsm n reducng purchases ncreases he chance ha he shor-run mpac on GDP s posve. The reason s ha permanen-ncome consumers respond mmedaely o hgher ancpaed lfeme ncome. The presence of fnancally consraned households as n he model used here furher booss he shor-run effec because her consumpon s more responsve o curren ncome. 9 For hese reasons he GDP mpac of our benchmark sraegy benefs from he greaer wegh on ransfer cus. Imporanly such a mxure s also more approprae o regn n governmen deb under curren crcumsances because pos-crss ncreases n governmen expendures are prmarly arbuable o greaer ransfers. Nex we consder hree dfferen expermens regardng he degree of gradualsm. In dong so we manan he orgnal mx of ransfers and purchases from he benchmark consoldaon. Frs we accelerae governmen spendng reducons keepng he speed of labor ax reducon unchanged. Second we also accelerae he ax reducon. Thrd we consder a delay of he ax reducon leavng he mng of spendng cus unchanged. The mpac of he frs wo expermens on he economy s dsplayed n Fgure. Purchases and ransfers are reduced wce as fas (doed and dashed lnes) as n he benchmark case (sold lne). If he speed of labor ax reducon remans he same (doed lne) hen he near-erm ncrease of GDP s smaller han under he benchmark consoldaon. 9 Ths fndng was also obaned n Cwk and Weland () n he case of ancpaed fuure spendng cus ha were of a emporary naure.

25 Fgure : Less gradual versus benchmark consoldaon Governmen purchases Transfers. Labor ax rae Oupu Consumpon Less gradual reducon of G TR ax Less gradual reducon of G TR Benchmark..5.5 Invesmen Noes: Values shown are percenage devaons from baselne excep for he labor ax rae whch s shown n levels. Thus more gradual phasng-n of expendure cus mproves he near-erm smulave effec on producon and employmen. However f he labor ax s also reduced wce as fas (dashed lne) as n he benchmark consoldaon hen GDP ncreases much more n he medum erm. Gradual phasng-n of ax cus herefore weakens he medum-erm smulus o producon and employmen ha comes from lowerng dsorons o ncenves. The oucome under he hrd expermen s shown n Fgure. In hs scenaro he labor ax cu s posponed by fve years. Spendng reducons however connue o be mplemened wh he orgnal mng. Relave o he benchmark consoldaon (sold lne) he delay n lowerng he labor ax subsanally weakens he posve medum-erm mpac on overall GDP consumpon and employmen. Invesmen even declnes n he medum erm. From a polcal perspecve he sraegy wh delayed ax cus mgh be consdered more easly mplemenable f such cus are perceved as unpopular durng he nal perod of expendure-based ausery. However o he exen ha he curren baselne oulook for he Uned Saes ncorporaes ax ncreases he sraegy would prmarly requre absanng from ax hkes. In hs case such concerns regardng polcal feasbly would appear less relevan. 3

26 Fgure : Lowerng of labor ax posponed by 5 years. Oupu Consumpon Invesmen ax reducon afer 5 years mmedae ax reducon Noes: Values shown are percenage devaons from baselne. Fnally we consder he nfluence of nomnal rgdes n he economy wh regard o he near-erm mpac of fscal consoldaon on GDP. To hs end we se he so-called Calvo parameers for wage and prce seng ( H X I ) and he ndexaon parameers ( H I ) ha govern he mporance of nomnal rgdes o zero. As shown n Fgure 3 GDP rses more slowly n he near erm f nomnal rgdes are suppressed n hs manner (dashed lne). Ths fndng ndcaes ha prce flexbly mues he near erm smulave mpac of fscal consoldaon. Wh rgd prces quanes ncludng overall producon and employmen adjus more n he near erm. Frms ha are faced wh hgher demand bu prevened from seng hgher prces nsead hre more labor and ncrease her oupu. Hgher household ncome ranslaes o greaer demand even more so f some of he households are fnancally consraned and consume more n lne wh curren ncome. Fgure 3: Exen of nomnal rgdes and fscal consoldaon.5 Oupu no nomnal rgdes benchmark Noes: Values shown are percenage devaons from baselne. 4

27 7. Sensvy sudes Oher modellng approaches To help esablsh he robusness of our resuls we consder wo addonal ypes of models. Frs we presen a neoclasscal growh model wh flexble prces forward-lookng households and dsoronary axes. Such a model s useful for comparng some of he longerrun mplcaons of changes n governmen spendng and ax cus. Second we employ he CCTW model whch s esmaed wh U.S. daa o check wheher comparable expermens mply smlar mpulse responses n he shor o medum run. The neoclasscal model we use bulds on Kng Plosser and Rebelo (988) and he dscusson n Baxer and Kng (993) and he Ljungvs and Sargen (4) exbook. As n he CMS model he governmen purchases goods and fnances s purchases wh dsoronary consumpon capal and labor axes as well as non-dsoronary lump-sum percapa axes. Households have preferences over consumpon and lesure usng exacly he same funconal form for he uly funcon as n he CMS model excep ha we se he degree of hab formaon o zero. However all households can buy bonds and hold physcal capal for smoohng consumpon. Households and he governmen have o fulfll he followng budge consrans: p ( ) c p r ( ) k w ( ) l p c (4) k l h p g c pc r kk w ll p h. (5) Here p denoes he me perod pre-ax prce of one un of nvesmen consumpon or governmen spendng. w refers o nomnal pre-ax wages and r o he nomnal pre-ax renal rae of capal. The consumpon- capal- and labor ax raes are se exogenously. Lump-sum axes are a resdual used o balance he governmen budge gven he exogenously specfed pahs for governmen spendng and dsoronary ax raes ( g 5 ). Oupu s produced wh a sandard Cobb-Douglas producon echnology (smlar o he one n equaon (8) bu whou any fxed coss) and capal s accumulaed as n equaon (5) bu whou any nvesmen adjusmen coss. The model s a closed economy model so ha marke clearng requres ha y c g. c k l

28 In equlbrum a represenave household chooses c l o maxmze uly subjec o he budge consran. A represenave frm chooses k l o maxmze profs subjec o he producon funcon. A feasble governmen polcy s an expendure and ax plan g c k l h c y a sequence ha sasfes s budge consran equaon (7). A feasble allocaon s ha sasfes marke clearng. The parameer values are chosen smlarly o comparable parameers n he CMS model ncludng he ax raes. One excepon s he labor ax rae whch we se o.5% nally ha s equal o he sum of he labor ax rae and households socal secury conrbuons n he CMS model. A comparson of he long-run effecs of he Fscal Consoldaon Sraegy and an alernave scenaro wh all ransfer cus n he CMS and he neoclasscal (NC) models s repored n Table 3. The long-run mpac on GDP s very smlar. I s up.8 percen n he CMS and.93 n he NC model. Also nvesmen and hours worked converge o very smlar values n he wo models. The effec on consumpon s a b larger n he NC model whch as Table 3: Long-run effecs: CMS versus NC model Model Varable Benchmark consoldaon N G TR All ransfers N TR Governmen Purchases -.5%.% Transfers -.9% -3.36% Labor ax rae -5%* -5%** CMS Oupu.8%.6% NC.93%.85% CMS Consumpon.83%.59% NC.8%.5% CMS Invesmen.3%.39% NC.36%.35% CMS Hours worked.99%.33% NC.93%.85% CMS Capal.4%.76% NC.93%.85% Noes: Values shown are percenage devaons from baselne. *In he case of he NC model we need o adjus he labor ax rae so ha he change n ransfers s -.9%. The requred change n he labor ax rae devaes slghly from 5% and amouns o 5.5%. **In he case of he NC we need o adjus he labor ax rae so ha he change n ransfers s -3.36%. The requred change n he labor ax rae devaes slghly from 5% a 4.7%. 6

29 a closed economy does no ncorporae he smulave effec of he real deprecaon ha s a work n he CMS model. Fnally he sock of capal rses somewha more n he NC model han he CMS model. The smulaon wh only ransfer cus mples slghly larger devaons n erms of he mpacs on GDP and hours bu smaller ones concernng he capal sock. Overall he smple NC model delvers he same qualave conclusons and surprsngly smlar quanave fndngs regardng he long-run mpac of fscal consoldaon when compared o he more complcaed CMS model. Addonally we consder he CCTW model whch s esmaed wh U.S. daa usng Bayesan mehods as an emprcal benchmark. Noe also he rule-of-humb households n hs model are less sophscaed han he households of ype J n he CMS model who can sll use money n place of bonds o smooh consumpon. Because he CCTW model does no ncorporae he ncenve effecs of changes n ax raes we confne hese comparsons o smulaons of reducons n governmen purchases where he funds saved are pad ou n lump sums. The shor- o medum run mpac s qualavely smlar o he CMS model hough consumpon ncreases a b less and oupu declnes faser n he CCTW model. Oher parameerzaons: labor supply elascy openness and capal ulzaon Snce we have no esmaed he CMS model s parameers drecly s mporan o consder he robusness of our fndngs across plausble parameer values. One check ha we have conduced s o use he euro area parameer values ha were aken by Coenen e al (8) from Smes and Wouers (3) for evaluang fscal consoldaons. We obaned he same qualave fndngs as wh our U.S. parameers from Cogan e al (). Clearly he household labor supply reacon plays an mporan role n he analyss. In he absence of a reducon n dsoronary axaon for example f governmen expendure cus are used o lower lump-sum axes households n a sandard neoclasscal model would reac by ncreasng consumpon bu also enjoyng more lesure. The negave labor supply response would nduce lower producon. Our consoldaon sraegy overcomes hs effec by applyng par of he governmen savngs o lower dsoronary axes (relave o baselne). The resulng boos o GDP hough sll depends on he preference parameer n household uly ha governs he labor supply elascy. In he benchmark calbraon we have se he parameer o he value esmaed by Cogan e al () whch n urn s very close o he value esmaed by Smes and Wouers (7). The resulng elascy s.5. Whle hs s a wdely used value ha s also conssen 7

30 wh mcroeconomc sudes (see Chey e al ) mgh be oo hgh o capure labor supply responses a leas wh regard o reducons n labor supply. Over comng years when he economy may requre subsanal shfs n secoral labor allocaon followng he grea recesson job holders may be less wllng o reduce hours or qu her job compared o earler decades. As o ncreases of hours worked he elascy may be hgher because of he pool of unemployed. Fgure 4: The role of he labor supply elascy. Oupu Consumpon Invesmen Hours elascy=4 elascy=.5 elascy=.5 Noes: Values shown are percenage devaons from baselne. The labor supply elascy parameer s se as follows: baselne: elascy=.5 (sold lne); very elasc (elascy=4; dashed-doed lne); very nelasc (elascy =.5; dashed lne). To llusrae he mplcaons of dfferen assumpons abou he elascy of labor supply we smulae he Fscal Consoldaon Sraegy n he CMS model wh more exreme sengs. Fgure 4 dsplays oucomes wh a low elascy of.5 (dashed lne) and a very hgh elascy of 4 (dashed-doed lne) relave o he orgnal parameerzaon (sold lne). Snce he consoldaon ncorporaes lower dsoronary axes and nduces an ncrease n labor supply n he benchmark sraegy s GDP mpac s even greaer wh a more elasc labor supply. As noed earler anoher specal feaure of he CMS model s he varably of capal ulzaon. The fscal consoldaon we have suded nduces a faser ncrease n consumpon han n GDP over he medum erm along wh a emporary declne n nvesmen. Even so capal servces npu ncreases hanks o greaer capal ulzaon (recall Fgure 5). Fgure 8

31 5 provdes a comparson wh consan capal ulzaon (dashed lnes). In hs case consumpon and oupu ncrease more slowly whle nvesmen rses n he medum erm. The capal sock ncreases much more quckly snce ulzaon canno be nensfed. Fgure 5: Consan versus varable capal ulzaon. Oupu Capal Consumpon Capal Ulzaon Invesmen Capal Servces consan capal ulzaon varable capal ulzaon Noes: Values shown are percenage devaons from baselne. Fnally we nvesgae moneary and fscal polcy neracon n he very near erm. To hs end we smulae versons of he CMS model wh dfferen moneary polcy rules. In one case we jus reduce he coeffcen on he lagged neres rae o zero ha s we remove he neres rae smoohng feaure of he rule. In he oher case we remove smoohng and ncrease he coeffcen of oupu growh from. n he orgnal model specfcaon o a much greaer value of. Fgure 6 ndcaes he near erm changes n he pah of GDP nduced by he fscal consoldaon under hese wo modfcaons relave o he baselne specfcaon. Quanavely he dfferences are raher small. Oupu rses a b less n he frs year of he smulaon bu exceeds he benchmark smulaon n he second and hrd year. 9

32 Fgure 6: Dfferen moneary polcy rules. Oupu No smoohng No smoohng + hgh oupu response benchmark Noes: Values shown are percenage devaons from baselne. 8. Conclusons In hs paper we esmaed he macroeconomc mpacs of a fscal consoldaon sraegy n whch he governmen gradually reduces spendng over me n order o reduce he defc and he growh of he deb. For concreeness he sarng pon for assessng he sraegy s he curren budge suaon n he Uned Saes where federal spendng ncreased sharply as a share of GDP durng he recen fnancal crss and grea recesson. Spendng s expeced o reman hgh no he fuure under he baselne projecon of he Congressonal Budge Offce (CBO) wh susanably requrng ha axes wll be rased n he fuure. The fscal consoldaon sraegy consdered here brngs federal spendng below hs CBO baselne wh spendng as a share of GDP reurnng o he percenage observed pror o he crss. Whle he decrease n spendng s gradual sars n he frs quarer of he new sraegy. Boh ransfer paymens and governmen purchases of goods and servces are reduced relave o he baselne hough ransfers are reduced by a larger amoun. The sraegy uses he funds saved boh o reduce ax raes and he deb relave o he baselne. A bg queson s wheher he reducon n governmen spendng reduces GDP n he shor run a concern ha has been rased by many economss and polcy makers. We examne hs queson and ohers by smulang he sraegy n a modern economc model calbraed o he U.S. and euro area economes. In hs model households are forward lookng and hey adjus her behavor n response o expecaons of fuure ax and spendng polcy. Furhermore he model ncorporaes prce and wage rgdes ha are amed a more explcly capurng shor run effecs as well. 3

33 Accordng o he model smulaons he sraegy ncreases GDP n boh he shor run and he long run relave o he baselne. There appear o be hree sources of hs posve effec. Frs lower levels of governmen spendng n he fuure compared o he baselne mply lower axes and hereby hgher lfeme ncome for households who respond by consumng more even n he shor run. Second he lowerng of fuure ax raes removes dsorons and provdes ncenves ha smulae employmen and producon. And hrd lower governmen spendng and deb reduces he exchange rae hereby ncreasng ne expors whch also help offse he declne n governmen spendng. More generally he gradual and credble declne n governmen spendng allows he prvae secor o adjus smoohly o he declne n spendng whou negave dsrupons. Delayng ax reducons by conras would also delay he benefcal mpac of reduced dsorons on employmen and producon. Clearly he credbly of fuure consoldaon s key o nducng he posve GDP response n he shor- o medum run. A full echncal analyss of he quanave mplcaons of mperfec credbly needs o be aken up n fuure work. Even so f credbly s mperfec polcy makers would be well advsed o mplemen bndng legslaons as quckly as possble so ha households and frms can make plans on hs new bass. Furhermore f mplemenaon needs o be acceleraed n order o convnce markes our smulaons would sugges ha he lowerng of axes should be acceleraed along wh he expendure cus n order o ake advanage of mproved ncenves a an earler sage. Whle he fscal consoldaon sraegy focusses on curren crcumsances n he Uned Saes he mehodology can easly be appled o consoldaon plans n oher counres or o jon consoldaon plans n several counres. Thus would be very worhwhle o conduc smlar nvesgaons usng srucural macroeconomc models ha are calbraed or esmaed wh daa from oher counres. Ineresngly emprcal sudes such as Alesna Favero and Gavazz () ha use he so-called narrave approach for analysng he mpac of mulperod consoldaon plans on economc growh oban fndngs ha complemen our more srucural analyss. See Roeger and n Veld () for an analyss of fscal polcy opons n he euro area. Usng daa from 7 OECD counres colleced by Devres e al () hey conclude ha spendng based adjusmens have been assocaed wh mld shor-lved recessons or no recesson a all whle ax-based adjusmens have been assocaed wh deep and pro-longed recessons. See also Alesna and Ardagna () and Pero () for he posve effecs of fscal consoldaons ha have been accompaned by reducons n polcy-nduced economc dsorons. 3

34 References Alesna A. and S. Ardagna () Wha makes fscal adjusmens successful? unpublshed. Alesna A. C. Favero and F. Gavazz () The oupu effec of fscal consoldaons NBER Workng Paper Baxer M. and R. G. Kng (993) Fscal polcy n general equlbrum The Amercan Economc Revew 83(3): Calvo G Saggered prces n a uly maxmzng framework Journal of Moneary Economcs Chey R. A. Guren D. Manol and A. Weber () Are mcro and macro labor supply elasces conssen? A revew of evdence on he nensve and exensve margns The Amercan Economc Revew Papers and Proceedngs (3): Chrsano L. J. M. Echenbaum and C. L. Evans (5) Nomnal rgdes and he dynamc effecs of a shock o moneary polcy Journal of Polcal Economy 3(): -45. Coenen G. P. McAdam and R. Sraub (8) Tax reform and labour-marke performance n he euro area: A smulaon-based analyss usng he New Area-Wde Model Journal of Economc Dynamcs and Conrol 3: Cogan J. T. Cwk J. B. Taylor and V. Weland () New Keynesan versus old Keynesan governmen spendng mulplers Journal of Economc Dynamcs and Conrol 34: Cwk T. G. J. Müller and M. Wolers (). Does rade negraon aler moneary polcy ransmsson? Journal of Economcs Dynamcs and Conrol 35(4): Cwk T. and V. Weland () Keynesan governmen spendng mulplers and spllovers n he euro area Economc Polcy July 6: Devres P. J. Guarjardo D. Legh and A. Pescaor () A new acon-based daase of fscal consoldaon IMF Workng Paper No. /8. Gavazz F. and M. Pagano (99) Can severe fscal conracons be expansonary? Tales of wo small european counres NBER Macroeconomcs Annual 5: 75-. Jullard M. (996) Dynare: A program for he resoluon and smulaon of dynamc models wh forward varables hrough he use of a relaxaon algorhm CEPREMAP Workng Paper 96. Ljungqvs L. and T. J. Sargen (4). Recursve Macroeconomc Theory MIT Press nd edon. Kng R. G. Plosser C. I. and Rebelo S. T. (988) Producon growh and busness cycles : I. The basc neoclasscal model Journal of Moneary Economcs (-3): Pero R. () The aushery myh: gan whou pan? forhcomng n A. Alesna and F. Gavazz (). Roeger W. n ' Veld J. (). Fscal smulus and ex sraeges n he EU: a model-based analyss" European Economy Economc Papers no. 46. Smes F.Wouers R. (3). An esmaed dynamc sochasc general equlbrum model of he euro area Journal of he European Economc Assocaon. (5) Smes F. and R. Wouers (7) Shocks and frcons n U.S. busness cycles: a Bayesan DSGE approach Amercan Economc Revew 97 3: Taylor J. B. and V. Weland () Surprsng comparave properes of moneary models The Revew of Economcs and Sascs forhcomng. Weland V. T. Cwk G. Müller S. Schmd and M.Wolers () A new comparave approach o macroeconomc modellng and polcy analyss Journal of Economc Behavor and Organsaon forhcomng. 3

35 IMFS WORKING PAPER SERIES Recen Issues 6 / Peer Tllmann Mak H. Wolers The Changng Dynamcs of US Inflaon Perssence: A Quanle Regresson Approach 59 / Mak H. Wolers Evaluang Pon and Densy Forecass of DSGE Models 58 / Peer Tllmann Capal Inflows and Asse Prces: Evdence from Emergng Asa 57 / Ahanasos Orphandes Volker Weland 56 / Fabo Verona Manuel M.F. Marns Inês Drumond Complexy and Moneary Polcy (Un)ancpaed Moneary Polcy n a DSGE Model wh a Shadow Bankng Sysem 55 / Fabo Verona Lumpy Invesmen n Scky Informaon General Equlbrum 54 / Tobas H. Tröger Organzaonal Choces of Banks and he Effecve Supervson of Transnaonal Fnancal Insuons 53 / Sebasan Schmd Opmal Moneary and Fscal Polcy wh a Zero Bound on Nomnal Ineres Raes 5 / Sebasan Schmd Volker Weland 5 / Vven Lews Arnoud Sevens The New Keynesan Approach o Dynamc General Equlbrum Modelng: Models Mehods and Macroeconomc Polcy Evaluaon The Compeon Effec n Busness Cycles 5 / Vven Lews Opmal Moneary Polcy and Frm Enry 49 / Volker Weland Tobas Cwk Gerno J. Müller Sebasan Schmd Mak Wolers A New Comparave Approach o Macroeconomc Modelng and Polcy Analyss 48 / Helmu Sekmann De rechlche Regulerung öffenlcher Banken n Deuschland 47 / Helmu Sekmann De Europäserung der Fnanzmarkaufsch 46 / Chrsos Koulovaanos Volker Weland Asse Prcng under Raonal Learnng abou Rare Dsasers