Tales of fiscal adjustment

Abstract

Fiscal adjustments Why they can be expansionary This paper examines the evidence on fiscal adjustments in OECD countries from the early 1960s to today. The results shed light on the recently observed phenomenon of fiscal tightening that produces (non‐Keynesian) expansionary effects. One interpretation is that a serious fiscal tightening increases demand. Wealth rises when future tax burdens decline, and when interest rates decline credibility is restored and inflation or default risks abate. Both consumption and investment rise. For this effect to produce an expansion, the tightening must be sizeable and occur after a period of stress when the budget is quickly deteriorating and public debt is building up. Another interpretation emphasizes the supply side. Typically, a fiscal consolidation based on tax increases is short‐lived. To be long lasting, it must include cuts in public employment, transfers and government wages. To be politically possible, such a policy must be supported by trade unions. These measures result in more efficient labour markets and boost the supply side. Based both on statistical evidence and on a detailed analysis of ten cases of major fiscal adjustment, this article provides cautious support to the supply‐side view, without denying a more limited role for the demand‐side channel. — Alberto Alesina and Silvia Ardagna