Fiscal consolidations and distributional effects: what fiscal austerity is least bad?

Distributional consequences of fiscal austerity, while being increasingly recognised in the policy debate, have received little attention in the existing formal work. This paper proposes a medium scale New-Keynesian DSGE model incorporating an appropriate dimension of household heterogeneity and a well-specified fiscal structure, allowing for a comprehensive analysis of losers and winners from austerity. We find that cutting transfers and public employment and raising labour income taxes are the most regressive forms of austerity, greatly raising income inequality. In contrast, raising capital income taxes is progressive - the only such policy in our analysis - with also the smallest output losses in the short-run. Second, the speed of austerity emerges as a potential tool in fiscal adjustment. Indeed, speedy austerity yields worst distributive and output effects irrespective of its composition. Finally, fiscal consolidation is particularly damaging in downturns where distributional effects are substantially more unfavourable than in normal times.

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CC BY-NC-ND 4.0