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ALBERTO ALESINA and ROBERTO PEROTTI*
This paper studies how the composition of fiscal adjustments influences their likelihood of "success," defined as a long-lasting deficit reduction, and their macroeconomic consequences. We find that fiscal adjustments that rely primarily on spending cuts in transfers and the government wage bill have a better chance of success and are expansionary. On the contrary, fiscal adjustments that rely primarily on tax increases and cuts in public investment tend not to last and are contractionary. We discuss alternative explanations for these findings by studying a full sample of members of the Organization for Economic Cooperation and Development and by focusing on three case studies: Denmark, Ireland, and Italy. [JEL HI, H5, E62]
IN THE LAST two decades, the debt-to-GDP ratios of many members of the Organization for Economic Cooperation and Development (OECD) have increased to levels historically observed only in the aftermath of major wars, as Table 1 documents. The policymakers of countries with fiscal problems face several critical questions:
How large should the fiscal adjustment be? Should one cut expenditures or raise revenues, and, more specifically, which components of spending and revenues should one adjust?
Will the fiscal consolidation last, or will it be reversed and will larger deficits soon reappear? and Will the fiscal adjustment cause a recession?
The critical point that we stress in this paper is that all these questions are deeply interconnected. ] For instance, the composition of the fiscal adjustment influences both the likelihood of achieving a permanent consolidation of the budget and the macroeconomic consequences of the fiscal consolidation.
We identify two different types of fiscal adjustments. "Type I" adjustments rely primarily on expenditure cuts, in particular, cuts in transfers, social security, government wages, and employment. Tax increases are a small fraction of the total adjustment, and, in particular, taxes on households are not raised at all or are even reduced. On the contrary, "Type 2" adjustments rely mostly on broad-based tax increases, and often the largest increases are in taxes on households and social security contributions. On the expenditure side, almost all the cuts are in public investment, while government wages, employment, and transfers are completely untouched or only slightly affected. We find that, even when the two types of adjustments...