Fiscal Consolidation

Fiscal consolidation is the reduction of government borrowing, achieved through spending cuts, tax increases, or a combination of the two. Consolidation is undertaken to restore fiscal sustainability, to reduce the debt ratio, and to reassure creditors and markets.

Objectives

The primary objective of consolidation is to restore sustainability, by ensuring that the debt ratio does not continue to rise. This requires a primary surplus sufficient to stabilise the ratio, given the difference between the interest rate and the growth rate.

Consolidation may also aim to reduce the cost of borrowing, to restore the confidence of investors, and to create space for future spending. It may be undertaken in response to pressure from markets or from international institutions, or as a matter of domestic policy.

Instruments

Consolidation can be achieved through expenditure measures or through revenue measures. On the expenditure side, measures include cuts to public sector pay and employment, reductions in transfers, and reductions in investment. On the revenue side, measures include increases in tax rates, the broadening of tax bases, and the introduction of new taxes.

The choice between the two affects the macroeconomic and distributional consequences. Expenditure cuts tend to reduce demand directly, while tax increases reduce disposable income and thereby consumption. The distributional effects differ, since the two approaches affect different groups.

The Multiplier and the Effects

The effects of consolidation on output depend on the size of the fiscal multiplier. If the multiplier is large, consolidation reduces output substantially in the short run. If the multiplier is small, the effect is more modest.

The effects also depend on the response of monetary policy. If the central bank lowers interest rates in response to consolidation, the contractionary effect is offset. If monetary policy is constrained, for example at the zero lower bound, the effect is larger.

A further consideration is the response of confidence. Some argue that consolidation can raise confidence and thereby stimulate private demand, an effect known as expansionary austerity. The evidence for this effect is mixed, and it appears to depend on the circumstances, particularly on the response of monetary policy and on the credibility of the consolidation.

Composition and Credibility

The composition of consolidation matters for its effects. Measures that are perceived as permanent and credible are more likely to reduce the cost of borrowing, while measures that are perceived as temporary are less likely to do so. The credibility of the adjustment depends on the institutions that support it, including fiscal rules and independent fiscal councils.

The composition also matters for equity. Measures that fall disproportionately on the poor may worsen inequality and may be politically difficult to sustain. The design of consolidation must therefore consider the distributional consequences as well as the macroeconomic effects.

Timing and Sequencing

The timing of consolidation is a central question. Consolidating during a downturn can deepen the recession, while delaying consolidation can allow the debt to grow and can increase the required adjustment. The choice depends on the urgency of the fiscal problem and on the scope for monetary policy to offset the contraction.

The sequencing of measures also matters. Measures that are announced in advance and phased in gradually can allow the private sector to adjust and can reduce the short-run costs. Measures that are implemented abruptly can have larger and more disruptive effects.

The credibility of the adjustment affects its success. If the private sector believes that the consolidation will be sustained, the effect on confidence and on the cost of borrowing can offset part of the contractionary effect. If the adjustment is not credible, the effect is weaker.

Distributional Effects

Consolidation has distributional effects, which depend on the composition of the measures. Cuts to transfers and to public services tend to affect lower-income households more, since they rely more on these programmes. Increases in consumption taxes are also regressive, since lower-income households spend a larger share of their income on consumption.

The design of consolidation can mitigate these effects. Measures that protect the most vulnerable while reducing spending elsewhere can achieve the fiscal objective with less harm to equity. Measures that raise revenue from progressive sources can also limit the regressive effects.

The distributional effects of consolidation matter for its political sustainability. Measures that are perceived as unfair may face resistance and may be reversed. The design of consolidation must therefore consider the political as well as the economic consequences.

Institutional Framework

The institutional framework affects the conduct and the outcome of consolidation. Fiscal rules can provide a framework for the adjustment and can anchor expectations. Independent fiscal councils can provide analysis and can hold governments to account.

The framework also includes the mechanisms for monitoring and for enforcement. The effectiveness of the framework depends on the credibility of the commitment and on the willingness of the authorities to bear the political costs of adjustment.

The experience of consolidation across countries suggests that the framework matters for the outcome. Countries with stronger institutions have generally been more successful in achieving lasting consolidation, while those with weaker institutions have often experienced repeated cycles of adjustment and of relaxation.

Summary

Fiscal consolidation is undertaken to restore sustainability, and its effects depend on its timing, its composition, and its credibility. The design of consolidation must balance the fiscal objective against the effects on output and on distribution, and it must be supported by an effective institutional framework.

See also

• Fiscal Policy
• Deadweight Debt
• Government Bond