Fiscal Austerity Measures : Spending Cuts vs . Tax Increases ∗ ( Preliminary and incomplete - Do not cite ! )

Increasing fiscal deficits raise the possibility that many advanced economies will reach a state at which taxes and spending can no longer adjust to stabilize debt, which eventually leads governments to implement “unpleasant” fiscal austerity measures. In this paper, we study the macroeconomic and welfare effects of reducing government debt. We formulate a dynamic general equilibrium, overlapping generations economy model that includes intra cohort heterogeneity and a productive government sector as well as key government investment and entitlement programs. Preliminary results indicate that: First, in the small open economy model calibrated to Greece, we find that a spending-based austerity reform dominates the tax-based reform with respect to growth effects but not with respect to welfare effects. Meanwhile, a mixed reform that combines tax adjustments and cuts in public pensions results in the largest effects on GDP growth, around 2.5 percent. Second, the analysis of transition dynamics indicates trade-offs between long-run and short-run efficiency. The welfare effects differ significantly across generations along the transition to the post reform equilibrium. Third, accessibility to international capital markets and risk premiums strongly influence the effects of fiscal austerity measures. The largest output and welfare effects are observed when risk premiums are included or when access to international capital markets is restricted. We would like to thank George Georgiou for helpful comments. All remaining errors are ours. The authors acknowledge support from the Towson University Research Fellowship Program and from an ANU Internal Research Grant. Department of Economics, Indiana University Bloomington, e-mail: [email protected] Towson University, Department of Economics, Stephens Hall Room 101K, 8000 York Road, Towson MD 21252-0001, phone: (812)-345-9182, e-mail: [email protected] Research School of Economics, The Australian National University, Canberra, ACT 0200, Australia, tel: +61 2 6125 5638, email: [email protected] JEL Classification: E21, E63, H55, J26, J45