Fiscal Reaction Functions in an Overlapping Generations Setting: Why “Unfair” Fiscal Stabilizations Are Most Effective

This paper examines the choice between alternative debt and deficit responses in an overlapping generations (OG) setting. The OG model is a convenient framework for making interest rates sensitive to the supply of public debt and for distinguishing between different types of taxes and transfers. A given deficit-reduction yields a greater reduction of future debt if the policy instrument also reduces the interest rate and raises future wages, and a lesser reduction if policy instrument does the reverse. Under benchmark assumptions, reduced outlays for retirees yield the relatively greatest debt reductions, followed by tax increases on non-savers and by cuts in public spending. Tax increases on bond-buying cohorts are least effective. Yet exempting the rich (bond-buyers) from tax increases and spending cuts seems politically unthinkable on fairness grounds. * Address: Department of Economics, UCSB, Santa Barbara, CA 93106. Phone: (805)-893-4532. E-mail: [email protected]. Home page: http://econ.ucsb.edu/~bohn..