Restoring Fiscal Sustainability in the Euro Area: Raise Taxes or Curb Spending?

32 Pages Posted: 2 Feb 2012

See all articles by Boris Cournede

Boris Cournede

Organization for Economic Co-Operation and Development (OECD) - Economics Department (ECO)

Frederic Gonand

Organization for Economic Co-Operation and Development (OECD)

Date Written: April 3, 2008

Abstract

With population ageing, fiscal consolidation has become of paramount importance for euro area countries. Consolidation can be pursued in various ways, with different effects on potential growth, which itself will be dragged down by ageing. A dynamic general equilibrium model with overlapping generations and a public finance block (including a pay-as-you-go pension regime, a health care system, non ageing-related public spending and a stock of debt to be repaid) is used to compare the macroeconomic impact of four scenarios: a) increasing taxes to finance unchanged pensions and repay public debt, b) lowering future pension replacement rates and repaying public debt through a lower ratio of non ageing-related outlays to GDP, c) raising the retirement age by 1.25 years per decade and increasing taxes only to pay off debt, and d) increasing the retirement age by 1.25 years per decade and paying off debt through a lower ratio of non ageing-related expenditure to GDP. This last scenario is the one where growth is strongest: with gradual increases in the retirement age and spending restraint, average GDP growth in the 2010s would be 0.34 percentage point stronger than in a scenario where fiscal consolidation is achieved exclusively through tax hikes. The appropriate conclusion from the model is not that public spending is bad per se, but that cuts to lower-priority spending items can deliver surprisingly large income gains compared with the alternative of raising taxes.

Keywords: public debt, potential growth, fiscal consolidation, ageing, general equilibrium, euro area, fiscal sustainability, public expenditure

JEL Classification: D58, E27, E60, H55, H63, J11

Suggested Citation

Cournede, Boris and Gonand, Frederic, Restoring Fiscal Sustainability in the Euro Area: Raise Taxes or Curb Spending? (April 3, 2008). Available at SSRN: https://ssrn.com/abstract=1997167 or http://dx.doi.org/10.2139/ssrn.1997167

Boris Cournede (Contact Author)

Organization for Economic Co-Operation and Development (OECD) - Economics Department (ECO) ( email )

2 rue Andre Pascal
Paris Cedex 16, MO 63108
France
+33145249037 (Phone)

HOME PAGE: http://www.oecd.org/eco

Frederic Gonand

Organization for Economic Co-Operation and Development (OECD) ( email )

2 rue Andre Pascal
Paris Cedex 16, 75775
France

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