DP11644 | Is it the "How" or the "When" that Matters in Fiscal Adjustments?

Publication Date

11/18/2016

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Abstract

Using data from 16 OECD countries from 1981 to 2014 we find that the composition of fiscal adjustments is much more important than the state of the cycle in determining their effects on output. Adjustments based upon spending cuts are much less costly than those based upon tax increases regardless of whether they start in a recession or not. Our results appear not to be systematically explained by different reactions of monetary policy. However, when the domestic central bank can set interest rates -that is outside of a currency union- it appears to be able to dampen the recessionary effects of tax-based consolidations implemented during a recession. This finding could help understand the recessionary effects of European austerity, which was mostly tax based and implemented within a currency union.