The Fiscal Arithmetic of a Slowdown in Trend Growth

We study the fiscal policy response to a slowdown in trend growth using an estimated open economy stochastic growth model. For equilibria to exist, fiscal policy must respond to the slowdown ensuring that the government budget constraint holds in the low growth regime. The slowdown reduces welfare but sets off a significant endogenous response of the private sector that increases capital accumulation and operates as an automatic stabilizer. If fiscal policy keeps the provision of public goods per capita constant, the slowdown gives rise to a pleasant fiscal arithmetic which requires either tax cuts or a higher target debt-to-GDP ratio for the government budget constraint to hold in the long run. We discuss the implications of different fiscal responses involving increasing per capita public spending and varying speeds of adjustment.