The pace of fiscal consolidations, fiscal sustainability, and welfare: An overlapping generations approach

This study investigates expenditure- and tax-based consolidations under the rule of reductions in debt-to-GDP ratios to the target level and the effects of these consolidations on fiscal sustainability and welfare, using an overlapping generations model with exogenous growth settings. We derive (i) the global transition dynamics of the economy, (ii) a threshold (ceiling) of public debt to ensure fiscal sustainability, (iii) sustainable paces of these consolidations, and (iv) the optimal pace of consolidations from viewpoints of both social welfare and fairness of each generation's welfare. We find that higher paces or lower targets of debt-to-GDP ratio make fiscal policies more sustainable. The pace of tax-based consolidation required to ensure fiscal sustainability is higher than that required of expenditure-based consolidation. As for welfare, countries may differ in their choice of the type of consolidation, which depends on the size of outstanding debts relative to capital, productivity of the economy, tax rate levels, and the extent of utility derived by individuals from public goods and services. More importantly, it may also depend on whether policymakers emphasize social welfare or fairness of welfare distribution between generations. By contrast, a common result from the viewpoints of both social welfare and fair distribution of welfare across generations is that rapid paces of fiscal consolidation are supported.