1887

OECD Economics Department Working Papers

Working papers from the Economics Department of the OECD that cover the full range of the Department’s work including the economic situation, policy analysis and projections; fiscal policy, public expenditure and taxation; and structural issues including ageing, growth and productivity, migration, environment, human capital, housing, trade and investment, labour markets, regulatory reform, competition, health, and other issues.

The views expressed in these papers are those of the author(s) and do not necessarily reflect those of the OECD or of the governments of its member countries.

English, French

Restoring Fiscal Sustainability in the Euro Area

Raise Taxes or Curb Spending?

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 ageingrelated 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.

English

Keywords: ageing, euro area, fiscal consolidation, general equilibrium, public debt, potential growth, public expenditure, fiscal sustainability
JEL: E27: Macroeconomics and Monetary Economics / Consumption, Saving, Production, Investment, Labor Markets, and Informal Economy / Macroeconomics: Consumption, Saving, Production, Employment, and Investment: Forecasting and Simulation: Models and Applications; E60: Macroeconomics and Monetary Economics / Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook / Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook: General; H55: Public Economics / National Government Expenditures and Related Policies / Social Security and Public Pensions; H63: Public Economics / National Budget, Deficit, and Debt / National Debt; Debt Management; Sovereign Debt; J11: Labor and Demographic Economics / Demographic Economics / Demographic Trends, Macroeconomic Effects, and Forecasts; D58: Microeconomics / General Equilibrium and Disequilibrium / Computable and Other Applied General Equilibrium Models
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