This paper studies the effects of the ongoing fiscal restructuring in the seven major industrial countries. It first presents and calibrates a simple model of the labor market that incorporates the effects of distortionary taxes and then integrates this framework into the IMF’s multicountry model (MULTIMOD), which has been extended to account for the effects of various tax instruments. The resulting framework is then used to simulate recent and prospective changes in fiscal policies in this group of countries and to estimate the impact of these policies on output, employment, and other macroeconomic variables during the 1990s.
The main conclusions to be drawn from the study can be summarized as follows. First, for the group as a whole, the fiscal adjustments implemented during the early 1990s, as well as those expected to be implemented in the next few years, are estimated to lead to some loss of output and employment in the short run (relative to a baseline path of no fiscal restructuring). However, most of the short-run output losses would be recovered by the end of the 1990s, as the fiscal adjustment is expected to contribute to a shift of resources from public consumption to private investment by lowering debt-financing needs and thereby reducing the burden of distortionary taxes.
The simulations also show that the output cost of various fiscal instruments tends to vary over different horizons. Increases in indirect taxes and expenditure cuts are more costly instruments for deficit reduction in the short run in terms of output losses, but potentially beneficial instruments over longer horizons. Thus, those countries that relied relatively more on indirect taxes and expenditure cuts in their restructuring (such as Canada, France, Japan, and the United Kingdom) are estimated to eventually realize the greatest benefits from the adjustment. By contrast, countries that relied more heavily on tax increases on factor income (Germany, Italy, and the United States), while incurring smaller losses in the short run (relative to the size of their adjustment), are anticipated to incur output losses in the long run.