Comparing Budget Repair Measures for a Small Open Economy with Growing Debt

In this study, we quantify the macroeconomic and welfare effects of alternative fiscal
consolidation plans in the context of a small open economy. Using a computable
overlapping generations model tailored to the Australian economy, we examine
immediate and gradual eliminations of the existing fiscal deficit with (i) temporary income
tax hikes, (ii) temporary consumption tax hikes and (iii) temporary transfer payment cuts.
The simulation results indicate that all three examined fiscal measures result in
favourable long-run macroeconomic and welfare outcomes, but have adverse
consequences in the short run that are particularly severe under the immediate fiscal
consolidation plan. Moreover, our results show that cutting transfer payments leads to
the worst welfare outcome for all generations currently alive, and especially the poor.
Increasing the consumption tax rate results in smaller welfare losses, but compared to
raising income taxes, the current poor households pay much larger welfare costs.
Overall, the welfare trade-offs between current and future generations, as well as
between the rich and poor, highlight key political constraints and point to challenging
policy choices for the wellbeing of future generations.