The Green and Equitable Challenge of Fiscal Consolidation

Fiscal consolidation and decarbonization are two of the European Union’s most pressing—and typically separately analyzed—policy challenges. This paper asks whether they can be pursued jointly, and at what distributional cost. We develop a Two-Agent New Keynesian model augmented with an environmental sector and compare a standard expenditure-based consolidation with an environmental–fiscal policy mix in which the carbon tax responds systematically to the debt gap, becoming an active consolidation instrument. The policy mix reaches the debt target faster under a pure announcement of future tax cuts (22 rather than 35 quarters), delivers a substantially larger reduction in emissions at a comparable output cost, generates a smaller transitional rise in consumption inequality, and lowers inequality in the long run. Automatic stabilizers cushion financially constrained households, roughly halving the transitional rise in inequality, while countercyclical monetary policy contains welfare costs for both household types. Debt reduction and decarbonization thus emerge as complementary, rather than competing, objectives under a coordinated policy design.