Can Fiscal Budget-Neutral Reforms Stimulate Growth? Model-Based Results

Abstract

This paper focuses on growth enhancing budget-neutral fiscal reforms, i.e. changes in the composition of government revenues and spending that stimulate GDP growth while keeping the ratio of the fiscal budget to GDP constant. To this aim, we present simulation results using a multi-country DSGE model with three large economic regions, the US, the euro area and the rest of the world. The model features constrained and unconstrained non-Ricardian households and a detailed government sector; its multi-country nature allows investigating cross-country spillovers. The paper focuses on the most growth-friendly budget-neutral fiscal measures: (i) an incomplete fiscal devaluation (ii) a rise in government investment compensated by a fall in government consumption and (iii) a rise in government investment compensated by a rise in consumption and labor taxes. Dampening or amplifying effects due to coordination across policies (monetary and fiscal) and across economic regions are also considered. Three main results stand out. First, an increase in government investment financed by rising less distortionary taxes appears to be an effective growth-friendly budget-neutral reform in the sense that it generates both short- and long-run GDP growth and improves fiscal sustainability. Second, benefits and costs of budget-neutral reforms are not equally distributed across agents, giving rise to a policy trade-off between growth and distributional consequences. Third, budget-neutral reforms do not have large cross-border trade spillovers; however, reforms coordinated across all countries in periods of accommodative monetary policy do have amplified domestic effects.