The domestic and spillover effects of fiscal consolidation: The role of fiscal instruments, exchange rate regimes, and capital controls

Abstract

This paper develops a two-country dynamic general equilibrium model with a range of fiscal policy instruments and external policies. We employ this model to examine the transmission mechanisms of fiscal consolidation and evaluate both the domestic and spillover effects of various fiscal consolidation strategies. In particular, we focus on how exchange rate regimes and financial openness influence these effects. Our findings are as follows. Firstly, a reduction in government investment significantly harms economic growth, while a reduction in transfer payments worsens income inequality. Additionally, a rise in corporate social security taxes has the most pronounced negative impact on the labor market. Secondly, the reforms of the exchange rate regime and financial account policy contribute to creating more favorable conditions for fiscal rebalancing. Lastly, China’s 2021 fiscal consolidation hit the domestic economy negatively both in the short and long term. However, it had a positive spillover effect in the short term, with a negative effect in the long term. Moreover, relative to the actual consolidation measure, the labor market-friendly and growth-friendly scenarios lead to less declines in employment and output, whereas the social-friendly scenario results in a lower domestic Gini coefficient and is preferred from a welfare perspective.