Fiscal consolidation and reforms: Substitutes, not complements

by Coen Teulings

Vox
September 13, 2012

Many OECD countries suffer from high sovereign debts. Sooner or later, this problem must be addressed. Many argue that this will require some form of fiscal retrenchment or institutional reform or a combination of the two. This column argues that the two are not complements as many suggest – they are instead substitutes.

Many OECD countries suffer from high sovereign debts. Sooner or later, this problem must be addressed. That will require some form of fiscal retrenchment.

Quite often the fiscal problems are due to market rigidities, barriers to entry, and distortive tax systems. A programme of reform must therefore include both fiscal consolidation and institutional reform to enhance future growth. Growth and the larger tax base that goes with it provides the best prospect for solving the fiscal problems.

The obvious question regards timing. What should have priority: fiscal consolidation or institutional reform? A hard-line reasoning would argue that both should go hand in hand.

• Immediate fiscal consolidation to convince financial markets that policymakers stand to get the budget under control, and
• Institutional reform to increase the future tax base.

In this view, fiscal consolidation and institutional reform are complements. I believe the contrary.

The more consolidation is put in place, the smaller the scope for institutional reform. Policymakers therefore face a trade off. The argument does not rely on political fatigue, but on the distribution of wealth between generations:

• Both consolidation and reform reduce the current generation’s wealth and hence their consumption.

There is a limit to the fall in current consumption that is helpful for the resolution of a country’s fiscal problems.

• Too sharp a fall in consumption will lead to costly adjustment of production capacity, from consumption goods and non-tradables (which can only be sold on the home market) to investment goods and tradables (which can be sold abroad).

Fiscal consolidation and institutional reform are therefore substitutes, not complements. The more a policymaker focuses on the one, the less scope there is for the other. Whether consolidation takes the form of lower expenditures or higher tax rates does not matter at this stage.

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