The Optimal Target of Fiscal Consolidation

If the government is politically strong enough to reduce fiscal privileges optimally, what time process for fiscal consolidation would be desirable? This issue is mainly related to intergenerational equity. The optimal time path of fiscal consolidation is determined by the discount rate, interest rate, and other economic conditions. For example, if the interest rate is high, the cost of debt issuance is also large; consequently, it becomes desirable to raise taxes as early as possible. The optimal debt/GDP ratio is small. In contrast, if the discount rate is high and it is desirable to consider the welfare of the present generation more than that of the future generation, it is good to attain fiscal consolidation slowly. In this instance, the speed at which taxes are raised is low. Then, the long-run target debt/GDP ratio is rather high.

Politically Weak Government

However, if the government is politically weak, each interest group achieves fiscal privileges. Thus, fiscal consolidation is attained only if each interest group agrees to accept a decrease in its own privileges. In this regard, it is important to consider how to set the fiscal consolidation schedule in advance. In particular, the crucial point is whether the pre-determined schedule can be revised in the future or not.

First, let us consider a commitment case whereby the predetermined fiscal consolidation schedule cannot be revised. Then, each interest group does not have much incentive for free riding. In the commitment case, it is impossible to revise the predetermined schedule of consolidation at a later stage. Since fiscal consolidation is attained only if each group agrees to cooperate from the beginning, the groups have an incentive to cooperate to some extent in order to enjoy the benefit of consolidation. As a result, the long-run debt/GDP ratio is smaller than in the non-commitment case. Moreover, the government may attain desirable consolidation faster than in the non-commitment case. Nevertheless, the speed of consolidation is slower than in the first best case where the government freely reduces privileges.

However, in a non-commitment case where the predetermined schedule may be revised in the future, each interest group has a significant incentive for free riding. In this case, each interest group knows the history of fiscal consolidation and the degree of cooperation by other groups. Thus, it may think that fiscal consolidation can be attained by other groups’ cooperation. Hence, it is not willing to accept a notable reduction in its own privileges. If so, predetermined cooperation may well be revised so that such groups have a greater free ride than in the commitment case.

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