## _wp13207

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---

### Context and Rationale
- Fiscal consolidation necessary to reduce risks to fiscal sustainability, improve conditions conducive to growth, and meet public debt and deficit targets with the EU and as committed in the Hungarian Constitution.
- Public debt near 80 percent of GDP at end 2012.
- Gross financing needs around 20 percent of GDP annually.
- Government size about 50 percent of GDP.
- High tax pressure from financing this level of expenditures leads to allocation inefficiencies, discourages investment and labor participation, and erodes competitiveness.

### Model and Policy Instruments
- Model: three-region GIMF (Global Integrated Monetary and Fiscal), calibrated to Hungary.
- Regions: Hungary (HN), euro area (EU), Rest of the World (RW).
- Non-Ricardian features: overlapping generations (OLG) with finite lifetimes and high subjective discount rates; life-cycle income profiles; liquidity-constrained agents; distortionary taxes on labor income, capital income, consumption, and imports.
- Nominal and real rigidities include habit persistence, adjustment costs (retail, investment, capital utilization, imports), price adjustment costs, and nominal wage rigidities.
- Asset markets incomplete: complete home bias in domestic nominal one-period bonds; only internationally traded assets are nominal one-period foreign currency bonds.
- Monetary policy: authority targets inflation; policy rate responds to inflation (concurrent and one-period-ahead forecast), inflation gap size, and lagged rates.
- Fiscal instruments modeled: public investment, public consumption, transfers to households, lump-sum taxes, consumption taxes, investment income taxes, and labor taxes.
- Seven policy instruments simulated (each calibrated to deliver a 1 percent of GDP permanent improvement in the overall fiscal balance starting in 2013):
  - Revenue-side: consumption taxes, corporate taxes, labor income taxes.
  - Expenditure-side: reduction in government consumption, reduction in government investment, reduction in general transfers (lump-sum), reduction in targeted transfers to liquidity-constrained consumers (lump-sum).
- Simulation assumption: fiscal space created by interest savings is spent as government consumption so overall balance consolidation remains constant at 1 percent of GDP; charts express deviations in percent of GDP from baseline.

### Key Findings and Analytical Focus
- Composition of consolidation across tax and expenditure categories deeply affects short- and long-term growth.
- Instruments differ in effects on investment, employment, wages, competitiveness, inflation, exchange rates, and other macro indicators.
- Given large government size (about 50 percent of GDP), consolidation composition is critical for Hungary.

### Calibration and Steady-State Parameters (selected exact values)
- Hungary represents 0.15 percent of world population and 0.25 percent of world GDP (PPP adjusted).
- Steady-state world technology growth rate: 1.5 percent per year.
- World population growth rate: 1 percent.
- Inflation: 2 percent in Hungary and the euro area; 2.5 percent in the rest of the world.
- World real interest rate: 3 percent per annum.
- External financing premium calibrated to produce 250 basis points premium over international interest rates at steady state net foreign liabilities to GDP ratio of 0.
- Factor shares in aggregate production: 40 percent capital and 60 percent labor for all three regions.
- Calibrated shares of labor in Hungary: tradable sector 54 percent, non-tradable sector 71 percent.
- Liquidity-constrained agents: 30 percent of consumers in Hungary, 30 percent in EU, 40 percent in RW; their share in dividend income is half their share in population.
- Selected steady-state fiscal and macro shares (Hungary / EU / RW where tabulated):
  - Investment (INV): 17.80 / 18.30 / 20.00
  - Consumption (CONS): 61.70 / 58.20 / 60.50
  - Government Expenditures (GOV): 20.50 / 23.50 / 19.50
  - Govt Revenue (GOVREV): 45.00 / 40.50 / 28.00
  - Government Debt (B): 50.00 / 85.00 / 40.00
  - government deficit (GOVSUR): 2.18 / 3.71 / 1.93
  - primary balance (PRIMSUR): 0.26 / 0.44 / 0.21
  - interest payments (INTCOST): 2.44 / 4.15 / 2.14
  - GDP (% of World Nominal): 0.25 / 22.24 / 77.51
  - dividend income (DIVINCOME): 6.40 / 5.23 / 1.46
  - capital income (CAPINCOME): 33.59 / 34.76 / 38.53
- Trade shares for Hungary: aggregate exports and imports set near 78.89 percent of GDP, with about 60.25 percent final goods and 18.64 percent intermediate goods.

### Policy Simulation Results — Instrument-Specific Outcomes (for 1 percent of GDP permanent consolidation)
- General result on public debt:
  - In all cases public debt would be between eight and ten percent of GDP lower than the baseline by 2025, depending on the policy instrument used.
- Cutting government investment (public investment):
  - Least desirable option short- and long-term.
  - Impact on output: sustained decline around 1 percentage point every five years for every percentage point of fiscal consolidation.
  - By 2025 GDP is 3 percent lower than baseline, and by 2050 GDP is 5 percent lower than baseline.
  - Aggregate demand declines immediately by about 0.5 percent of GDP.
  - Private investment: total real investment accumulates to around 2 percent of GDP below baseline after 10 years.
  - Current account initially improves about same magnitude as fiscal balance; improvement split roughly ½ increase in exports and ½ decline in imports but erodes as competitiveness declines.
  - Inflation and interest rates: consumer and core inflation decline 0.1 percentage points below baseline short term, picking by year three near 0.2 percentage points; decline in real interest rates as de-investment materializes.
  - Real wages: decline 1 percent after five years, and more than 3 percent in the long–term.
  - Summary headline: output declines ½ percent of GDP on impact, and continues to decline to more than triple the initial amount of fiscal consolidation in the long term.
- Cutting government consumption:
  - Aggregate demand declines short-term about ¼ percent below baseline, then partially recovers but remains below baseline.
  - Private investment remains almost unaffected; private consumption increases to almost fully offset decline in public consumption.
  - Current account balance improves proportionally (roughly ½ improvement via exports and ½ via decline in imports).
  - Exchange rate: small depreciation that peaks in first year at 0.2 percent compared to baseline.
  - Real wages decline by less than 0.5 percent short-term and partially recover over long-term.
- Cutting transfers (general and targeted):
  - Initial impact mute: consumption declines immediately by same amount as transfers’ cut.
  - Medium/Long term:
    - Targeted transfers cut leads to output 0.4 percent of GDP relative to baseline.
    - General transfers cut leads to output 0.1 percent of GDP relative to baseline.
  - Current account improves relative to baseline but less than in government consumption or investment cuts.
  - General transfers: long-term GDP increases above baseline by ½ percent after a minor initial contraction in year 1.
- Increase in consumption taxes (permanent increase to improve overall balance by 1 percent of GDP):
  - GDP reduces growth by 0.2 percent in the first year; recovers somewhat but never back to baseline.
  - Private consumption: declines 1 percent of GDP in the first year, 1.5 percent by year three, then gradual recovery.
  - Current account increases to 0.8 percent of GDP by year three and stabilizes below 1 percent of GDP in the long term.
  - Exports peak at 0.4 percent of GDP by year three; imports peak near 0.4 percent of GDP (more protracted).
  - Inflation declines to 0.02 percentage points below baseline over the first three years, then returns to baseline.
  - Nominal and real exchange rate: depreciates by less than 0.2 percent; real depreciation similar and very protracted.
  - Mechanisms: higher consumption taxes stimulate savings; forward-looking OLG consumers internalize increased wealth income; lower interest rates raise investment and capital stock; external demand switching cushions domestic demand decline.
  - Quantitative ratio: decline in output is less than ¼ the size of the improvement in the fiscal surplus targeted.
- Increase in corporate income taxes:
  - Short-term contractionary: Output declines 0.4 percentage points below baseline in the first year.
  - Medium/Long-term: output declines 0.5 percent by year five, peaks after ten years at 1.5 percentage points below baseline.
  - Private investment: over 5 percentage points below baseline in year 1; more than 8 percentage points by year 3.
  - Private consumption: declines 0.6 percent below baseline in year 1.
  - Real wages: by year five real wages are 1 percent below baseline and remain around that level thereafter.
  - Current account peaks at 1 ½ percent of GDP by year 3 (about 1 percent from import contraction, ½ percent from export increase).
  - Inflation and interest rates: inflation declines more than 0.1 percent below baseline; nominal and real interest rates decline.
  - Real exchange rate: appreciates (similar to government investment cut).
- Increase in labor taxes:
  - GDP reduces by 0.3 percentage points below baseline in first year; decline rises to 0.6 percentage points below baseline by year 5.
  - Output recovers after year 5 driven by allocation of fiscal space from debt reduction to government consumption.
  - Mechanism: decrease in labor participation is main driver; initially increases real wages.
  - Investment: reduced (¾ percentage points below baseline by year 3).
  - Consumption: significant short-term decline, protracted.
  - External sector: smallest improvement across alternatives; current account near 0.4 percent of GDP in first year, gradually to around 0.6 percent in long term; exports improvement lowest until year five (0.3 percent of GDP above baseline by year five).
  - Inflation and interest rates: minor near-term decline below baseline, then increase above baseline after year 3.

### Quantitative Summary (selected entries from Table 4; deviations relative to baseline after 1 percent of GDP consolidation)
- Consumption taxes: GDP -0.15; Investment -0.36; Real wage -0.15; Rankings: GDP 3, Investment 4, Real wage 3; Avg. 3
- Corporate taxes: GDP -1.56; Investment -8.24; Real wage -1.56; Rankings: GDP 7, Investment 6, Real wage 7; Avg. 6
- Labor taxes: GDP -0.60; Investment -0.75; Real wage -0.60; Rankings: GDP 5, Investment 5, Real wage 5; Avg. 5
- Government consumption: GDP -0.28; Investment -0.34; Real wage -0.28; Rankings: GDP 4, Investment 3, Real wage 4; Avg. 3
- Government investment: GDP -2.88; Investment -1.90; Real wage -2.88; Rankings: GDP 7, Investment 6, Real wage 7; Avg. 7
- General transfers: GDP -0.04; Investment -0.12; Real wage -0.04; Rankings: GDP 2, Investment 2, Real wage 2; Avg. 2
- Targeted transfers: GDP -0.03; Investment 0.01; Real wage -0.03; Rankings: GDP 1, Investment 1, Real wage 1; Avg. 1

### Main Mechanisms Driving Results
- Labor market responses:
  - Cuts in transfers stimulate labor participation, raising return to capital and investment.
  - Increases in labor taxes reduce labor participation, raising real wages initially, lowering investment.
- Investment channel:
  - Corporate tax increases sharply reduce private investment, compounding output declines over time.
- External sector and exchange rate:
  - Hungary’s openness (exports averaging around 80 percent of GDP) amplifies external demand responses; real exchange rate movements cushion domestic declines by switching demand to external sector.
- Forward-looking behavior:
  - OLG consumers internalize wealth effects from tax changes and debt reduction, influencing consumption and saving.
- Allocation of fiscal space:
  - Assumption that reductions in public debt are partly reallocated to government consumption affects recovery dynamics.

### Policy-Relevant Conclusions
- Consolidation focused on current expenditures (especially transfers) is generally more conducive to growth and investment than cutting capital expenditures.
- Consolidation of transfers can stimulate long-term GDP (increase of ½ percent above baseline) after minor short-run contraction, via higher labor participation and investment.
- Cutting government investment is the most costly for long-term growth, producing deep and persistent declines in investment, output, and real wages.
- Tax-based consolidations produce intermediate outcomes:
  - Corporate tax increases are most harmful to investment and long-term GDP.
  - Consumption taxes are least costly for growth but inflict the deepest short-term consumption decline.
  - Labor taxes reduce labor participation and have distributional tradeoffs.
- Distributional and social consequences vary substantially across instruments and must be weighed against aggregate GDP outcomes.

### Important Caveats
- Results are model-specific and hinge on assumed transmission channels and behavior (e.g., forward-looking agents, credibility of consolidation).
- Some channels not modeled explicitly (e.g., effects of transfers on human capital like health and education) may alter growth impacts.
- Assumes consolidation is fully credible and anticipations are rational; outcomes depend critically on these expectations.

### Appendix 1 — Dynamic Parameters Calibrations (selected exact parameter values as reported)
- Preferences and demographics:
  - Intertemporal (1/GAMMA): 0.50.50.5
  - OLG Agents (ETA_OLG): 0.8270.8320.798
  - Elasticity of Labor Supply OLG Agents: 0.50.50.5
  - Elasticity of Labor Supply LIQ Agents: 0.50.50.5
  - Habit Persistence (NU): 0.40.40.4
  - 'Pure' Discount Factor (BBETA): 98.17699.04698.012
  - Probability of Survival (THETA): 0.950.950.95
  - Income Decline Rate (CHI): 0.950.950.95
  - Marginal Propensity to Consume (MPC): 4.5224.6654.974
  - Share of LIQ Agents (PSI): 0.30.30.4
- Production, distribution, and finance:
  - Depreciation business capital (DEPKBAR): 0.10.10.1
  - Depreciation public capital (DEP_KG1): 0.040.040.04
  - P-share for Investment: 0.3140.3290.089
  - Financial accelerator borrower riskiness tradables (ZIGGY_T): 0.4520.4520.452
  - Elasticities SIGMA_N, SIGMA_T, SIGMA_R, SIGMA_C, SIGMA_I, SIGMA_U: 111111, 111111, 212121, 212121, 212121, 111111 respectively
  - Markups MUN, MUT, MUW: 101010; MUR, MUC, MUI: 555
  - Final Imports markup: 2.52.52.5
  - Home versus Foreign elasticities XI_C, XI_I, XI_T: 1.51.51.5
  - Home Bias consumption (ALPHA_CH): 0.5250.9340.93
- Corporate sector (selected):
  - Aggregate capital utilized (K): 142.229146.225159.808
  - Investment (I): 17.818.320
  - Tradables capital utilized (KT): 72.13473.63178.852
  - Nontradables capital utilized (KN): 70.09672.59480.956
  - All firms net worth (NW): 72.90374.95181.914
  - Insolvencies (%): 888
  - Leverage ($; LEVERAGE_T): 100100100
  - Equity premia EQPT, EQPN: 8.2098.2098.209
  - External financing premia XFPT, XFPN: 2.52.52.5

*Source: _wp13207.*

### References .............................................................................................................

### _wp13207 - References

### Context and Rationale
- Fiscal consolidation is necessary to reduce risks to fiscal sustainability, improve conditions conducive to growth, and meet public debt and deficit targets with the EU and as committed in the Hungarian Constitution.
- Public debt stands at near 80 percent of GDP at end 2012.
- Gross financing needs are around 20 percent of GDP annually.
- Government size is about 50 percent of GDP.
- High tax pressure resulting from financing this level of expenditures leads to allocation inefficiencies, discourages investment and labor participation, and erodes competitiveness.

### Model and Policy Instruments
- A general equilibrium model suitable for fiscal policy analysis is calibrated to the Hungarian economy.
- The policy simulation exercise considers seven broad instruments:
  - Revenues: consumption taxes, corporate taxes, labor income taxes.
  - Expenditures: reduction in government consumption, reduction in government investment, reduction in general transfers (lump-sum), reduction in targeted transfers to liquidity-constrained consumers (lump-sum).

### Key Findings and Analytical Focus
- The composition of a fiscal consolidation across tax and expenditure categories can have a deep impact on growth in both the short and long terms.
- Different instruments have distinctive effects on investment, employment, wages, competitiveness, and other macroeconomic indicators.
- Choosing the right consolidation composition is particularly critical for Hungary given the large government size (about 50 percent of GDP).

### Content Inventory (Selected Figures, Tables, and Appendixes referenced)
- Tables listed:
  - Table 1. Calibration
  - Table 2. Trade Matrix
  - Table 3. Policy Rules
  - Table 4. Maximum Declines Relative to Baseline after 1 Percent of GDP Consolidation
- Figures listed:
  - Figure 1. Simplified Presentation of GIMF Sectors 1/
  - Figure 2. Permanent Fiscal Consolidation Using Alternative Fiscal Instruments
  - Figure 3. Impact of 1 Percent of GDP Permanent Fiscal Consolidation on National Accounts
  - Figure 4. Impact of 1 Percent of GDP Permanent Fiscal Consolidation on Inflation, Exchange Rates and Interest Rates
- Appendixes:
  - Appendix 1. Dynamic Parameters Calibrations
    - Table A.1. Preferences and Population Related
    - Table A.2. Production, Distribution and Finance
    - Table A.3. Corporate Sector Calibration

*Source: _wp13207 - References.*

### Section II provides a broad background of recent fiscal developments that provide context to the

### _wp13207 - Section II provides a broad background of recent fiscal developments that provide context to the

### Fiscal Policy Context
- Hungary experienced significant fiscal consolidation after a decade of large budget deficits and public debt accumulation; the Hungarian Constitution specifies a public debt upper threshold at 50 percent of GDP.
- Hungary was the first European nation to enter a Fund-supported program at the early stages of the 2008 global financial crisis.
- Key policy actions and developments:
  - Personal income tax reduced to a flat-rate system at 16 percent (effective in 2010).
  - Sector-specific levies on bank, energy, and retail sectors introduced as transitory measures; some made permanent (e.g., bank levy).
  - One-off revenues from nationalization of the pension system of 9½ percent of GDP in 2011.
  - Szell-Kalman Plan launched in 2011 with reforms in 2012–2013; around ¾ of these reforms were expenditure-based.
  - Savings in 2011–2012 in goods and services, public wages, and transfers to households totaling 2¼ percent of GDP.
  - Revenue-based consolidation packages in 2011 and 2012 included increase in VAT (to 27 percent), multiple small taxes, increases in excises and levies, increase in social security contributions, and simplified tax schemes for small businesses and individuals.
  - 2013 budget included a new tax on financial transactions and additional sector-specific taxes on insurance, utilities and telecoms; bank levy made permanent.
  - Expenditure-side measures since 2011 included across-the-board expenditure restraint via cancelation of budgetary reserves and wage freezes.
- Convergence Programs of 2011 and 2012 projected declining fiscal deficits and public debt, but deteriorating external conditions slowed revenue performance and required further measures.

### Model Overview
- Model used: three-region GIMF (Global Integrated Monetary and Fiscal) general equilibrium model (Kumhof, Laxton, Muir, and Mursula (2010) (KLMM)).
- Three regions modeled: Hungary (HN), euro area (EU), and Rest of the World (RW).
- Key model features:
  - Non-Ricardian features: (i) overlapping generations (OLG) agents with finite lifetimes and high subjective discount rates; (ii) life-cycle income profiles; (iii) liquidity-constrained agents; (iv) distortionary taxes on labor income, capital income, consumption, and imports.
  - Nominal and real rigidities: habit persistence in consumption; quantity adjustment costs in retail; investment adjustment costs and variable capital utilization; imports’ adjustment costs and productivity spillovers; price adjustment costs by firms; nominal wage rigidities.
  - Growth: steady-state growth exogenous; world technology growth and population grow at constant rates.
  - Asset markets: incomplete; complete home bias in government debt (domestic nominal one-period bonds); only internationally traded assets are nominal one-period foreign currency bonds.
  - Risk premium: foreign exchange risk premium (non-linear function of current account to GDP) and an exogenously set sovereign risk premium.
  - Monetary policy: authority targets inflation; policy interest rate responds to inflation (concurrent and one-period-ahead forecast), inflation gap size, and lagged interest rates.
- Economy sectors replicated for each region: Households (OLG and liquidity constrained), Firms (primary producers through retailers, entrepreneurs, banks), Distributors, Retailers, Government.
- Government fiscal policy instruments modeled: public investment, public consumption, transfers to households, lump-sum taxes, consumption taxes, investment income taxes, and labor taxes.
- Fiscal policy objectives in model: debt sustainability (non-explosive debt dynamics adjusted by expenditure to stabilize overall fiscal balance at long-run debt ratio target) and cycle smoothing (structural balance rule responding to output gap).

### Calibration (Steady-State and Key Parameters)
- Hungary represents 0.15 percent of world population and 0.25 percent of world GDP (PPP adjusted).
- Steady-state world technology growth rate: 1.5 percent per year.
- World population growth rate: 1 percent.
- Inflation set at 2 percent in Hungary and the euro area, and at 2.5 percent in the rest of the world.
- World real interest rate equalized across countries at 3 percent per annum.
- External financing premium calibrated to produce 250 basis points premium over international interest rates at steady state net foreign liabilities to GDP ratio of 0.
- Factor shares in aggregate production: 40 percent capital and 60 percent labor for all three regions.
- Calibrated shares of labor in Hungary: tradable sector 54 percent, non-tradable sector 71 percent.
- Liquidity-constrained agents: 30 percent of consumers in Hungary, 30 percent in EU, 40 percent in RW; their share in dividend income is half their share in population.
- Table 1 steady-state expenditure and fiscal calibrations (selected exact values preserved):
  - Investment shares: Hungary 17.8 percent, euro area 18.3 percent, rest of world 20 percent.
  - Revenues (general government): 45 percent of GDP.
  - Long-term debt target: 50 percent (Hungarian Constitution upper threshold).
  - Resulting steady-state primary surplus: ¼ percent of GDP.
  - Government consumption calibrated at 17.5 percent of GDP for Hungary.
  - Government investment calibrated at 3 percent of GDP for Hungary.
- Selected entries from Table 1 (Hungary / EU / RW where tabulated):
  - GDP (% of World Nominal): 0.25 / 22.24 / 77.51
  - Capital/GDP (CAPITAL): 40 / 40 / 40
  - dividend income (DIVINCOME): 6.40 / 5.23 / 1.46
  - capital income (CAPINCOME): 33.59 / 34.76 / 38.53
  - Consumption (CONS): 61.70 / 58.20 / 60.50
  - Investment (INV): 17.80 / 18.30 / 20.00
  - Government Expenditures (GOV): 20.50 / 23.50 / 19.50
  - Govt Revenue (GOVREV): 45.00 / 40.50 / 28.00
  - Government Debt (B): 50.00 / 85.00 / 40.00
  - government deficit (GOVSUR): 2.18 / 3.71 / 1.93
  - primary balance (PRIMSUR): 0.26 / 0.44 / 0.21
  - interest payments (INTCOST): 2.44 / 4.15 / 2.14
- Trade and export/import shares: aggregate exports and imports for Hungary set near 78.89 percent of GDP, with about 60.25 percent final goods and 18.64 percent intermediate goods (Table 2).
- Policy rules (Table 3, selected Hungary values):
  - Monetary: weight on lagged interest rate (DELTAI) 0.25; core inflation weight (DELTAPIE) 0.50; contemporaneous inflation weight (PIEWT0) 0.80; 1 period ahead inflation weight (PIEWT1) 0.20.
  - Fiscal: weight on excess output gap (DAMP_GDPGAP) 0.25; weight on government debt (DAMP_DEBT) 0.00.

### Policy Simulation: Fiscal Consolidation Instruments
- Seven instruments considered (each calibrated to achieve 1 percent of GDP permanent improvement in overall fiscal balance starting in 2013):
  - Revenue-side: consumption taxes, corporate taxes, labor income taxes.
  - Expenditure-side: reduction in government consumption, government investment, general transfers (lump-sum), targeted transfers to liquidity-constrained consumers (lump-sum).
- Simulation assumptions: fiscal space created by interest savings is spent as government consumption so overall balance consolidation remains constant at 1 percent of GDP; charts express deviations in percent of GDP from baseline (no policy change).
- General simulation results:
  - A fiscal consolidation is more effective in reducing public debt to GDP if it reduces government consumption or induces a decline in private consumption.
  - In all cases public debt would be between eight and ten percent of GDP lower than the baseline by 2025, depending on the policy instrument used.

- Consolidation via Government Investment (cutting public investment):
  - Least desirable option short- and long-term.
  - Impact on output: sustained decline around 1 percentage point every five years for every percentage point of fiscal consolidation.
  - By 2025 GDP is 3 percent lower than baseline, and by 2050 GDP is 5 percent lower than baseline.
  - Aggregate demand declines immediately by about 0.5 percent of GDP.
  - Private investment: total real investment accumulates to around 2 percent of GDP below baseline after 10 years.
  - External sector: current account improves initially about same magnitude as fiscal balance; improvement broad split roughly ½ increase in exports and ½ decline in imports, but improvement erodes as competitiveness declines.
  - Real exchange rate: appreciation (driven by protracted consumption decline slower than output decline due to habit persistence).
  - Inflation and interest rates: consumer and core inflation decline 0.1 percentage points below baseline short term, picking by year three near 0.2 percentage points; decline in real interest rates as de-investment materializes.
  - Real wages: decline 1 percent after five years, and more than 3 percent in the long–term.

- Consolidation via Government Consumption (cut in goods/services and/or wage expenditures):
  - Aggregate demand declines in short-term about ¼ percent below baseline, then partially recovers but remains below baseline.
  - Private investment remains almost unaffected; private consumption increases to almost fully offset decline in public consumption.
  - Current account balance improves proportionally (roughly ½ improvement via exports and ½ via decline in imports).
  - Exchange rate: small depreciation that peaks in first year at 0.2 percent compared to baseline (both core and CPI).
  - Real wages decline by less than 0.5 percent short-term and partially recover over long-term.
  - Inflation decline minimal.

- Consolidation via Transfers (general and targeted):
  - Initial impact of cut in transfers on output is mute: consumption declines immediately by same amount as transfers’ cut.
  - Medium and long term: output increases relative to baseline.
    - Targeted transfers cut leads to output 0.4 percent of GDP relative to baseline.
    - General transfers cut leads to output 0.1 percent of GDP relative to baseline.
  - Current account improves relative to baseline but less than cases of consolidation via government consumption or investment.

### Key Comparative Findings and Policy Implications
- Cutting public investment imposes the largest and most persistent costs to output, investment, competitiveness, inflation, wages, and long-run potential—making it the least desirable consolidation instrument among those studied.
- Consolidation via cuts in government consumption is less harmful: short-term demand costs are moderate (about ¼ percent of GDP), private consumption and investment are relatively sheltered due to openness and import content, and external adjustment occurs largely through import compression.
- Transfers-based consolidation yields limited short-term contraction (consumption falls one-to-one with transfers) and can produce medium- to long-term output gains, particularly when targeted transfers to liquidity-constrained consumers are adjusted.
- Across instruments, public debt falls by 8–10 percentage points of GDP by 2025 relative to baseline for a 1 percent of GDP permanent consolidation starting in 2013, with distribution of macroeconomic costs and benefits varying substantially by instrument.

*Italic: Source — _wp13207 - Section II provides a broad background of recent fiscal developments that provide context to the (IMF Working Paper).*

### 0.4 percent of GDP on impact, and continues to improve over time to stabilize at around

### _wp13207 - 0.4 percent of GDP on impact, and continues to improve over time to stabilize at around

### Summary of simulated fiscal consolidation outcomes (by instrument)
- Cut in transfers (general)
  - Short-term: muted impact on output; households' disposable income reduced → labor participation increases → output offsetting consumption decline.
  - Currency: permanent real depreciation (mainly nominal depreciation) improves competitiveness.
  - Medium/Long-term: higher output permanently; consolidation reduces government debt → interest rates fall → fiscal space allocated to government consumption → partial reversal of short-term external improvement.
  - Private sector accumulates net foreign assets; non-wage income of OLG consumers increases, aiding consumption recovery.
  - Long-term: consolidation of transfers increases GDP above baseline by ½ percent (after a minor initial contraction in year 1).

- Cut in transfers targeted to liquidity-constrained agents
  - More pronounced dynamics than general transfers: liquidity-constrained agents cannot smooth income declines → larger immediate effects for same consolidation size concentrated on fewer households.

- Consolidation with consumption taxes (increase permanently to improve overall balance by 1 percent of GDP)
  - GDP: reduces growth by 0.2 percent in the first year; recovers somewhat but never back to baseline.
  - Private consumption: declines 1 percent of GDP in the first year, 1.5 percent by year three, then gradual recovery.
  - External accounts: current account increases to 0.8 percent of GDP by year three and stabilizes below 1 percent of GDP in the long term.
  - Trade composition: exports peak at 0.4 percent of GDP by year three; imports peak near 0.4 percent of GDP (more protracted).
  - Inflation: declines to 0.02 percentage points below baseline over the first three years, then returns to baseline.
  - Exchange rates: nominal exchange rate depreciates by less than 0.2 percent → real depreciation about the same; very protracted.
  - Mechanisms: higher consumption taxes stimulate savings; forward-looking (OLG) consumers internalize increased wealth income; lower interest rates raise investment and capital stock; external demand switching cushions domestic demand decline.
  - Quantitative ratio: decline in output is less than ¼ the size of the improvement in the fiscal surplus targeted.

- Consolidation with corporate income taxes
  - Short-term: contractionary; Output declines 0.4 percentage points below baseline in the first year.
  - Medium/Long-term: output declines 0.5 percent by year five, peaks after ten years at 1.5 percentage points below baseline.
  - Private investment: over 5 percentage points below baseline in year 1; more than 8 percentage points by year 3 (lowest point).
  - Private consumption: declines 0.6 percent below baseline in year 1.
  - Real wages: about same magnitude decline as under government investment cut in first five years; by year five real wages are 1 percent below baseline and remain around that level thereafter.
  - External accounts: current account peaks at 1 ½ percent of GDP by year 3 (about 1 percent from import contraction, ½ percent from export increase).
  - Inflation and interest rates: inflation declines more than 0.1 percent below baseline; nominal and real interest rates decline.
  - Real exchange rate: appreciates (similar to government investment consolidation result).

- Consolidation with labor taxes (increase)
  - GDP: reduces GDP by 0.3 percentage points below baseline in the first year; decline rises to 0.6 percentage points below baseline by year 5.
  - Recovery: output recovers after year 5 (slow), driven by allocation of fiscal space from debt reduction to government consumption.
  - Mechanism: decrease in labor participation is main driver; uniquely results in an increase in real wages initially.
  - Investment: reduced (¾ percentage points below baseline by year 3).
  - Consumption: significant short-term decline, protracted due to reduced investment and labor demand.
  - External sector: smallest improvement across alternatives; current account near 0.4 percent of GDP in first year, gradually to around 0.6 percent in long term; exports improvement lowest until year five (0.3 percent of GDP above baseline by year five).
  - Inflation and interest rates: minor near-term decline below baseline, then increase above baseline after year 3.

- Consolidation by cutting government investment
  - Least preferred option: large and protracted declines in private investment, output, and real wages.
  - Output: declines ½ percent of GDP on impact, and continues to decline to more than triple the initial amount of fiscal consolidation in the long term.

### Quantitative summary (Table 4 results; maximum declines relative to baseline after 1 percent of GDP consolidation)
- Declines and rankings (deviations in GDP and investment are percentage points of GDP; declines in real wages are percent of baseline level)
  - Consumption taxes: GDP -0.15; Investment -0.36; Real wage -0.15; Rankings: GDP 3, Investment 4, Real wage 3; Avg. 3
  - Corporate taxes: GDP -1.56; Investment -8.24; Real wage -1.56; Rankings: GDP 7, Investment 6, Real wage 7; Avg. 6
  - Labor taxes: GDP -0.60; Investment -0.75; Real wage -0.60; Rankings: GDP 5, Investment 5, Real wage 5; Avg. 5
  - Government consumption: GDP -0.28; Investment -0.34; Real wage -0.28; Rankings: GDP 4, Investment 3, Real wage 4; Avg. 3
  - Government investment: GDP -2.88; Investment -1.90; Real wage -2.88; Rankings: GDP 7, Investment 6, Real wage 7; Avg. 7
  - General transfers: GDP -0.04; Investment -0.12; Real wage -0.04; Rankings: GDP 2, Investment 2, Real wage 2; Avg. 2
  - Targeted transfers: GDP -0.03; Investment 0.01; Real wage -0.03; Rankings: GDP 1, Investment 1, Real wage 1; Avg. 1

### Main mechanisms driving results
- Labor market responses: cuts in transfers stimulate labor participation (raising return to capital and investment); increases in labor taxes reduce labor participation (raising real wages initially, lowering investment).
- Investment channel: corporate tax increases sharply reduce private investment, compounding output declines over time.
- External sector and exchange rate: openness of Hungary (exports averaging around 80 percent of GDP) amplifies external demand responses; real exchange rate movements cushion domestic declines by switching demand to external sector.
- Forward-looking behavior: OLG (overlapping generations) consumers internalize wealth effects from tax changes and debt reduction, influencing consumption and saving behavior.
- Allocation of fiscal space: assumption that reductions in public debt are partly reallocated to government consumption affects recovery dynamics.

### Policy-relevant conclusions
- Consolidation focused on current expenditures (especially transfers) is generally more conducive to growth and investment than cutting capital expenditures.
- Consolidation of transfers can stimulate long-term GDP (increase of ½ percent above baseline) after minor short-run contraction, via higher labor participation and investment.
- Cutting government investment is the most costly for long-term growth, producing deep and persistent declines in investment, output, and real wages.
- Tax-based consolidations produce intermediate outcomes: corporate tax increases are most harmful to investment and long-term GDP; consumption taxes are least costly for growth but inflict the deepest short-term consumption decline; labor taxes reduce labor participation and have distributional tradeoffs.
- Distributional and social consequences vary substantially across instruments and must be weighed against aggregate GDP outcomes.

### Important caveats
- Results are model-specific and hinge on assumed transmission channels and behavior (e.g., forward-looking agents, credibility of consolidation).
- Some channels not modeled explicitly (e.g., effects of transfers on human capital like health and education) may alter growth impacts.
- Assumes consolidation is fully credible and anticipations are rational; outcomes depend critically on these expectations.

*Source: Staff estimates, _wp13207 (simulation results and Table 4 as reported in the provided content).*

### APPENDIX 1. DYNAMIC PARAMETERS CALIBRATIONS

### APPENDIX 1. DYNAMIC PARAMETERS CALIBRATIONS

### Preferences and Population Related
- Elasticities of Substitution in Utility
  - Intertemporal (1/GAMMA): 0.50.50.5
  - Labor and Consumption
    - OLG Agents (ETA_OLG): 0.8270.8320.798
- Elasticity of Labor Supply
  - OLG Agents: 0.50.50.5
  - LIQ Agents: 0.50.50.5
- Other Structural Parameters
  - Habit Persistence (NU): 0.40.40.4
  - 'Pure' Discount Factor (BBETA): 98.17699.04698.012
  - Probability of Survival (THETA): 0.950.950.95
  - Income Decline Rate (CHI): 0.950.950.95
  - Marginal Propensity to Consume (MPC): 4.5224.6654.974
  - Share of LIQ Agents (PSI): 0.30.30.4

### Production, Distribution and Finance
- Depreciation Rate for
  - business capital stock (DEPKBAR): 0.10.10.1
  - public capital stock (DEP_KG1): 0.040.040.04
  - public durables stock (DEP_KG2): 0.040.040.04
- P-share for Investment: 0.3140.3290.089
- Financial Accelerator
  - Borrower Riskiness
    - tradables (ZIGGY_T): 0.4520.4520.452
    - nontradables (ZIGGY_N): 0.4520.4520.452
  - Cost of Bankruptcy
    - tradables (MU_T): 0.3570.3570.357
    - nontradables (MU_N): 0.3570.3570.357
- Elasticities of Substitution between varieties in all sectors
  - Nontradables (SIGMA_N): 111111
  - Tradables (SIGMA_T): 111111
  - Retail (SIGMA_R): 212121
  - Consumption Goods (SIGMA_C): 212121
  - Investment Goods (SIGMA_I): 212121
  - Real Wages (SIGMA_U): 111111
  - Final Imports (SIGMA_DM): 414141
  - Intermediate Imports (SIGMA_TM): 414141
- Markups on Price (in %)
  - Nontradables (MUN): 101010
  - Tradables (MUT): 101010
  - Retail (MUR): 555
  - Consumption (MUC): 555
  - Investment (MUI): 555
  - Real Wages (MUW): 101010
  - Final Imports: 2.52.52.5
  - Intermediate Imports: 2.52.52.5
- Elasticities of Substitution — Home versus Foreign
  - consumption (XI_C): 1.51.51.5
  - investment (XI_I): 1.51.51.5
  - intermediate (XI_T): 1.51.51.5
- Elasticities of Substitution — Among Foreign
  - final (XI_DM): 1.51.51.5
  - intermediate (XI_TM): 1.51.51.5
- Tradable/Nontradable (XI_A): 0.50.50.5
- Capital versus Labor
  - nontradables (XI_ZN): 0.990.990.99
  - tradables (XI_ZT): 0.990.990.99

- Bias Parameters
  - Home Bias
    - consumption (ALPHA_CH): 0.5250.9340.93
    - investment (ALPHA_IH): 0.3050.9270.895
    - intermediate (ALPHA_TH): 0.4090.8940.921
    - Nontraded vs Traded (ALPHA_N): 0.5140.5110.58
  - Labor Over Capital
    - nontradables (ALPHA_N_U): 0.7010.6910.666
    - tradables (ALPHA_T_U): 0.540.5320.513

- Trade-Related Bias Parameters
  - Domestic over Imported Tradables for
    - intermediate goods (ALPHA_TH): 0.4090.8940.921
    - consumption goods (ALPHA_CH): 0.5250.9340.93
    - investment goods (ALPHA_IH): 0.3050.9270.895
  - Among Foreign Countries for final imports (ZETA_D)
    - from Hungary: 0.0450.015
    - from Euro Area: 0.7470.985
    - from Rest of World: 0.2530.955
  - Among Foreign Countries for intermediate imports (ZETA_T)
    - from Hungary: 0.0220.012
    - from Euro Area: 0.6740.988
    - from Rest of World: 0.3260.978

- Nominal Rigidities
  - Real Wage (PHI_P_U): 406040
  - Consumption Price (PHI_P_C): 456040
  - Investment Price (PHI_P_I): 456040
  - Nontradables Price (PHI_P_N): 456040
  - Tradables Price (PHI_P_T): 456040
    - final goods (PHI_P_DM): 452030
    - intermediate goods (PHI_P_TM): 452030

- Real Adjustment Costs
  - Labor Demand (PHI_U): 111
  - Consumption (PHI_C): 222
  - Investment (PHI_I): 111
  - Imports of
    - consumption goods (PHI_FC): 111
    - investment goods (PHI_FI): 111
    - tradable goods (PHI_FT): 111

### Corporate Sector Calibration
- Corporate Sector (% GDP unless otherwise stated)
  - Aggregate Capital Stock
    - utilized (K): 142.229146.225159.808
    - equity price (level): 1.0420.9891.037
    - investment (I): 17.818.320
    - current price (level; PI): 1.0420.9891.037
  - Tradables Capital Stock
    - utilized (KT): 72.13473.63178.852
    - equity price (level; QT): 1.0420.9891.037
    - investment (IT): 9.0289.2159.868
    - current price (level; PI): 1.0420.9891.037
  - Nontradables Capital Stock
    - utilized (KN): 70.09672.59480.956
    - equity price (level; QN): 1.0420.9891.037
    - investment (IN): 8.7729.08510.132
    - current price (level; PI): 1.0420.9891.037
  - All Firms
    - net worth (NW): 72.90374.95181.914
    - debt (BPRIV): 72.90374.95181.914
    - insolvencies (%): 888
    - leverage ($; LEVERAGE_T): 100100100
  - Tradables Firms
    - net worth (NWT): 36.97437.74140.418
    - debt (BPRIV_T): 36.97437.74140.418
    - insolvencies (%; BUST_T): 888
    - leverage (%; LEVERAGE_T): 100100100
    - premia
      - equity (EQPT): 8.2098.2098.209
      - external financing (XFPT): 2.52.52.5
  - Nontradables Firms
    - net worth (NWN): 35.92937.2141.496
    - debt (BPRIV_N): 35.92937.2141.496
    - insolvencies (%; BUST_N): 888
    - leverage (%; LEVERAGE_N): 100100100
    - premia
      - equity (EQPN): 8.2098.2098.209
      - external financing (XFPN): 2.52.52.5

*Source: _wp13207 - APPENDIX 1. DYNAMIC PARAMETERS CALIBRATIONS*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2013/_wp13207.pdf_