IMF Working Papers

Fiscal Consolidation During Times of High Unemployment: The Role of Productivity Gains and Wage Restraint

Author/Editor:

Ruy Lama ; Juan Pablo Medina Guzman

Publication Date:

December 10, 2015

Electronic Access:

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Summary:

This paper studies the Swedish fiscal consolidation episode of the 1990s through the lens of a small open economy model with distortionary taxation and unemployment. We argue that the simultaneous reduction in the fiscal deficit and unemployment rate in this episode stems from two factors: (i) high growth rates of total factor productivity (TFP), experienced after the implementation of structural reforms; and (ii) a sustained wage restraint that occurred during the 1990s. The model simulations show that economic growth, accounted for mostly by TFP gains, improved the fiscal balance by 8 percentage points of GDP through an expansion of the tax base and fiscal revenues. Moreover, the combination of stable wages and higher TFP boosted net exports and led to a reduction in the unemployment rate. A counterfactual simulation assuming stagnant TFP shows that fiscal consolidation measures alone would have generated a double-digit unemployment rate without eliminating the fiscal deficit.

Series:

Working Paper No. 2015/262

Subject:

Fiscal consolidation Fiscal policy Fiscal stance Labor Production Productivity Total factor productivity Unemployment rate