by Apostolis Philippopoulosa,b, Petros Varthalitisc and Vanghelis Vassilatosa
We welfare rank various tax-spending-debt policies in a New Keynesian model of a small open economy featuring sovereign interest rate premia and loss of monetary policy independence. When we compute optimized state-contingent policy rules, our results are as follows: (i) Debt consolidation comes at a short-term pain, but the medium- and long-term gains can be substantial. (ii) In the early phase of pain, the best fiscal policy mix is to cut public consumption spending to address the debt problem and, at the same time, to cut income tax rates to mitigate the recessionary effects of debt consolidation. (iii) In the long run, the best way of using the fiscal space created is to reduce capital taxes.
JEL Codes: E6, F3, H6.
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a Athens University of Economics and Business
b CESifo
c Economic and Social Research Institute, Trinity College Dublin