Output effects of fiscal consolidations: does spending composition matter?

Abstract

This paper studies whether changes in the composition of public spending affect the macroeconomic consequences of fiscal consolidations. Based on a sample of 52 developing countries and 18 advanced economies during 1980-2019, results show that while fiscal consolidations tend to be on average, contractionary, the size of the output fall depends on the behavior of public investment vis-a-vis public consumption during the fiscal adjustment, with heterogeneous responses growing over time. When public investment is penalized relative to public consumption and thus, its share in public expenditures decreases, a 1 percent of GDP consolidation reduces output by 0.7 percent within three years of the fiscal shock. In contrast, fiscal consolidations can even be expansionary in countries that protect public investment visa-vis public consumption the most: a similar-sized consolidation leads to an increase in output of about 0.9 percent within the same time frame. The component of GDP that mostly drives the heterogeneity between both types of adjustments is private investment. The results hold up to a number of robustness tests, including alternative identification strategies of fiscal shocks. The findings have policy implications for the design fiscal adjustment strategies to protect economic growth as countries recover from the coronavirus pandemic.