The Role of Composition in Deficit-Driven Fiscal Consolidations: The Differing Effects of Spending Cuts and Tax Hikes on Economic Activity

Fiscal consolidation has become more common among advanced countries after the 2008 global financial crisis, renewing interest in its possible effects on economic activity. Although there is an extensive amount of literature on the effects of fiscal consolidation as a whole, few studies have looked at how the composition of a fiscal adjustment may affect economic activity differently depending on which parts of the budget are cut. Using data from 17 OECD countries between 1978 and 2009, this thesis analyzes fiscal consolidation in four aspects of the government budget---public consumption, public investment, transfer payments, and tax revenue---and how these components affect economic output differently. Results show that public investment cuts have the most negative effect on real GDP, followed by tax increases. I conclude this is likely due to a complementary relationship between public investment and private investment as well as public investment and private consumption. Spending cuts to public consumption had the least negative effect on real GDP. Consequently, policy makers should use public consumption cuts if they feel the need to consolidate the budget, because this type of adjustment has the least negative impact on economic output.