Many EU member states are implementing fiscal consolidation measures to reduce their budget deficits and comply with EU fiscal rules. New empirical evidence shows that fiscal consolidation in EU countries reduces economic output, increases the unemployment rate and income inequality, and lowers inflation. Crucially, however, the dampening effects are significantly stronger during recessions than during upswings. Governments should aim to mitigate the negative distributional and employment effects of future consolidation measures.

The real cost of tightening

In many EU countries, budget deficits and public-debt-to-GDP ratios remain significantly higher than before the Covid-19 and energy crises. National governments are under pressure to implement measures to reduce deficits and comply with EU fiscal rules.

In a new study, we examine the impact on economic output, unemployment, inflation, and income distribution. We use a dataset from the International Monetary Fund (IMF) on consolidation measures since the 1980s, which includes the magnitude and timing of the measures. Our analysis focuses on 12 EU countries: Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, the Netherlands, Portugal, Spain, and Sweden.

We show the effects of a fiscal consolidation amounting to one percentage point of GDP. Real output declines by about 0.6 per cent in the first year following consolidation. Three years later, cumulative GDP losses amount to 1.6 per cent. The unemployment rate rises as a result of fiscal consolidation — by 0.6 percentage points upon implementation and by a total of around 0.9 percentage points two years later. Income inequality increases in the short to medium term. In addition, consolidation measures reduce the inflation rate due to their overall dampening effects — by about 0.35 percentage points in the short term and around 0.15 percentage points in the medium term.

Fiscal consolidation has contractionary effects throughout the business cycle. However, our results show that fiscal tightening slows the economy far more in recessions — with an average fiscal multiplier greater than 1.0, meaning one additional euro of consolidation reduces output by more than one euro — than in upswings, where the multiplier is well below 1.0.

We demonstrate that fiscal tightening is invariably contractionary, thereby overturning earlier findings suggesting that budget cuts can stimulate economic activity. Our estimates are consistent with findings from a meta-analysis of fiscal multipliers, which finds average multipliers close to 1.0 and stronger effects during economic downturns, with multipliers greater than one. This supports the Keynesian view that periods of economic weakness are not suitable for fiscal tightening. Budget cuts during recessions can, in fact, be counterproductive, harming growth and employment so severely that the debt-to-GDP ratio may increase rather than decrease.

A smarter path to consolidation

Future consolidation measures by national governments in EU countries should pay particular attention to minimising negative distributional and employment effects. Doing so would help limit increases in unemployment-related spending and stabilise government revenues.

A balanced mix of tax increases and spending cuts could mitigate the negative macroeconomic and distributional consequences. IMF research shows that cuts to public investment are particularly detrimental, whereas progressive tax measures that primarily target financially well-off households result in significantly smaller economic losses. A balanced consolidation strategy would therefore increase the chances of fiscal adjustment succeeding on its own terms.

Beyond consolidation, it is important to recognise that stable public finances in the long term require strong economic and labour market performance. What is needed, in particular, are active labour-market policies and high levels of public investment with positive macroeconomic effects. This also requires creating fiscal space at the European level to promote public investment.

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