This paper studies the joint dynamics of fiscal deficits and unemployment in a neoclassical growth model with distortionary taxation, labor market search frictions, and real wage rigidities. First, we show that a tax increase or a reduction in government spending can improve the fiscal balance at the expense of a higher unemployment rate. However, under a scenario of rigid wages and productivity gains, it is possible to achieve a simultaneous reduction of the fiscal deficit and the unemployment rate. Second, we analyze the Swedish fiscal consolidation episode of the 1990s through the lens of the model. The model is capable of reproducing the simultaneous reduction in fiscal deficits and unemployment observed during this episode. Counterfactual simulations show that in the absence of TFP gains and rigid wages, fiscal consolidation measures alone would not have eliminated fiscal deficits, and the unemployment rate would have reached double digit levels.
- Distortionary taxation
- Fiscal deficits
- Search models of unemployment