Effects of Fiscal Consolidation in the OECD The bigger difference in terms of GDP outcomes occurs when the deficit reduction is undertaken through increases in corporate taxes. The corporate tax has different consequences on both the aggregate demand and aggregate supply. The higher corporate tax rate , reduces the return to private capital. Thus private investrnent decliiies. Even though real interest rates also decline by more in this case, the impact of higher taxes on liquidity constrained firms far outweighs the stimulative effect of lower real interest rates on real investment. There is also a long run contraction in CDi? because the lower rate of investment implies a lower physical capital stock in the longer rum. Note that the share market rises under each policy because of lower real interest rates. However, the sinilarity in share market outcomes does not imply similar investment responses because of the role of liquidity constraints in investment.

The form of the defi,cit reduction has quite different implications within the U.S. economy. This is also true in the transmission of these policies to other countries. Although the MSG2 model contains country detail on a number of countries and regions it is convenient to stummarize the transmission of the fiscal change by focussing on results for the ROECD region. These are shown in Ftgure 5.

The quantitative results differ for each country but the qualitative story is similar. In the first year of the fiscal contraction, there is a decline in ROEC-D GDP. This occurs because of the fall in U.S.demand for goods from other countries. The negative effects are reversed by 1994 because the faU in global real interest rates stimulates private investment in non-U.S. economies. This is seen clearly in Figure 5. It is also true that in the long run real GDP is higher in all countries. This occurs through the same mechanism as discussed above for the United States. Lower long term real interest rates must be consistent with a lower marginal product of capital in each country and therefore a higher capital stock , which implies that output is permanently higher.

The results for foreign economies across the three fiscal instruments also differ. The increase in corporate taxes leads to a larger outflow of private capital from the U.S. which results in a larger increase in physical capital in the rest of the world. The higher path of future output and the larger fall in real interest rates lead to a larger rise in non-U.S. share markets in the case cf the corporate tax increase.

The consequences for countries outside the OECD are summarized in figure 5a. The MSG2 model does not contain a detailed internal macroeconomic structure for the non-oil developing countries. It is assumed that these countries are constrained by the amount of lending offered by the rest of the world. The amount that these countries can borrow plus the revenue from exports is then used to service outstanding debt and to purchase imported goods from each other region. Importantly it is also assumed that this region pegs to the U.S. dollar. Figure 5a contains the results for the trade balance and exports for this region. The key transmission mechanism to this region is that for a given capital account, lower interest rates imply a larger trade balance deficit can be run. In addition with a real and nominal depreciation relative to non-U.S. economies, real exports (defined in terms of US goods) also rise due to substitution by non-U.S. industrial economies towards the goods from developing countries. Thus real imports rise by more than the reductioin in debt servicing costs. In this sense, the non-oil developing countries are better off. In both the case of non-U.S. industrialized economies and economies with balance of payments constraints the U.S. fiscal contraction is on balance positive. The channels arc different in the sense that for ROECD economies, the assumption of open capital markets leads to a stimulus to investment through a reduction in real long term interest rates. In countries with a balance of payments constraint due to incomplete access to global capital markets, the benefits emerge from lower costs of servicing foreign debt.

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