Labour Market Rigidity and Expansionary Austerity

This study provides new evidence on how labour market rigidities affect the transmission of fiscal consolidations using a sample of 17 OECD countries. Owing to a novel empirical approach, the outcomes of consolidations are modelled as a function of employment and wage rigidities. The evidence confirms that tax-based consolidations are distortionary, while expenditure-based consolidations have wealth effects. These effects are then magnified by flexible employment and rigid wages, while they are moderated by rigid employment and flexible wages. This indicates that labour market conditions influence how fiscal consolidation is propagated in the economy by affecting both the magnitude and the transmission channels of consolidation plans. This result has crucial policy implications and suggests that the design of consolidation plans should account for the labour market structure.