gpw054

Oxford Economic Papers, 69(3), 2017, 632–654
doi: 10.1093/oep/gpw054
Advance Access Publication Date: 22 December 2016
The design of fiscal consolidation

measures in the European Union:
distributional effects and implications
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for macro-economic recovery
By Alari Paulusa, Francesco Figarib, and Holly Sutherlanda
a
ISER, University of Essex, Colchester
b
Department of Economics, University of Insubria, via Monte Generoso 71, 21100 Varese, Italy;
ISER, University of Essex; CeRP, Collegio Carlo Alberto; DONDENA, Bocconi University; e-mail:
francesco.figari@uninsubria.it
Abstract
The paper considers the austerity measures introduced in the wake of the financial
and economic crisis in the late 2000s in relation to their distributional impact across
households and potential effects on aggregate demand. We determine the size,
composition and effects of fiscal consolidation using a ‘bottom-up’ measurement
strategy and find notable cross-country variation. We show that while richer house-
holds tend to bear a greater burden in most countries, combined cuts in public
wages and transfers are more likely to affect liquidity-constrained households and
thereby aggregate demand, casting doubts on the presumed effectiveness of such
measures for macro-economic recovery. This suggests that in order to reach robust
policy conclusions it is important to consider the distributional patterns of detailed
policy measures.
JEL classifications: D31, H24, H55, I30.
1. Introduction
Following the financial and economic crisis which started in the late 2000s, governments
introduced extensive fiscal consolidation measures to address budget deficits. The way in
which fiscal consolidation is achieved and the cost of the crisis is distributed has implica-
tions for the prospects for macro-economic recovery and financial stability, as well as for
the political acceptability of pathways in this direction.
Several studies have suggested that fiscal adjustments based on spending cuts, including
both cuts in government services and public transfers to households, are more effective
in reducing public debt and less harmful to economic growth than fiscal adjustments based
on tax increases (e.g. Alesina and Perotti, 1995, 1997; McDermott and Wescott, 1996;
C Oxford University Press 2016.

V
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A. PAULUS, F. FIGARI, AND H. SUTHERLAND 633
Alesina and Ardagna 1998, 2010, 2013; von Hagen and Strauch, 2001; IMF, 2010;
Guajardo et al., 2011; Alesina et al., 2012).1 Nevertheless, recent studies based on struc-
tural macro models shed some light on the fact that cuts in (unproductive) government
spending are associated with long-run benefits but they can have short-run adjustment costs
and pronounced distributional effects. In particular, some studies highlight the potentially
detrimental effects of cuts in public transfers that are borne by liquidity-constrained house-
holds (Coenen et al., 2008, 2012; Forni et al., 2010; Clinton et al., 2011).
Such studies, however, tend to take a macro-economic perspective and overlook how
measures affect the whole distribution of household incomes, which could be a critical

element for determining the impact of policies on aggregate demand. Indeed, it is increas-
ingly recognized in the economic literature that it is important to consider the heterogeneity
of agents in order to avoid aggregation bias (e.g. Blundell and Stoker, 2005). For example,
one might expect that cuts in non-contributory public transfers place a greater burden
on the lower part of household income distribution, while tax increases require relatively
bigger contributions from richer households who have a lower marginal propensity to con-
sume, resulting in a smaller effect on aggregate demand. As recognized in Coenen et al.
(2008), it is important to stress that the distributional effects depend on the overall design
of the tax-benefit systems and also vary notably among specific benefit and tax instruments,
pointing to the need to consider even more disaggregated categories.
Nevertheless, the distributional consequences of fiscal consolidation have been
recognized to be of potential importance (Coenen et al., 2008). For example, Perotti (1996,
p. 108) already stated: ‘The crucial question, however, remains the impact of fiscal consoli-
dations on the distribution of disposable income. On this, there is very little information,
because very rarely does the timing of income-distribution surveys allow an analysis of its
evolution before and after a fiscal consolidation . . .’. His claim is still valid after almost
20 years in spite of the generally wider availability of microdata than in the 1990s.
Although, more recently, there has been a notable increase in concern about the distribu-
tional consequences of the economic crisis, fiscal stimulus packages and fiscal consolidation
measures, an assessment of the effect on the income distribution is still lacking not least
because of data availability and difficulties in linking various budget items to specific
household characteristics and in building a proper counterfactual scenario (Joumard
et al., 2012).
The aim of this paper is to fill a gap in the fiscal consolidation literature regarding distri-
butional effects, taking a cross-country perspective to give a stronger base for generalizing
the results. First, considering the actual design of the fiscal consolidation measures, we pro-
vide evidence on the distributional impact of the austerity measures implemented in EU
countries up to 2012. Second, we explore to what extent the design of the measures is asso-
ciated with the potential impact on the consumption reactions of individuals and house-
holds facing the burden of the austerity measures. To the best of our knowledge we are the
first to quantify the size, the distributive effects and the incidence on liquidity-constrained
households of the fiscal consolidation measures actually faced by the household sector.
This evidence does not only matter in its own right but can in principle offer valuable
1 It should be noted that there are some differences between early studies in terms of whether some
items have been considered as part of spending or tax adjustments. For example, Alesina and
Perotti (1995) include cash transfers in spending, while Blanchard and Perotti (2002) deduct these
from taxes.
634 DESIGN AND DISTRIBUTIONAL EFFECTS OF AUSTERITY MEASURES
insights into the macro-economic performance of fiscal adjustments, complementing

the flourishing macro-economic literature. Moreover, our paper provides a methodological
approach for estimating (ex ante) the impact of fiscal consolidation measures on household
disposable income that can be fed into macro-models. For example, our approach could
potentially offer micro-based estimates to enrich the calibration of the structural param-
eters of the fiscal structure of macro models (e.g. Coenen et al., 2012), allowing for the def-
inition of scenarios which track the policy rules implemented in reality rather than stylized
scenarios which are often not plausible specifications for a given country (e.g. Clinton
et al., 2011).

We make use of microsimulation techniques, which allow us to simulate tax-benefit pol-
icy changes in detail and estimate their effect on disposable income for each household in a
nationally representative sample, with the help of relevant counterfactual scenarios.
Aggregating the impact across all households yields a measure of total fiscal consolidation
in the household sector, providing an alternative, ‘bottom-up’ measurement strategy to the
usual approaches in the macro-economic literature. Specifically, we employ EUROMOD,
the only EU-wide tax-benefit model, and concentrate our analysis on the Southern
European countries (Greece, Italy, Portugal and Spain), the Baltic countries (Estonia,
Latvia and Lithuania) and Romania which experienced the largest budget deficits and/or re-
ductions in economic output during the crisis. These countries are also among those de-
veloped economies which have implemented or announced the largest fiscal consolidation,
ranging between 6% and 18% of GDP (OECD, 2012; Sutherland et al., 2012).
Our paper has common elements with the strand of fiscal consolidation literature that
uses a narrative approach to identify discretionary changes in fiscal policy (e.g. IMF, 2010;
Romer and Romer, 2010) rather than statistical methods (e.g. Alesina and Perotti, 1995;
Alesina and Ardagna, 1998; Blanchard and Perotti, 2002). However, unlike other studies
relying on a narrative approach, we exploit the microsimulation model to derive our own
estimates of fiscal consolidation measures, and their incidence across the income distribu-
tion, in a common framework rather than relying on official assessments by governments.
An additional advantage of the microsimulation method in this context is that it allows for
a focus on the design of the consolidation measures and an assessment of policy changes
in great detail as we can consider each individual policy instrument separately as well as in
combination.
Overall, our study is the first attempt to model the (short-term) effect of fiscal consolida-
tion measures on the full income distribution. Previous studies focusing on the distribu-
tional impact of fiscal consolidation measures (often identified based on statistical
methods) take a time-series perspective using episodes of fiscal consolidation for a sample
of countries over a long period, to estimate the impact on aggregate inequality or poverty
and to analyse the determinants of cross-country variations in income inequality (Ball et al.,
2013; Woo et al., 2013; Agnello and Sousa, 2014). In contrast, we have estimated the
distributional effects of a specific (and important) episode for a number of countries, iden-
tifying and modelling fiscal consolidation policies in great detail.
The degree of deficit reduction that the countries which are included in our analysis set
out to achieve, influenced by the Stability and Growth Pact rules, naturally varied, and so
did the policy mix chosen to achieve it. Our analysis addresses the question of how changes
to direct and indirect (personal) taxes, cash benefits and public sector pay – which have a
direct impact on household (cash) resources – affected different income groups. We focus
on these instruments as they provide governments with better control on distributional
outcomes and offer more explicit choices, while macro-economic and labour market poli-
cies – and even cuts in public services – are blunt instruments in terms of their distributional
effects.
The extent to which a decrease in disposable income due to fiscal consolidation meas-
ures reduces household spending on goods and services provides a link between our micro-
based approach and the macro literature on fiscal consolidation. We exploit the variation
in income among households and link such a change to the potential reduction in their con-
sumption, depending on the liquidity constraints they face (Auerbach and Feenberg, 2000;
Coenen et al., 2012). Our approach shows the importance of the interactions between the

design of fiscal consolidation measures and the income distribution; these matter on their
own but also for the prospects for macro-economic recovery.
We find notable variation in the size, composition and first order effects of fiscal con-
solidation. Overall, richer households tend to bear a greater burden in most countries,
though this differs a lot between types of tax-benefit instruments. Such heterogeneity tends
to be less visible when measures are grouped as cuts of public transfers and tax increases,
a dichotomy which is typically used in the fiscal adjustment literature. Moreover, our find-
ing that combined cuts in public wages and transfers are more likely to affect liquidity-
constrained households casts doubts about such measures being less detrimental for
aggregate demand than increases in taxes. This suggests that it is not the type of policy in-
strument per se which matters but how it affects different parts of income distributions,
hence our emphasis on the need to consider more disaggregated evidence to reach robust
policy conclusions.
The remainder of the paper is structured as follows. Section 2 discusses methodology
and summarizes the fiscal consolidation measures taken in each country and the scope of
our analysis. Section 3 presents an analysis of the composition and distributional effects
of the measures in the eight countries considered and shows how the different policy
mixes each have their own distributional implications as well as certain common features.
Section 4, provides micro-based insights to the macro-economic effects of austerity policies,
by combining the design aspects of the austerity measures with their potential impact on ag-
gregate demand, taking into account the liquidity constraints faced by households in the
crisis period. The final section concludes by summarizing our policy relevant findings.
2. Methodology
2.1 Fiscal microsimulation
We focus on policy measures which directly impact household budgets and household ag-
gregate demand, and which were introduced explicitly in order to cut the public deficit or
stem its growth. These policy changes were not only many but also typically applied across
the board, affecting large parts of population to some extent or another, and therefore pro-
vided no natural control groups for estimating causal effects on household incomes and de-
mand. We therefore make use of fiscal microsimulation techniques (Bourguignon and
Spadaro, 2006; Figari et al., 2015) to define and construct a counterfactual scenario: what
would have happened in the absence of the fiscal consolidation measures.
In essence, fiscal or ‘tax-benefit’ microsimulation modelling applies detailed tax-benefit
policy rules to a representative sample of households, using survey or register information
on household characteristics and market income as input. It enables the derivation of
disposable income for each household as well as the overall distribution under existing
tax-benefit systems and, more importantly, the effect of tax-benefit policy changes on the
household income distribution. In doing so, the heterogeneity in household budget con-
straints due to the interactions between the detailed tax-benefit rules and personal and
household characteristics is fully taken into account. The focus on the entire distribution of
changes in the target variable (rather than change for an average person or in the mean
value alone) is one of the key distinctions from regression techniques or macro models. The
first-order impact of tax-benefit policy changes on household incomes, i.e. the mechanical
effect, is estimated without imposing any behavioural relationships and is strictly atheoreti-
cal. Static calculations also represent an important element of behavioural models, where

these are combined with behavioural assumptions or a (detailed) choice mechanism.
We depart from purely arithmetic calculations and capture not only the first-order ef-
fects but also the extent to which these translate into changes in aggregate demand given
that households have different capacities to absorb income shocks (due to liquidity con-
straints) and were affected by different types of policy measures (benefit cuts vs tax in-
creases). Our micro-based approach is novel in the literature on fiscal consolidation, which
is typically based on macro-economic evidence alone. Microsimulation modelling has al-
ready been used to consider the role of tax-benefit policies in stabilizing aggregate house-
hold demand to (hypothetical) income or unemployment shocks in the presence of liquidity
constraints (Dolls et al., 2012), while our study is the first to consider the effect of actual
policy changes in this context. Our analysis is partial as it does not attempt to cover wider
general equilibrium or dynamic effects. We focus on household demand and liquidity con-
straints, leaving aside potential labour supply changes (as these are likely to be of second
order in terms of magnitude) as well as other sectors in the economy (businesses, govern-
ment spending on public goods and services).
2.2 The counterfactual

We identify and simulate changes in national legislation regarding individual tax and bene-
fit instruments introduced for austerity reasons since the beginning of the economic down-
turn in 2008. We evaluate the effect of such austerity measures in 2012, the reference point
in time of our simulations, at which point fiscal adjustments were at their maximum in
most of the countries considered. The starting point from which measures were introduced
is different across countries depending on many factors, including the timing of the national
macro-economic and budgetary reactions to the financial crisis in order to respect the for-
mal fiscal rules imposed by the Stability and Growth Pact. Among the countries included in
the analysis, the Baltic countries (Estonia, Latvia and Lithuania) and Portugal started intro-
ducing fiscal consolidation measures in 2009 and followed with further measures in 2010
to 2012. Other countries (Greece, Spain and Romania) started fiscal consolidation in 2010
and Italy introduced its first measures in 2011.
Our aim is to distinguish between changes that were part of a ‘business as usual’ scen-
ario and those introduced for austerity reasons. While the latter mostly involved tax in-
creases and cuts in social benefits and public sector pay, such policy changes also included
increases in some benefits or reductions in taxes for certain groups to compensate or allevi-
ate the impact of other measures. On the other hand, we do not consider the expiry of fiscal
stimulus measures as part of the fiscal consolidation package if those were intended to
be temporary from the beginning. Overall, we follow the spirit of other studies relying
on historic sources (e.g. IMF, 2010; Romer and Romer, 2010; Devries et al., 2011).
We have chosen to interpret the ‘absence of the fiscal consolidation measures’, i.e. our
counterfactual scenario, as the continuation of pre-fiscal consolidation policies, indexed ac-
cording to standard practice and official assumption, or law. Such indexation of monetary
values of tax-benefit policies is not the same across countries under consideration. Apart
from public pensions, most of the countries do not regularly index fiscal policies and in-
stead change these occasionally on an ad hoc basis. The only countries not applying any
indexation are Greece and Lithuania.
To estimate the effect of policies we apply both the actual 2012 tax-benefit policies and
the (indexed) pre-fiscal consolidation policies to the same households, keeping their charac-

teristics (including market incomes) constant. This allows us to isolate the policy effect
from changes in other dimensions (e.g. demographics or labour market outcomes). It is
important to note that the estimation of policy effects is, however, conditional on market
income and household characteristics in a particular moment in time, which we have
chosen to be the year of our simulations (i.e. 2012). A more formal methodological presen-
tation is provided in Appendix 1. Overall, we present a positive analysis of the design and
redistributive effects of fiscal consolidation measures. A normative analysis providing wel-
fare considerations based on how society weighs costs and benefits of simulated policy
changes is beyond the scope of the paper.
2.3 The European tax-benefit model EUROMOD and data

Simulations are carried out using the EU-wide tax-benefit model EUROMOD (Sutherland
and Figari, 2013), which is the only comparative model available for European countries. It
has a unique design within which the different country specific tax-benefit systems are mod-
elled in a common conceptual and technical framework, with the aim to maximize cross-
country comparability. It also serves as the main or only national model in a number of EU
member states.
EUROMOD simulates (non-contributory) cash benefit entitlements and personal tax
and social insurance contribution (SIC) liabilities on the basis of the tax-benefit rules in
place and information on original and replacement incomes as well as socio-demographic
characteristics from the underlying survey data. The base simulations refer to the mid-point
of a given policy year (30 June). Annual tax-benefit policy changes for each country are
summarized in EUROMOD Country Reports, along with technical notes and validation re-
sults.2 The base model provides estimates of the first-order impact of tax-benefit changes
and is non-behavioural. Overall, the comparison of the simulated income distribution (with
taxes and benefits simulated by EUROMOD) and the distribution reported in the survey re-
veals a very good match as shown in Table A1 and Fig. A1 in the online Appendix.
EUROMOD is publicly available and has been widely applied in academic research3 and
policy analysis4, representing a further layer of cross-checks and validation.
2 See https://www.euromod.ac.uk/using-euromod/country-reports (last accessed on 30 September,

2016).
3 For example, see Immervoll et al. (2011), Dolls et al. (2012), Bargain et al. (2014).
4 The prime examples of the EU-level policy analysis with EUROMOD are its regular use for the
Social Situation Monitor (http://ec.europa.eu/social/main.jsp?catId¼1049& – last accessed on 4
August, 2016) and increasing occurrence in annual country assessments as part of the European
Semester (http://ec.europa.eu/economy_finance/eu/index_en.htm – last accessed on 4 August,
2016). In addition, EUROMOD has been applied in numerous policy analyses at the national level.
The version of EUROMOD used in this paper is based on information on personal and
household characteristics (including market incomes) from the 2008 EU Statistics on
Incomes and Living Conditions (EU-SILC) micro-data (or its more detailed national version
where available). EU-SILC is a nationally representative annual household survey collecting
detailed income information, in this wave for 2007 calendar year. Sample sizes range from
about 12,000 to13,000 individuals in Portugal, Estonia, Latvia and Lithuania to more than
50,000 people in Italy.
Due to the gap between the data collection year (which was before the financial and eco-
nomic crisis) and the reference time of our analysis, we adjust the input data to account for

the most important labour market changes up to 2012 when the measures covered in our
analysis were in place. As the economic crisis deepened, the countries considered here expe-
rienced reductions in labour market activity. We predict transitions from employment into
short- or long-term unemployment and from being out of work into employment, based on
the changes in employment as indicated by 2007 and 2011 Labour Force Survey (LFS)
data. Transitions are applied within 18 strata of characteristics – according to age group
(3), gender and educational level (3), selecting (randomly) for each stratum a required num-
ber of people for whom employment status is changed. This method builds on previous
work by Figari et al. (2011) and is explained in detail in Navicke et al. (2014). We also ad-
just the nominal level of market incomes by source, in line with actual changes since the in-
come reference period. Finally, where relevant, some calibrations are adopted to take into
account tax evasion (Greece, Italy) and non-take-up of certain means-tested benefits
(Estonia, Greece, Latvia, Romania), assuming behaviour in this respect to be the same be-
fore and after the policy changes.
The labour market changes are of course due to many factors (and their interactions)
and may partly reflect the fiscal consolidation measures themselves. We cannot disentangle
these factors a priori – in fact, the very purpose of the paper is to measure the impact
of discretionary policy measures on household disposable incomes at the micro-level
and how that in turn may affect aggregate demand. Such an aggregate demand
shock is likely to have contributed to further reduce economic output and labour market
activity.
The effects of fiscal consolidation measures are assessed on the market income distribu-
tion at the reference point of the analysis. This is the only distribution known to policy-
makers when they take decisions on policy changes and makes the choice of this
counterfactual scenario of interest and relevance (Matsaganis and Leventi, 2014).
As a robustness check for redistributive effects of fiscal consolidation measures, we
show results based on unadjusted population characteristics as well (Table A3 and Fig. A4
in the online Appendix). Regardless of whether or not there was a causal relationship be-
tween the austerity policies and the labour market changes in 2007–11, our assessment of
the distributional effects of the fiscal consolidation measures is not greatly affected by our
adjustment for labour market changes.
2.4 Scope of simulations

We focus on measures which have a direct impact on household resources, i.e. changes in
cash benefits, public pensions, direct personal taxes, social contributions and indirect taxes
as well as public sector pay cuts, the latter measured net of any reduction in income tax and
social contributions. We chose to exclude changes in employer contributions on the

grounds that these are unlikely to affect disposable income in the short-term.
EUROMOD base simulations do not cover indirect taxes as there is no comprehensive
information collected on household expenditures in EU-SILC. Nevertheless, as indirect
tax changes have been an important part of fiscal consolidation packages, we approximate
the effects of changes in the VAT rates (in terms of household disposable income) based on
extrapolations from the latest estimates for the incidence of VAT across the income distri-
bution in the pre-crisis period. Specifically, we use estimates from V~ ork et al. (2008) for
Estonia, Matsaganis and Leventi (2013) for Greece, IFS (2011) for Spain, Taddei (2012)

for Italy, Ivaskait_e-Tamosi
un_e (2013) for Lithuania and Avram et al. (2013) for the other
countries, which draw on information from Household Budget Surveys (HBS) on the distri-
bution of expenditure by COICOP categories (by income decile/quintile group). The ori-
ginal estimates are shown in Table A2 in the online Appendix. We then derive the effect of
VAT rate increases by scaling the pre-crisis estimates in proportion to the VAT rate changes
up to 2012.
Table 1 summarizes the types of fiscal consolidation measures that have been used
in each country within the scope of our analysis (up to 2012). The table shows that all
countries have cut cash benefits and/or pensions and, all of the countries except Lithuania
and Romania increased income taxes or workers’ social insurance contributions. Greece
further introduced additional new taxes and contributions. All countries also cut (or froze
or somehow limited) public sector pay, though in Estonia public pay had risen again (simi-
lar to the average wage in the private sector) by the end of the period in question. A number
of countries also increased property taxes: these have been simulated in Greece and Italy,
where the change in the tax revenue over the period 2008–2012 accounted for about 0.4
and 0.8 percentage points of GDP, respectively. In Spain, Latvia, Lithuania, Portugal
and Romania it is not possible to simulate the changes in property tax due to lack of rele-
vant information in the data: however, the size of such changes in these countries were
more limited, accounting for about 0.1 percentage points of GDP (European Commission,
2013). Finally, all countries have also increased the rate(s) of VAT. Detailed information
on the changes in each country can be found in Avram et al. (2013).
Table 1. Type of introduced household income-related fiscal consolidation measures
Type of measures EE EL ES IT LV LT PT RO
Benefit/pension cuts (or freezing) Yes Yes Yes Yes Yes Yes Yes Yes
Increased income taxes/reduced tax concessions Yes Yes Yes Yes Yes No Yes No
Increased worker social insurance contributions Yes Yes No Yes Yes No Yes No
Public sector pay-cuts (or freezing) No Yes Yes Yes Yes Yes Yes Yes
Increased property taxes No Yes (Yes) Yes (Yes) (Yes) (Yes) (Yes)
Increased rates of VAT Yes Yes Yes Yes Yes Yes Yes Yes
Start period of measures 2009 2010 2010 2011 2009 2009 2009 2010
Notes: ‘Yes’ in bold indicates that measures are simulated in our analysis. (Yes) in parenthesis indicates that
measures were introduced but are not possible to simulate given data limitations. The fiscal consolidation
measures included here are those that have a direct effect on household income plus increases in the VAT
rate(s) as of June 2012.
3. The redistributive effects of fiscal consolidation measures

Our estimates of the extent and composition of the ‘fiscal consolidation packages’ analysed
here are shown in Table 2. As noted above, the aggregate measure of fiscal consolidation
is derived from micro-data and, hence, can provide a useful complement to typical
approaches in the fiscal adjustments macro literature.
Measured as a percentage of pre-austerity total disposable income (i.e. the counterfac-
tual is given by the incomes in 2012 without the fiscal consolidation measures), the overall
fiscal consolidation generated by tax increases and cuts in public transfers (including cuts in

public wages as well) faced by the household sector varies from 1.6% of disposable income
in Italy to 9.2% in Latvia and 11.7% in Greece. Table 2 also shows the relative importance
of the different types of measures and how countries differ in terms of the main source of
consolidation: increases in income tax in Greece, Spain and Italy; increases in worker social
insurance contributions in Estonia; cuts in non-means-tested benefits in Lithuania and
Latvia; cuts in public pensions in Romania and Portugal. Pay cuts in the public sector
played a major role in Greece, Latvia and Portugal. Means-tested benefits were cut in
Portugal while in the other countries, spending on these benefits tended to increase, partly
making up for reductions in other incomes. There are also interactions between pension
and benefit cuts and income tax (and in some countries, social contributions) payable
on these benefits. The figures for income tax increases are net of reductions due to the
decreased tax base in these respects. The net effect is positive in Romania where there were
no consolidation-related changes to income tax.
While changes to indirect taxes do not have an effect on household disposable income
they do impact directly each household’s consumption potential. The last column of
Table 2 shows the increase in VAT payment due to the increase in the VAT rates (mainly
the standard rate; reduced rates have been increased in Greece and Italy and we simulate
these increases as well) as a proportion of disposable income. In doing so, we focus again
on first order effects and have assumed that: (1) there is no change in pre-tax expenditure
Table 2. Aggregate effect of simulated consolidation measures in place in 2012 as a percentage

of total household disposable income, by type of policy
Country Public Public Means- Non means- Income Workers Total effect Effect of VAT
sector pensions tested tested taxes SIC on disposable changes on
salaries benefits benefits income disposable
income
EE 0.00 1.64 0.15 0.21 0.32 1.96 3.98 1.22

EL 2.52 1.92 0.02 0.17 6.57 0.53 11.73 3.33
ES 1.27 0.92 0.03 0.11 2.13 0.00 4.41 2.55
IT 0.20 0.36 0.00 0.00 0.92 0.15 1.63 0.49
LV 2.28 1.05 0.04 2.65 1.26 2.03 9.23 2.96
LT 0.40 0.00 0.42 2.63 0.04 0.28 2.93 2.12
PT 2.16 2.69 1.33 0.32 0.33 0.05 6.88 1.33
RO 1.15 4.72 0.15 0.55 0.56 0.00 5.71 3.30
Notes: The measures included here are those that have a direct effect on household disposable income (changes
to direct taxes, cash benefits and public sector pay) and increases in the VAT rate(s) (see Table A2 in the online
Appendix).
Source: own calculations with EUROMOD. A negative sign indicates a reduction in household income.
or in pre-tax relative prices; and (2) the VAT increases are proportional to the pre-reform
VAT payments. The effect of VAT increases ranges from less than 1% of disposable income
in Italy to more than 3% in Greece and Romania and is clearly substantial compared to
other components considered here.
To the best of our knowledge, the simulated size of each policy offers a unique quantifi-
cation of the consolidation measures faced by the household sector across countries. As
stressed in Anderson et al. (2015), who use aggregate data from the IMF World Economic
Outlook, ‘information on the composition of the adjustment on a country basis is not read-
ily available’. Indeed, one of the aims of our paper is to provide alternative and more pre-

cise (bottom-up) measures of fiscal consolidation faced by the household sector than what
is usually presented in the macro-economic literature. In interpreting these figures it is im-
portant to remember that they do not reflect the scale of the fiscal consolidation effort as a
whole in each country but they indicate the scale of immediate and direct losses in monet-
ary resources experienced by households. Nevertheless, as shown in Fig. A2 in the online
Appendix, there is clear correlation between the simulated measures with an immediate
impact on household resources (expressed in terms of total household disposable income)
and the total fiscal consolidation (expressed in terms of GDP), as estimated by the OECD
and the European Commission using macro-based approaches, which supports the cross-
country comparability of our analysis.
The implications of the fiscal consolidation measures across the income distribution are
illustrated in Fig. 1. First, the figure shows (dashed line) the average proportional change in
household disposable income by decile group caused by the fiscal consolidation measures
with a direct effect on household disposable income (increases in income taxes and contri-
butions, cuts in public transfers; not including VAT changes here). The largest group of
countries (Greece, Spain, Italy, Latvia, Romania), show progressive reductions in income
on the whole, i.e. richer income groups contributing more in relative terms. Portugal and,
to a lesser extent, Lithuania show an inverted U-shape pattern where middle income groups
contribute less compared to low and high income groups. Estonia is the only country with a
strong regressive distribution of income losses, although the effect is mitigated for the poor-
est decile group. Second, the solid line shows the distributive effects of the consolidation
measures including increases in VAT rates. As expected, the effect of the VAT changes is
regressive across the income distribution in each of the countries and, generally, makes
the combined effect flatter. The relative degree of regressivity across countries is due to:
(1) differences in the structure of VAT and how it relates to consumption patterns, i.e. the
extent to which goods with lower tax rates are consumed by those on low incomes; and
(2) the effective savings rate across the income distribution. In all of the countries spending
is much higher than income in the lower income decile groups, especially in Greece. The im-
pact of VAT changes is naturally larger in countries with bigger increases in the standard
VAT rate but what is important to note is that in several countries (Spain, Latvia,
Lithuania, and Romania) the effects of VAT changes alone are of similar magnitude
to those due to the measures affecting household incomes directly, highlighting their
importance.
Looking at the design of the austerity measures (Table 3), in four countries (Estonia,
Greece, Spain, and Italy) tax increases represent roughly 50% or more of aggregate auster-
ity measures even without the VAT changes (the first column). At the other extreme,
in Romania the net effect of tax changes resulted in lower tax revenue due to a substantial
erosion of the tax base stemming from cuts in public pensions. Including VAT (the second
EE EL ES
-20-15-10 -5 0
0
change as % of average disposable income
-5
-5
-10
-10
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
IT LV LT
0
0
-15 -10 -5

-5
-5
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 1 2 3 4 5 6 7 8 9 10
PT RO
0
0
-5
-5
-10
-10
1 2 3 4 5 1 2 3 4 5 6 7 8 9 10
income decile/quintile group
simulated measures simulated measures + VAT
Fig. 1. Percentage change in household disposable income due to simulated household income-based
fiscal consolidation measures by household income decile group
Notes: The measures included here are those that have a direct effect on household disposable in-
come (changes to direct taxes, cash benefits and public sector pay) and increases in the VAT rate(s).
Deciles are based on equivalized household disposable income in 2012 in the absence of fiscal con-
solidation measures and are constructed using the modified OECD equivalence scale. The charts are
drawn to different scales, but the interval between gridlines on each of them is the same.
Source: own calculations with EUROMOD.
Table 3. The design of austerity measures and effect on inequality
Austerity measures design Effect on Inequality
% of austerity % of austerity measures % change in P90/P10

measures as taxes as taxes, including VAT
Estonia 57.29 67.31 3.69

Greece 60.44 69.19 11.64
Spain 48.30 67.24 3.79
Italy 65.64 73.58 0.43
Latvia 35.64 51.27 4.31
Lithuania 10.92 48.32 0.40
Portugal 5.52 20.83 4.55
Romania 9.81 30.41 4.85
Source: own calculations with EUROMOD.
column) shifts the overall balance between cuts in public transfers and tax increases further
towards the latter. Public wage and benefit cuts remain clearly a dominant source of
consolidation in Portugal and Romania (70% or more), while tax increases account for
67–74% of consolidation in Estonia, Greece, Spain, and Italy. Unlike other countries,
Lithuania and Latvia have roughly an equal mix. Nevertheless, there is no clear association
between the design of the austerity measures and the change in inequality of disposable
income.
To have a better understanding of the extent to which the design of the austerity
measures is related to their distributional pattern, Fig. 2 shows the variation in disposable
income due to tax increases and cuts in public transfers by income decile groups. It is im-
portant to note that the tax increases are net of any automatic tax reductions due to public
sector pay cuts or other taxable benefits. The overall effect from cuts of public transfers
tends to be progressive in all countries but Estonia. The main drivers of such a distribu-

tional pattern are public wage cuts which show a strong progressive pattern while cuts in
public pensions and other benefits show mixed results (see Fig. A3 in the online Appendix).
The large size of the public sector wage cuts drives the overall progressivity observed
in Greece, Latvia, and Romania and determines the contributions of those at the top of the
income distribution in Portugal. The distributional incidence of cuts to public pensions de-
pends on the design of the changes and the location of pensioners in the income distribu-
tion. In most of the countries where public pensions were reduced, this was implemented in
the form of suspending pension indexation and freezing their nominal values (with higher
losses for the pensioners in the lower-middle decile groups as in Spain and Latvia) or limit-
ing the indexation for higher pensions (with losses larger in percentage terms in the middle
and top of the distribution than at the bottom, as in Greece, Italy, and Portugal). In
Estonia, the change in the indexation of public pensions resulted in the average pension
being almost 10% lower in 2012 than it would have been otherwise, with a regressive effect
because of the location of pensioners towards the bottom of the distribution. Cuts to non-
EE EL ES
0 0
0
change in average disposable income, %
-5
-10
-5 -15 -5
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
IT LV LT
0 0 0
-5
-5 -10 -5
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 1 2 3 4 5 6 7 8 9 10
PT RO
0 0
-5 -5
-10 -10
1 2 3 4 5 1 2 3 4 5 6 7 8 9 10
income decile/quintile group

cuts in public transfers tax increases
Fig. 2. Percentage change in household disposable income due to cuts in public transfers and tax
increases by household income decile group
Notes: See Fig. 1.
pension benefits are notable only in a few countries though their incidence across the in-
come distribution is very diverse (progressive in Latvia, regressive in Portugal, flat in
Lithuania). There are important interactions in all countries, in the form of means-tested
benefits absorbing part of income losses due to other instruments. However, this is only evi-
dent for countries like Estonia (where social assistance was also made more generous),
Spain and Romania; while in other countries the negative effect from cuts in non means-
tested benefits (Greece, Lithuania) or even in means-tested benefits themselves (Portugal)
dominates.
On the revenue side, the pattern of the distribution of tax increases is regressive in

Lithuania and Romania but is generally quite flat in other countries with the exception of
the larger burden faced by individuals in the first decile in several instances. In the case
of the Baltic countries, small progressive increases from worker contributions are balanced
with small regressive tax increases. Stronger progressive effects can be seen for Greece
(with the exception of the first decile group) and Spain, where the tax increases are incident
mainly on the top decile group.
4. Micro-based insights on the macro-economic

effects of austerity policies
It is widely recognized that the way fiscal consolidation is achieved has implications for the
prospects for macro-economic recovery and financial stability. In this context, the contro-
versy regarding the impact of fiscal consolidation on economic output (i.e. fiscal multipli-
ers) has dominated the academic and policy debate since the outset of the Great Recession.
Nowadays it is broadly agreed that the short term effects of fiscal consolidation measures
are more severe than originally thought, with fiscal multipliers (i.e. the output loss associ-
ated with a percentage point of fiscal consolidation) ranging between 0.9 and 1.7 rather
than the assumed 0.5 at the beginning of the crisis (IMF, 2012; Blanchard and Leigh,
2013).
The debate on the fiscal multipliers is about the consequences of the fiscal consolidation
measures on the intensity of the economic crisis which are two aspects clearly linked at least
in the short term. On the one hand, austerity measures can result in a fall in aggregate de-
mand with wider consequences for the economy in terms of firms’ output, salaries and jobs
availability. On the other hand, a depressed level of economic activity can undermine the
effects of the austerity measures in terms of deficit reduction. Nevertheless, Blanchard and
Leigh (2013, p. 20), stress that ‘the short term effects of fiscal policy on economic activity
are only one of the many factors that need to be considered in determining the appropriate
pace of fiscal consolidation for any single country’.
Building on the detailed counterfactual established in the previous section, we explore
the extent to which austerity measures impact directly on the aggregate level of demand of
the household sector. In other words, we provide an estimate of how the decrease in real in-
come due to such measures is transmitted through to reduction in expenditures for goods
and services in a partial equilibrium setting. It seems reasonable to assume that the channel
through which the distributional impact of fiscal adjustments is likely to matter the most
for macro-economic performance is the effect on aggregate demand. Consumption patterns
usually differ between income groups with low-income households showing a much larger
marginal propensity to consume than affluent households (Jappelli and Pistaferri, 2010,
2014; Parker, 2011).
Table 4. Percentage of liquidity-constrained individuals and incidence of austerity measures
% of liquidity- % of austerity measures % of austerity measures,

constrained on liquidity-constrained including VAT, on liquidity-
individuals individuals constrained individuals
Estonia 42.18 35.93 35.38

Greece 34.48 15.86 17.80
Spain 33.01 19.50 22.27
Italy 35.57 20.25 23.11

Latvia 75.93 59.80 60.38
Lithuania 61.66 49.83 51.29
Portugal 30.16 16.57 17.42
Romania 53.82 45.36 44.95
Notes: Liquidity-constrained individuals based on the out-of-sample prediction of the probability of being
liquidity constrained taking into account the simulated effects of austerity measures and labour market adjust-
ments. Per cent of austerity measures in terms of the aggregate revenue.
Source: Own calculations with EUROMOD.
Following Auerbach and Feenberg (2000) one can assume that if the income shock is
perceived as transitory and households can borrow, their demand does not change.
However, according to Auerbach and Feenberg (2000) and Galı et al. (2007) it is also usual
to assume that households who face liquidity constraints fully adjust consumption expend-
iture after changes in disposable income or, in other words, consume their entire after-tax
income each year (Clinton et al., 2011). Our identification of the liquidity (and credit) con-
strained households follows the usual practice in the micro-based literature (Jappelli et al.,
1998) and uses survey questions to define who is liquidity constrained. In our analysis, we
consider liquidity-constrained households to be those who declare themselves as not having
‘the capacity to face unexpected financial expenses’ (see Dolls et al., 2012, for a robustness
check with respect to the alternative questions included in the Survey of Consumer
Finances). Given the estimates found in the literature (Jappelli et al., 1998), the identifica-
tion of liquidity-constrained households through direct survey evidence represents an upper
bound.5 We rely on the information included in the EU-SILC 2011 to predict the probabil-
ity of being liquidity constrained in 2012 given income and other socio-economic character-
istics of the household and taking into account the simulated effects of austerity measures
and labour market adjustments. The percentage of liquidity-constrained individuals ranges
from around 35% in Greece, Spain, Italy, and Portugal to 76% in Latvia (see Table 4)
showing an increasing trend since the beginning of the economic crisis.6
In aggregate terms, liquidity-constrained individuals face a relatively small share of total
austerity measures (taking into account VAT increases as well), ranging from less than
5 In addition to the effects on household spending capacity, liquidity constraints might cause the re-
cession to be deeper and more prolonged through their effects on firm productivity. As supported
by recent empirical evidence, credit to enterprises is positively and significantly associated with
economic growth (Beck et al., 2012), while the effect of household credit on economic growth
seems ambiguous.
6 According to the SILC in 2008 the share of liquidity constrained individuals ranged from around
20% in Estonia to 57% in Latvia.
Table 5. Potential reduction in the aggregate demand due to

austerity measures
Austerity measures faced by liquidity-constrained

households as % of total household disposable income
Excluding VAT Including VAT
Estonia 1.43 1.84

Greece 1.86 2.68
Spain 0.86 1.55

Italy 0.33 0.49
Latvia 5.52 7.36
Lithuania 1.46 2.59
Portugal 1.14 1.43
Romania 2.59 4.05
20% in Greece and Portugal to 35% in Estonia and 45% in Romania, while in Lithuania
and above all in Latvia, most of the austerity measures fall on their shoulders.
Assuming that households who face liquidity constraints fully adjust consumption ex-
penditure after changes in disposable income, we can derive a lower bound for the effect on
aggregate household demand as the effect of fiscal consolidation measures faced by the li-
quidity constrained (Table 5).7 The potential impact on aggregate demand, considering the
effects of increases in indirect taxes as well, is highly diverse and ranges from less than 1%
(of total household disposable income) in Italy to more than 7% in Latvia.
In order to explore the potential channels through which fiscal consolidation can affect
aggregate demand, and assuming that variation in income translates into a reduction in
household consumption due to liquidity constraints, we look at the associations between
the size and the design effects and the probability of being liquidity constrained. Table 6
shows the results of ordinary least squares (OLS) regressions where the probability of being
liquidity constrained is regressed over a measure of the size and the design of austerity
measures. From the results it emerges that the size of the austerity measures (expressed as a
percentage of household disposable income) is negatively correlated with the probability of
being liquidity constrained in all countries except Estonia and Romania. This is expected
given the distributive pattern of the austerity measures, being progressive in all countries
but Estonia and Romania (showing a somewhat U-shaped pattern). The design effect,
in turn, shows that a greater reliance on taxes is also associated with a lower probability
of being liquidity constrained, in other words households more likely to be liquidity
constrained tend to be more affected by cuts in public transfers rather than tax increases.
It is important to bear in mind that cuts in public transfers include both reductions in pub-
lic sector pay and in benefits, the latter often being an important source of income for
liquidity-constrained households. Assuming that liquidity-constrained households are more
7 The implications for the overall aggregate demand can be different in a general equilibrium setting
taking into account, among other factors, changes in government debt, future expectations, factor
costs, sovereign risk, cross-country linkages, and monetary policy as shown, e.g. in Coenen et al.
(2008), Clinton et al. (2011), and Anderson et al. (2015).
Table 6. Size and design effects of austerity measures on the probability of being liquidity constrained
Estonia Greece Spain Italy Latvia Lithuania Portugal Romania
Size 0.12 1.44*** 1.92*** 7.19*** 1.22*** 0.36*** 1.18*** 0.61***

(0.106) (0.048) (0.066) (0.164) (0.063) (0.088) (0.059) (0.055)
Design 0.11*** 0.11*** 0.19*** 0.01* 0.14*** 0.06*** 0.25*** 0.10***
(0.009) (0.011) (0.006) (0.006) (0.007) (0.013) (0.012) (0.035)
Constant 49.21*** 57.67*** 49.65*** 46.71*** 94.12*** 65.41*** 43.77*** 52.13***
(0.888) (1.028) (0.452) (0.597) (0.646) (0.468) (0.626) (0.526)
R2 0.03 0.12 0.12 0.09 0.10 0.01 0.13 0.02
Controlling for income decile groups
A. PAULUS, F. FIGARI, AND H. SUTHERLAND
Size 0.31*** 0.09** 0.30*** 5.58*** 0.28*** 0.31*** 0.06 1.12***

(0.095) (0.044) (0.067) (0.141) (0.052) (0.070) (0.059) (0.047)
Design 0.06*** 0.08*** 0.05*** 0.07*** 0.09*** 0.08*** 0.05*** 0.02
(0.008) (0.009) (0.006) (0.005) (0.006) (0.011) (0.011) (0.028)
Constant 15.30*** 8.86*** 11.91*** 31.18*** 66.21*** 53.04*** 25.20*** 61.60***
(1.335) (1.426) (0.996) (0.704) (0.993) (1.122) (1.23) (0.932)
Controls for decile groups yes yes yes yes yes yes yes yes
R2 0.41 0.46 0.27 0.34 0.47 0.39 0.39 0.37
Including changes in the VAT in the Austerity measures
Size 0.32*** 0.11** 0.16* 5.37*** 0.47*** 0.12 0.16** 0.70***
(0.094) (0.046) (0.081) (0.145) (0.055) (0.076) (0.074) (0.134)
Design 0.07*** 0.09*** 0.01 0.05*** 0.14*** 0.09*** 0.01 0.07***
(0.009) (0.013) (0.009) (0.007) (0.009) (0.012) (0.014) (0.021)
Constant 14.75*** 10.53*** 8.80*** 32.06*** 72.71*** 45.67*** 22.96*** 16.97***
(1.415) (1.793) (1.430) (0.838) (1.240) (1.529) (1.590) (2.284)
Controls for decile groups yes yes yes yes yes yes yes yes
R2 0.41 0.45 0.27 0.33 0.47 0.39 0.38 0.37
N. Obs. 4,744 6,504 13,014 20,928 5,196 4,823 4,454 7,805
647
Notes: OLS regressions at household level. Dependent variable: Probability of being liquidity constraint. Size: Austerity measures as % of household disposable income. Design: % of
Austerity measures as taxes. Standard errors in brackets; ***significant at 1%; ** at 5%; * at 10%.
responsive in terms of consumption to income shocks, then cuts in public transfers can be
seen as having more detrimental effects on aggregate demand than tax increases. The same
pattern is observed even controlling for income decile groups, with the exception of Estonia
and Romania, which is consistent with the distributive pattern observed in those countries.
Once changes in VAT are included, as expected given the regressivity of VAT, in some
countries we observe that higher reliance on taxes is associated with higher probability of
being liquidity constrained but the association is still negative and significant in four
countries.
Overall, our finding that cuts in public transfers are more likely than tax increases to

affect liquidity-constrained households casts doubts over previous findings in the macro-
economic literature about the effectiveness of such measures for macro-economic recovery
(Alesina and Perotti, 1995, 1997; Alesina and Ardagna, 1998, 2010, 2013) and supports
the view that cuts in public transfers borne by liquidity-constrained households can have
potential detrimental effects (Coenen et al., 2008, 2012; Forni et al., 2010; Clinton et al.,
2011).
This suggests that it is important to distinguish between reductions in general govern-
ment spending and cuts in benefits targeted on households and it is not the type of policy in-
strument per se which matters but how it affects different parts of the income distribution.
This could be another source of variation adding to relevant aspects of country heterogen-
eity in the context of fiscal consolidation as discussed elsewhere (e.g. Favero et al., 2011).
Disaggregated data and micro-based analysis seem necessary to reach robust policy
conclusions.
5. Conclusion
The design and distributional effects of fiscal consolidation measures are of great rele-
vance, not only because inequality, and any driver of growth in it, matters in its own right,
but also because they have implications for the effectiveness of policy for macro-economic
recovery.
We contribute to the literature on fiscal consolidation by estimating the distributional
effects of recent policy reforms in eight EU countries which were intended to reduce budget
deficits. Using the microsimulation approach, we identify and quantify fiscal consolidation
measures introduced through cuts in cash benefits, increases in direct and indirect taxes and
workers’ social contributions and cuts in public sector pay. Our ‘bottom-up’ measure
shows that there is wide cross-country variation in the scale of the resulting aggregate re-
duction in household monetary resources (from 2% to 15%), and in the combinations of
policy instruments that were adopted, resulting in variation in the distributional profiles of
income losses. Most are progressive on the whole, although it should be emphasized that
even if the poor contribute a lower proportion of their income than the rich, in some coun-
tries the scale of the reductions in their income is still large (e.g. in Greece). Including the ef-
fect of increases in VAT, which have been introduced in all the countries, reduces any
progressive effect. The latter are also substantial in absolute terms, in several countries
being of similar magnitude to the changes resulting from the measures affecting household
incomes directly.
The distributional pattern of austerity measures is not only relevant in its own right but
can also have important implications for macro-economic prospects. Based on previous epi-
sodes of fiscal consolidation over the period 1971–2009, Kaplanoglou et al. (2013, p. 7)
conclude that ‘ameliorating the effects of adjustment on the weaker parts of society is cru-
cial and . . . “fair fiscal adjustments” [may] provide the double dividend of promoting social
cohesion, and enhancing the probability of success of the adjustment’.
The distributional impact of fiscal adjustments can matter for macro-economic dy-
namics, for example, through the effect on aggregate demand as consumption patterns usu-
ally differ between income groups. More disaggregated data and micro level modelling are
needed in order to provide indications for the macro-economic performance of the fiscal
adjustments. Our finding that combined cuts in public wages and transfers are more likely
to affect liquidity-constrained households shows that these measures are not necessarily less

detrimental for aggregate demand and thereby more effective than increases in taxes. This
suggests that it is not the type of policy instrument per se which matters but how it affects
different parts of income distributions, hence emphasizing the need to consider more disag-
gregated data to reach robust policy conclusions.
In interpreting our analysis there are some caveats to be borne in mind. Most import-
antly, our analysis does not include the impact of cuts in in-kind benefits and services on
specific households. These would require additional information on the way in which cuts
in public spending translate into a reduction of services available for households by their
characteristics. Such data are not available in a comparable way across countries.
Supplementary material
Supplementary material – the Appendix – is available online at the OUP website.
Funding
This work was supported by the European Commission through the Social Situation Monitor;
and the Economic and Social Research Council (ESRC) through the Research Centre on Micro-
Social Change (MiSoC) at the University of Essex [grant number ES/L009153/1].
Acknowledgements
We are grateful to the Editor, two anonymous referees, S. Avram, C. Leventi, H. Levy, J.
Navicke, M. Matsaganis, E. Militaru and O. Rastrigina for their help. We would also like to
thank A. Brandolini, F. Bourguignon, H. Immervoll as well as the participants of the 8th Winter
School on Social Cohesion and Public Policy (Canazei, 2013), the IZA Workshop on the Future
of Labor (Bonn, 2013), the 2013 LIS Summer Lecture (Luxembourg), the 5th Meeting of
ECINEQ (Bari, 2013), the 2013 ImPRovE Conference (Brussels), the 2016 York Fiscal Policy
Symposium for their useful comments. We use EUROMOD F6.0 and acknowledge the contribu-
tion of all past and current members of the EUROMOD consortium. We use microdata from the
2008 EU Statistics on Incomes and Living Conditions (EU-SILC) made available by Eurostat
under contract EU-SILC/2011/55 (for Latvia, Lithuania, Portugal and Romania) and the national
2008 SILC data made available by respective national statistical offices (for Estonia, Greece,
Spain, and Italy).
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Appendix 1: Formal presentation of modelling approach

To present our modelling approach in more formal terms, we draw on the framework sug-
gested in Bargain and Callan (2010) for decomposing (observed) changes in the income dis-
tribution over time and its adaption in Figari et al. (2015) to a broader range of tax-benefit
microsimulation applications. Following the latter, we denote labour market (and socio-
demographic) characteristics of a given household with a vector c and household original
income with a vector x. (We omit a subscript denoting the household.) Household original
income consists of income from private and public employment, self-employment, prop-
erty, investments etc, x ¼ ðx1 ; x2 ; . . . ; xz Þ, which are separately recorded in the input data.
Where relevant below, we distinguish public wages ðxw Þ from other components of original
income ðxw Þ.
Under the tax-benefit system k, the household receives a net transfer fk , which depends
on household characteristics (c; x), and is negative if the household is a net contributor.
We also distinguish monetary values of policy parameters (mk ) from the general structure
of the tax-benefit system. Household’s disposable income y, or post-indirect tax income if
f ðÞ includes indirect taxes as well, can then be calculated as:
yk ðc; x; mk Þ ¼ x þ fk ðc; x; mk Þ (1)
The term fk ðc; x; mk Þ is a composite arithmetic function what the tax-benefit model can
provide under a range of scenarios, once corresponding tax-benefit rules as they are in place
in each country have been coded. The term can be expanded to indicate that it is a sum of
various cash benefits/transfers and direct taxes (with negative values), a total of N compo-
nents, indexed by i and denoted fk;i :
X
N Xi
fk ðc; x; mk Þ ¼ fk;i c; x; mk ; j¼1
f k;j (2)
i¼1
Each component – such as personal income tax, property tax, child benefit and social
assistance to name a few – is calculated in steps that closely follow actual policy rules.
The rules are often complex and highly non-linear and modelled in as much detail as pos-
sible given the information on relevant individual and household characteristics available in
the input datasets. The list of individual instruments and the order of their calculation are
specific to the country and the period in question.8 Furthermore, the nested summation-
term in eq. (2) captures potential interactions between instruments (e.g. a benefit might be
means-tested on the basis of income net of taxes, some non means-tested benefits are tax-
able), indexed by j, which in turn determine the order of calculations in a given country.

The effect of fiscal consolidation measures on a household’s disposable income is esti-
mated as:

Dy ¼ yb ðcb ; xb ; mb Þ ya cb ; xa;w ; xb;w ; Ama (3)
Here a refers to the year prior to the start of fiscal consolidation (e.g. 2010 in Greece) and
b to the end point of our analysis (i.e. 2012). A expresses statutory indexation rules for the
period from a to b, which can differ across tax-benefit instruments. A is therefore a vector,
which is different from the initial Bargain and Callan (2010) approach where a single scalar
a was used to adjust the monetary values of all instruments. In cases where there are no
statutory rules defined for a particular instrument i, the corresponding adjustment factor is
simply one (i.e. Ai ¼ 1). cb refers to household labour market (and socio-demographic)
characteristics in 2012, derived using the observed characteristics available in EU-SILC
2008 as the basis and modelling labour market transitions in line with labour force changes
observed in LFS between 2007 and 2011 (by selecting individuals randomly according to
their age, gender and education characteristics). Similarly, xb refers to household original
income in 2012, which is obtained by uprating observed income components in 2007 by
growth in the average amount (conditional on employment status in 2012).
The first term on the right hand side of eq. (3), yb ðcb ; xb ; mb Þ, represents disposable in-
come in 2012 simulated according to actual policy rules and (projected) household charac-
teristics and original incomes (including cuts and freezes in public wages). The second term

on the right hand side, ya cb ; xa;w xb;w ; Ama , is our counterfactual disposable income in
2012 with pre-consolidation tax-benefit policy rules (after adjusting monetary values of
policy parameters, ma , according to statutory indexation rules A) applied to the same

household characteristics and original incomes apart from public wages xa;w , which have
been adjusted to reflect their counterfactual levels without enacted cuts and freezes. The dif-
ference between the two terms is our estimate of the effect of fiscal consolidation measures
on disposable income at the household level. In Bargain and Callan’s (2010) terminology,
we estimate the policy effect conditional on end-period household characteristics. This is
not to be confused with the redistributive properties of a given tax-benefit system, which
focuses on how the distribution of x and y differ from each other.
8 The full list of tax-benefit instruments simulated in EUROMOD for each country, the order of calcu-
lation and underlying rules in a given year are documented in EUROMOD Country Reports (avail-
able at https://www.euromod.ac.uk/using-euromod/country-reports/ – last accessed on 4 August,
2016). All components of household disposable income are also indicated in EUROMOD Statistics
on the Distribution and Decomposition of Disposable Income (see https://www.euromod.ac.uk/
using-euromod/statistics – last accessed on 4 August, 2016).
Summing Dy across all households provides an aggregate estimate of changes in house-

hold income. To estimate the effect on a distributional summary statistic (such as the extent
of poverty or inequality), I, we can rewrite eq. (3) as:

DIðyÞ ¼ Iðyb ðcb ; xb ; mb ÞÞ I ya cb ; xa;w ; xb;w ; Ama (4)
where IðÞ takes the whole disposable (or post-indirect tax) income distribution as the
argument.
In section 4, we estimate the probability for a household to be liquidity constrained:

PrðLQ ¼ 1jyb ðcb ; xb ; mb Þ; cb Þ ¼ p (5)
on the basis of realized disposable incomes in 2012. Our estimate of the likely impact on
P
aggregate household demand (in the short run) in turn is derived as DD ¼ pDy.

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Oxford Economic Papers, 69(3), 2017, 632–654

The design of fiscal consolidation

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JEL classifications: D31, H24, H55, I30.

C Oxford University Press 2016.

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insights into the macro-economic performance of fiscal adjustments, complementing

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2.2 The counterfactual

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2.3 The European tax-benefit model EUROMOD and data

2 See https://www.euromod.ac.uk/using-euromod/country-reports (last accessed on 30 September,

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2.4 Scope of simulations

social contributions. We chose to exclude changes in employer contributions on the

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Table 1. Type of introduced household income-related fiscal consolidation measures

3. The redistributive effects of fiscal consolidation measures

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Table 2. Aggregate effect of simulated consolidation measures in place in 2012 as a percentage

EE 0.00 1.64 0.15 0.21 0.32 1.96 3.98 1.22

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income decile/quintile group

simulated measures simulated measures + VAT

Table 3. The design of austerity measures and effect on inequality

Austerity measures design Effect on Inequality

% of austerity % of austerity measures % change in P90/P10

Estonia 57.29 67.31 3.69

Source: own calculations with EUROMOD.

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income decile/quintile group

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4. Micro-based insights on the macro-economic

Table 4. Percentage of liquidity-constrained individuals and incidence of austerity measures

% of liquidity- % of austerity measures % of austerity measures,

Estonia 42.18 35.93 35.38

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Table 5. Potential reduction in the aggregate demand due to

Austerity measures faced by liquidity-constrained

Excluding VAT Including VAT

Estonia 1.43 1.84

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Source: Own calculations with EUROMOD.

Estonia Greece Spain Italy Latvia Lithuania Portugal Romania

Size 0.12 1.44*** 1.92*** 7.19*** 1.22*** 0.36*** 1.18*** 0.61***

Size 0.31*** 0.09** 0.30*** 5.58*** 0.28*** 0.31*** 0.06 1.12***

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Perotti, R. (1996) Fiscal consolidation in Europe: composition matters, American Economic

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Appendix 1: Formal presentation of modelling approach

yk ðc; x; mk Þ ¼ x þ fk ðc; x; mk Þ (1)

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Summing Dy across all households provides an aggregate estimate of changes in house-

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Size 0.12 1.44* 1.92* 7.19* 1.22* 0.36* 1.18* 0.61***

Size 0.31* 0.09 0.30* 5.58* 0.28* 0.31* 0.06 1.12***