Fiscal Consolidation and Public Wages

Abstract

A New Keynesian model with government production, public compensation, and unemployment is fit to U.S. data to study the macroeconomic and fiscal effects of public wage reductions. We find that accounting for the type of government spending is crucial for its macroeconomic implications. Although reductions in public wages and government purchases of goods have similar effects on total output and the fiscal balance, the former can raise private output slightly, in contrast to the substantial contractionary effects of the latter.In addition, the baseline estimation finds that exogenous public wage reductions decrease private wages. Model counterfactuals show that sufficiently rigid nominal private wages can reverse the response of private wages, as the rigidity dampens the labor reallocation effect from the public to private sector that exerts downward pressure on private wages.

Keywords: Public sector wages, Real interest rates, Income tax revenue, Wage policy, Consumption taxes, public wage, fiscal consolidation, government spending, fiscal policy, NewKeynesian model, Bayesian estimation, state and local governments, wage reduction, baseline model, wage rigidity, government compensation, reallocation

JEL Classification: E62, E32, C11, E01, J3, E2, H83