Day of reckoning : output losses from fiscal stabilizations

We derive the quantitative implications of reducing sustained budget deficits (labeled fiscal stabilizations) in the context of a general equilibrium model of innovation-led growth. In the model, innovation comes from entrant firms creating new products and incumbent firms improving own existing products. We discipline parameters using post-war observations for the U.S. economy. We find that fiscal stabilizations achieved via labor tax rate hikes permanently lower the equilibrium path of aggregate output. Output losses are sizable. For example, stabilizing the government debt-to-GDP ratio after 10 consecutive years of approximately 5% deficit-to-GDP ratios, entails a nearly 2% permanent loss in income per capita