The reform of the fiscal system has for many years occupied center stage in policy discussions in developing countries. The authors employ a simple overlapping generations (OLG) model in a small open economy setting to study the impact of fiscal policy reform on the welfare of various generations and on the country’s growth rate. The authors find that while reallocating public expenditures from transfers to productive expenditures has sizable positive growth effects, individuals who are retired at the time of the policy change experience a welfare loss. However, younger generations experience larger welfare gains. The authors also find that running a public debt to finance transfer payments can decrease growth substantially and only slightly increase welfare of retirees. However, if debt is used to finance education expenditures or infrastructure investment, growth and welfare increase but only in the short run.
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