This paper explores the effects of austerity measures on labour markets and on income inequality and finds evidence of a mechanism that can mitigate the size of the economic contraction. The results indicate that: (i) Fiscal consolidation causes greater distortions for the youth, hence they deserve a special attention to avoid severe long-term economic costs. (ii) While at first glance transfers cuts seem to be ideal, a careful examination suggests that these policies can jeopardise the success of fiscal consolidation. (iii) Tax hikes, negatively affecting the productive sector, trigger frictions in the labour market that give rise to recessionary effects. (iv) Spending cuts, targeting public sector wages and employment, can endanger the capabilities of the current and future labour force. (v) Lastly, income inequality increases with tax hikes and spending cuts, whereas the muted response to transfers cuts is explained by the reaction of labour demand.

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