## CLIMBING OUT OF DEBT

## Source details

**Canonical URL:** [CLIMBING OUT OF DEBT](https://www.imf.org/-/media/files/publications/fandd/article/2018/march/alesina.pdf)

## Other formats

- [Markdown version](/-/media/files/publications/fandd/article/2018/march/alesina.pdf.md)
- [Structured JSON version](/-/media/files/publications/fandd/article/2018/march/alesina.pdf.json)

---

### Overview
- Almost a decade after the global financial crisis, national debt in advanced economies averages 104 percent of GDP.
- Country-specific ratios stated in the source:
  - Japan: 240 percent of GDP
  - Greece: almost 185 percent of GDP
  - Italy: exceeds 120 percent of GDP
  - Portugal: exceeds 120 percent of GDP
- As central banks withdraw extraordinary monetary measures, interest rates are expected to rise from historic lows, increasing interest payments and crowding out public services and long-term investments.

### Methodology and scope
- Sample: 16 of the 35 countries in the Organisation for Economic Co-operation and Development between 1981 and 2014 (includes Canada, Japan, the United States, and most of Europe; excludes postcommunist nations).
- Dataset: about 3,500 policy changes aimed at reducing deficits either by raising taxes or by cutting spending.
- Exclusions: fiscal measures aimed at stabilizing output (for example, countercyclical measures) were excluded because they are endogenous to the state of the economy.
- Fiscal plans reconstructed and classified into two categories:
  - Expenditure-based plans (mostly spending cuts)
  - Tax-based plans (mostly tax hikes)
- Typical fiscal plans span "typically three to four years."

### Main empirical findings
- Aggregate comparison:
  - Expenditure-based plans generally were less harmful to growth than tax-based plans.
- Quantified effects on GDP:
  - An expenditure-based plan worth 1 percent of GDP implied a loss of about half a percentage point relative to the average GDP growth of the country.
  - The loss in output from expenditure-based plans typically lasted less than two years.
  - If an expenditure-based plan was launched during a period of economic growth, the output costs were zero, on average.
  - A tax-based plan amounting to 1 percent of GDP was followed, on average, by a 2 percent decline in GDP relative to its pre-austerity path.
  - The recessionary effect of tax-based plans tends to last several years.
- Sectoral responses:
  - Private investment responded positively to spending-based plans and negatively to tax-based plans.
  - Business confidence behaved consistently with private investment (increases immediately at the start of a spending-based austerity plan).
  - Household consumption and net exports did not appear to differ on average between the two types of adjustments.
- Social transfers and entitlements:
  - Reductions in entitlement programs and other government transfers were less harmful to growth than tax increases.
  - Social security reforms, being persistent, entail some of the smallest costs in terms of lost output.

### Recent post-crisis episodes (selected examples)
- Countries that adopted spending-based austerity and performed relatively well:
  - Ireland and the United Kingdom (despite Ireland’s massive bank bailout problems).
- United Kingdom specifics:
  - Spending cuts (planned or implemented) between 2010 and 2014 amounted to 2.9 percent of GDP—about 0.6 percent a year on average.
  - Of these measures, 87 percent were implemented within the five-year interval, with the rest deferred.
  - Investment growth recovered from a 21 percent drop in 2009 and increased almost 6 percent in 2010.
  - Overall result: growth in the United Kingdom was higher than the European average.

### Mechanisms and explanations explored
- Monetary policy:
  - Differences in monetary policy responses were investigated; the authors find only a small fraction of the difference between tax- and spending-based plans to be related to monetary policy.
- Exchange rate behavior:
  - No systematic difference in exchange rate behavior before the two types of fiscal adjustment; net exports did not drive the GDP differences.
- Structural reforms:
  - Large fiscal adjustments are often periods of deep structural reforms, but such reforms did not systematically occur during periods of spending cuts in the sample.
- Confidence and expectations:
  - Stabilization that removes uncertainty about future fiscal costs can stimulate demand today, particularly investment.
  - Spending-based plans are more likely to remove uncertainty credibly because they can address automatic growth in entitlements; tax-based plans that do not curb spending growth leave higher expected future taxes and smaller confidence effects.
- Persistence and supply-side effects:
  - A tax-based plan that lasts longer produces a deeper recession, possibly because long-lasting tax increases create persistent distortions (for example, on labor supply and investment).
  - A longer-lasting spending cut may produce milder recessionary effects because it signals potential for future tax reductions and reduced distortions.

### Policy implications and bottom line
- The impact on the debt-to-GDP ratio depends critically on how deficits are reduced:
  - Raising taxes to increase the primary surplus can cause downturns in growth large enough to raise rather than reduce the debt-to-GDP ratio.
  - Deficit reduction policies based on spending cuts typically have almost no effect on output and are thus more reliable for reducing debt-to-GDP.
- Reforms that reduce entitlements and other transfers can be less harmful to growth than equivalent tax increases, particularly when perceived as permanent.
- Given the differential effects on private investment and business confidence, spending-based austerity is more likely to be associated with favorable investment dynamics and quicker recoveries.

*Alberto Alesina, Carlo A. Favero, and Francesco Giavazzi, Finance & Development, March 2018.*

---


_Source: https://www.imf.org/-/media/files/publications/fandd/article/2018/march/alesina.pdf_