Improving Economic Growth: Cut Spending or Raise Taxes?
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Bibliographic details
- Authors: ALBERTO ALESINA, CARLO A FAVERO, FRANCESCO GIAVAZZI
- Published: March 1, 2018
Summary and context
- Study based on forthcoming book Austerity: When It Works and When It Does Not by Alberto Alesina, Carlo A. Favero, Francesco Giavazzi; published in F&D Magazine, March 2018.
- Focus: short-term macroeconomic effects of deficit-reduction plans in a sample of developed economies.
- Sample and scope:
- 16 of the 35 countries belonging to the Organisation for Economic Co-operation and Development between 1981 and 2014.
- Analysis of some 3,500 policy changes geared toward reducing deficits either by raising taxes or by cutting spending.
- Excludes fiscal measures aimed at stabilizing output and excludes postcommunist nations.
- Focuses on developed economies; does not analyze developing economies or long-term issues such as the impact of aging populations on pensions.
Data, methodology, and classification
- Fiscal plans reconstructed as multiyear plans typically spanning three to four years.
- Plans divided into:
- Expenditure-based plans: consisting mostly of spending cuts.
- Tax-based plans: consisting mostly of tax hikes.
- Excludes fiscal measures that are endogenous to the state of the economy (e.g., cyclical stabilization).
Key empirical findings
- Public debt context (as stated in the source):
- Advanced-economy national debt averaging 104 percent of GDP.
- Japan: 240 percent of GDP.
- Greece: almost 185 percent of GDP.
- Italy and Portugal: debt exceeds 120 percent of GDP.
- Macroeconomic effects of fiscal corrections:
- Expenditure-based plans:
- A 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 typically lasted less than two years.
- If launched during a period of economic growth, the output costs were zero, on average.
- Some spending-based plans were associated with almost immediate surges in growth (phenomenon termed “expansionary austerity”).
- Tax-based plans:
- 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.
- This large recessionary effect tends to last several years.
- Social-security and entitlement reforms:
- Reductions in entitlement programs and other government transfers were less harmful to growth than tax increases.
- Such cuts were accompanied by mild and short-lived economic downturns.
- Private-sector responses:
- Private investment responded positively to spending-based plans and negatively to tax-based plans.
- Business confidence increased immediately at the start of a spending-based austerity plan and did not for tax-based plans.
- Household consumption and net exports did not appear to differ on average between the two types of adjustments.
- Post-2008 crisis episodes:
- Outcomes of large postcrisis austerity episodes did not differ significantly from previous episodes.
- Countries that chose tax-based austerity suffered deeper recessions than those that chose to cut spending.
- Examples: Ireland and the United Kingdom adopted spending-based austerity and performed relatively well given circumstances.
- United Kingdom fiscal specifics (2010–2014):
- Spending cuts (planned or immediately 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 this five-year interval, with the rest deferred.
- Investment growth recovered from the 21 percent drop of 2009 and increased almost 6 percent in 2010.
Possible explanations evaluated
- Monetary policy:
- Prior literature (Guajardo, Leigh, and Pescatori 2014) attributes differences largely to monetary policy responses.
- This study finds only a small fraction of the difference attributable to monetary policy.
- Exchange-rate effects:
- No systematic difference found in exchange-rate behavior before tax- versus spending-based adjustments.
- Net exports did not drive the differential outcomes; domestic private investment was the driving force.
- Structural reforms:
- Large fiscal adjustments often coincide with structural reforms, but such reforms did not systematically occur during periods of spending cuts in the sample.
- Confidence and expectations:
- Removing uncertainty about fiscal stabilization can stimulate demand, particularly investment.
- Spending-based plans are more likely to be perceived as permanently addressing the budget problem (including automatic growth of entitlements), increasing business confidence.
- Tax-based plans that do not address automatic spending growth generate expectations of future tax increases, dampening confidence and investment.
- Supply-side and persistence effects:
- A longer-lasting tax-based plan produces a deeper recession, likely due to persistent distortionary effects on labor supply and investment.
- A longer-lasting spending cut may signal future potential tax reductions and thus produce milder recessionary effects.
Policy implications and bottom line
- The way the budget deficit is corrected matters for the debt-to-GDP ratio outcome:
- If a surplus is increased by raising taxes, the downturn in growth may be so large that it raises rather than reduces the debt-to-GDP ratio.
- Deficit reduction policies based on spending cuts typically have almost no effect on output, making them more reliable for reducing debt-to-GDP.
- Reforms of social security rules and entitlement reductions are comparatively less costly in terms of lost output and can be more effective in restoring fiscal sustainability with smaller short-term growth costs.
- Restoring fiscal health should consider the persistence and credibility of measures to influence expectations, business confidence, and private investment.
Authors
- ALBERTO ALESINA, Nathaniel Ropes Professor of Political Economy, Harvard University.
- CARLO A. FAVERO, Deutsche Bank chair in quantitative finance and asset pricing, Bocconi University.
- FRANCESCO GIAVAZZI, Professor of Economics, Bocconi University.
Source: F&D Magazine, March 2018 — Alberto Alesina, Carlo A. Favero, Francesco Giavazzi.
Content in this bundle
- Improving Economic Growth: Cut Spending or Raise Taxes? - IMF F&D Magazine
- تسلق جبال الديون
- Saliendo del abismo de la deuda ● Ejercicio de equilibrio ● Finanzas y Desarrollo ● Marzo de 2018
- Sortir du gouffre de la dette
- 財政再建の分かれ道
- Выбираясь из долгов – Финансы и развитие – март 2018 года
- 摆脱债务 - <金融与发展>, 2018年3月号·第55卷·第1期, 国际货币基金组织季刊