## Improving Economic Growth: Cut Spending or Raise Taxes? ## Source details **Canonical URL:** [Improving Economic Growth: Cut Spending or Raise Taxes?](https://www.imf.org/en/publications/fandd/issues/2018/03/alesina) ## Other formats - [Markdown version](/en/publications/fandd/issues/2018/03/alesina/index.md) - [Structured JSON version](/en/publications/fandd/issues/2018/03/alesina/index.json) - [Bundle manifest](/en/publications/fandd/issues/2018/03/alesina/bundle-manifest.json) ## 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** - [Improving Economic Growth: Cut Spending or Raise Taxes? - IMF F&D Magazine (Markdown version)](/-/media/files/publications/fandd/article/2018/march/alesina.pdf.md){rel="alternate" type="text/markdown"} - [Improving Economic Growth: Cut Spending or Raise Taxes? - IMF F&D Magazine (PDF)](/-/media/files/publications/fandd/article/2018/march/alesina.pdf){rel="external" type="application/pdf"} - **تسلق جبال الديون** - [تسلق جبال الديون (Markdown version)](/-/media/files/publications/fandd/article/2018/march/ar/alesina.pdf.md){rel="alternate" type="text/markdown"} - [تسلق جبال الديون (PDF)](/-/media/files/publications/fandd/article/2018/march/ar/alesina.pdf){rel="external" type="application/pdf"} - **Saliendo del abismo de la deuda ● Ejercicio de equilibrio ● Finanzas y Desarrollo ● Marzo de 2018** - [Saliendo del abismo de la deuda ● Ejercicio de equilibrio ● Finanzas y Desarrollo ● Marzo de 2018 (Markdown version)](/-/media/files/publications/fandd/article/2018/march/es/alesina.pdf.md){rel="alternate" type="text/markdown"} - [Saliendo del abismo de la deuda ● Ejercicio de equilibrio ● Finanzas y Desarrollo ● Marzo de 2018 (PDF)](/-/media/files/publications/fandd/article/2018/march/es/alesina.pdf){rel="external" type="application/pdf"} - **Sortir du gouffre de la dette** - [Sortir du gouffre de la dette (Markdown version)](/-/media/files/publications/fandd/article/2018/march/fr/alesina.pdf.md){rel="alternate" type="text/markdown"} - [Sortir du gouffre de la dette (PDF)](/-/media/files/publications/fandd/article/2018/march/fr/alesina.pdf){rel="external" type="application/pdf"} - **財政再建の分かれ道** - [財政再建の分かれ道 (Markdown version)](/-/media/files/publications/fandd/article/2018/march/jp/alesina.pdf.md){rel="alternate" type="text/markdown"} - [財政再建の分かれ道 (PDF)](/-/media/files/publications/fandd/article/2018/march/jp/alesina.pdf){rel="external" type="application/pdf"} - **Выбираясь из долгов – Финансы и развитие – март 2018 года** - [Выбираясь из долгов – Финансы и развитие – март 2018 года (Markdown version)](/-/media/files/publications/fandd/article/2018/march/ru/alesina.pdf.md){rel="alternate" type="text/markdown"} - [Выбираясь из долгов – Финансы и развитие – март 2018 года (PDF)](/-/media/files/publications/fandd/article/2018/march/ru/alesina.pdf){rel="external" type="application/pdf"} - **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** - [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 (Markdown version)](/-/media/files/publications/fandd/article/2018/march/zh/alesina.pdf.md){rel="alternate" type="text/markdown"} - [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 (PDF)](/-/media/files/publications/fandd/article/2018/march/zh/alesina.pdf){rel="external" type="application/pdf"} --- _Source: https://www.imf.org/en/publications/fandd/issues/2018/03/alesina_