The Corner

Spending Cuts, Tax Increases, and Austerity

The debate over the merits of austerity (the implementation of debt-reduction packages) is frustrating for two main reasons. First, the word itself is confusing because it means different things to different people. That’s because in theory a country can reduce its debt by increasing taxes, by cutting spending, or by doing a mix of both. What makes this more confusing is that not all policies meant to reduce the deficit and debt qualify as austerity measures. That is the case for growth-inducing policies such as cutting taxes (supply-side) or increasing spending (Keynesian)

Unfortunately, the word austerity leads to a lot of miscommunications on both sides of the political aisle. On the free-market side, people will say, “Where is the austerity in Europe?” when what they mean is “Spending wasn’t cut very much in Europe, and often it wasn’t cut at all.” To that statement liberals will respond, “It is not true, austerity was implemented in Europe” while pointing to data about the size of fiscal-adjustment packages in Europe. The reality, however, is somewhere in between. Yes, austerity has taken place in Europe. Big time, actually. However, with some rare exceptions, the form of austerity that was implemented was fairly heavy on the tax-increase side and was far from involving savage spending cuts (some countries, such as Ireland and Greece, did cut spending, but others just slowed its rate of growth). I think this distinction matters because, at least until now, the general consensus in the academic literature is that fiscal adjustment based more heavily on spending cuts was much more likely to achieve successful and lasting reductions in debt-to-GDP ratio than tax-base adjustments. It is, of course, possible that this is not the case today but at least this fact should be acknowledged. 

The second source of frustration in this debate is that we tend to lump together the impact of fiscal adjustments on a country’s debt and its impact on short-term growth. Yet, these are not the same things and these effects should be looked at separately. For instance, again, looking at past fiscal adjustments, the literature shows that while spending cuts will effectively reduce a country’s debt, they do not necessarily grow the economy in the short-term. However, as Garett Jones reminded us in this piece, spending cuts probably won’t hurt the economy as much as tax increases will. It should be noted that there have been documented cases where cutting spending led to short-term growth in the past. Even Keynesian academics such as David Romer have admitted that possibility. That being said, I think it is very unlikely that it would happen today because many of the expansions took place through export booms, which is hard to do when your trading partners’ economies are doing badly.

Now, the question is the following: If cutting spending doesn’t lead to growth in the short term, does it mean a country shouldn’t try to reduce its debt and engage in structural reforms to rein in its future debt? I don’t think so. In fact, there is a strong case to be made that cutting spending and reforming a country’s fundamental structural problems should be done independently of the impact on short-term growth, mostly because the alternative of doing nothing and letting our long-term problems continue is not acceptable and will bring much more harm. 

This morning, Tyler Cowen writes that there is a case to be made (on paper at least) that it is possible that in the present environment cutting spending in Europe would be more damaging than increasing taxes. That’s because the underlying structure of the economy is so messed up that the private sector won’t respond by shifting resources around towards a more effective use when spending is cut and it won’t respond by reducing output when taxes are increased. He may be totally right that this is what is going on in Europe. However, that to me, it is evidence of why structural reforms must be implemented in Europe independently of their short-term impact on growth. In fact, if Tyler is right, finding a politically plausible path for structural reforms should help a lot.

An additional reason to not simply focus on short-term growth is that in the medium term, after spending cuts, the economy very often starts growing again (that is the finding of this paper by Robert Barro that looks at the five-year impact of cuts to defense spending). Unfortunately, austerity critics refuse to acknowledge this point or even discuss it.

I doubt that there is an easy way out of the mess that is Europe. But again, doing nothing shouldn’t be an option because when countries are that deep in debt, they are more vulnerable to future financial crises and the traditional tools of fiscal policy become impotent. Cutting spending is never easy and engaging in fundamental structural reforms is also politically hard. Besides, European countries have the added problem that they can’t set their own monetary policy to ease some of the pain of cutting spending (for better or worse). In addition, Europe has a serious banking problem, which is made worse by the fear of contagion from country to country. But leaving these details aside, I would like to see a debate over austerity that unbundles the type of austerity that has taken place and that separates the impact of austerity on debt levels and its impact on growth.  




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