The Corner

Which Hurts More, Tax Increases or Spending Cuts?

In the debate over the fiscal cliff, and beyond the politics, the president and Congress should be asking the following question: Between the choices of tax increases and spending cuts, which measures will hurt the economy the most? 

Over at EconLog, George Mason University’s Garett Jones provides the answer: Tax increases. He looks at an IMF paper, often used by anti-spending cuts advocates to say that spending cuts hurt the economy, to show that actually fiscal adjustment based mostly on tax increases will hurt the economy the most. Here is Jones:

Quick summary of the method: The economists looked at 173 “fiscal consolidations” in rich countries, times when governments decided to reduce the long-run deficit.  They then checked to see whether consolidations based mostly on tax hikes turned out better or worse than ones based on spending cuts (Inside baseball: They followed a version of the Romer and Romer event study methodology, but applied it to exogenous-looking fiscal tightening instead of exogenous-looking monetary tightening). . . .

 Both GDP and consumer spending tell the same story: Spending cuts are the less painful path to fiscal rectitude. When countries tried to get right with the bond markets, this IMF study found that  nations that mostly raised taxes suffered about twice as much as nations that mostly cut spending.  

This is consistent with a new paper called “The Design of Fiscal Adjustments,” by Harvard economists Alberto Alesina and Silvia Ardagna. Building up on their previous work, they provide even more evidence that fiscal consolidations based mostly on the spending side result in smaller recessions, or none at all, when compared to tax-based adjustments. Additionally, they find that private investment tends to react more positively to spending-based adjustments. Thus, they argue that spending cuts are more sustainable and effective in reducing debt and raising economic growth; expansionary fiscal consolidation is possible.  

Jones continues:

The authors give a possible (I said possible) explanation of the results: Central banks play nice when governments cut spending, loosening up monetary policy.  They’re not as nice when governments raise taxes.  I’m sure somebody out there will say that the Federal Reserve and the ECB have run out of ammo so we can ignore Figure 9.  To those people I say QE3 and sovereign bond purchases.  Central banks still do stuff and they do more when things look bad: In 2012, you can just read the newspaper and you’ll see.  Plus, possible.  We might want to meditate on Figure 9 out here in the reality-based community, since both the U.S. and Europe will be spending some time this fall wrestling with how to get our fiscal houses in order. A benevolent social planner would like to take the least-cost path to solvency, a path probably based on spending cuts and loose money.  

Basically, spending-based fiscal adjustment accompanied by the “right polices” (easy monetary policy, liberalization of goods and labor markets, and other structural reforms) tend to be less recessionary or even have a positive impact on growth. (See this piece by economists Alberto Alesina and Francesco Giavazzi.)

Congress and the president should keep these findings in mind when drafting a “fiscal cliff” deal: Raising taxes will hurt the economy much more than spending cuts. #more#And we know that spending cuts are the way to go if the goal is to reduce our debt (I have mentioned before that economists have found that successful debt-reduction packages are made of spending cuts rather than a mix of spending cuts and tax increases.)

In light of these findings, I find it interesting to see that the president is pushing measures that we know will hurt the economy. That makes me wonder whether the president thinks that:

  • tax increases will not actually impact the economy

  • increasing taxes is more important than the impact it may have on the economy

  • he will not be blamed if the economy suffers as a result of large tax increases

I would be interested in all our readers’ thoughts on this.

On the issue of who will get blamed if taxes go up, you should read this other fantastic piece of Garrett Jones’s. But more interestingly, he gives an interesting perspective on the question of who gives in during tax negotiations involving tax increase on the rich. He writes:

Fortunately, recent history gives us an N=1 piece of data on who blinks first when tax cuts for the rich are on the line: Democrats.  You’ll recall that we actually faced a similar tax standoff in 2010, and I’m sure Google can prove that plenty of left of center bloggers told the President that he didn’t need to give in to the GOP’s demands because of some theory of human rationality.  But all the same, the President gave in.  [Insert obligatory reference to Dixit and Nalebuff’s excellent treatment of brinksmanship here.]

And remember, President Obama didn’t even face a GOP-controlled House at that point.  One can detail the differences between 2010 and 2012 but I doubt the differences net out to much.  

Why did President Obama cave in 2010?  Why might he cave today?  What does he (probably) see that the progressive blogosphere (probably) does not?  

His predictions for this set of negotiations:

My prediction: The outcome of the fiscal cliff battle will be reasonably far from President Obama, Majority Leader Reid, and Minority Leader Pelosi’s bliss points.  More formally, it will be outside their Pareto set.   Boehner–a willing compromiser–will ultimately be able to say he kept tax rates on the rich from going all the way back up to Clinton-era levels.

The whole thing is here.

Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University.

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