November 5, 2012

FORTUNATELY, BOTH CANDIDATES WILL CUT SPENDING NOT RAISE TAXES:

The Kindest Cuts : Shrinking spending reduces deficits without harming the economy--unlike tax hikes. (ALBERTO ALESINA, Autumn 2012, City Journal)

In 2011, the International Monetary Fund identified episodes from 1980 to 2005 in which 17 developed countries had aggressively reduced deficits. The IMF classified each episode as either "expenditure-based" or "tax-based," depending on whether the government had mainly cut spending or hiked taxes. When Carlo Favero, Francesco Giavazzi, and I studied the results, it turned out that the two kinds of deficit reduction had starkly different effects: cutting spending resulted in very small, short-lived--if any--recessions, and raising taxes resulted in prolonged recessions.

We weren't the first people to distinguish between the two kinds of deficit-cutting, of course. In the past, such critics as Paul Krugman, Christina Romer, and some economists at the IMF have responded that the two approaches don't have different results. When an economy performs well after government spending cuts, they say, it's actually because the business cycle has picked up, or else because the government's monetary policy happened to be more expansionary at the time. But my colleagues and I took both factors into account in our research, carefully analyzing the business cycle and monetary policy in relation to each fiscal episode, and concluded that the difference between expenditure-based and tax-based actions remained.

The obvious economic challenge to our contention is: What keeps an economy from slumping when government spending, a major component of aggregate demand, goes down? That is, if the economy doesn't enter recession, some other component of aggregate demand must necessarily be rising to make up for the reduced government spending--and what is it? The answer: private investment. Our research found that private-sector capital accumulation rose after the spending-cut deficit reductions, with firms investing more in productive activities--for example, buying machinery and opening new plants. After the tax-hike deficit reductions, capital accumulation dropped.

The reason may involve business confidence, which, we found, plummeted during the tax-based adjustments and rose (or at least didn't fall) during the expenditure-based ones. When governments cut spending, they may signal that tax rates won't have to rise in the future, thus spurring investors (and possibly consumers) to be more active. Our findings on business confidence are consistent with the broader argument that American firms, though profitable, aren't investing or hiring as much as they might right now because they're uncertain about future fiscal policy, taxation, and regulation.

But there's a second reason that private investment rises when governments cut spending: the cuts are often just part of a larger reform package that includes other pro-growth measures. In another study, Silvia Ardagna and I showed that the deficit reductions that successfully lower debt-to-GDP ratios without sparking recessions are those that combine spending reductions with such measures as deregulation, the liberalization of labor markets (including, in some cases, explicit agreement with unions for more moderate wages), and tax reforms that increase labor participation.

Let's be clear: this body of evidence doesn't mean that cutting government spending always leads to economic booms. Rather, it shows that spending cuts are much less costly for the economy than tax hikes and that a carefully designed deficit-reduction plan, based on spending cuts and pro-growth policies, may completely eliminate the output loss that you'd expect from such cuts. Tax-based deficit reduction, by contrast, is always recessionary.
Posted by at November 5, 2012 5:14 AM
  
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