July 23, 2011


Yes, You Really Can Cut Your Way to Prosperity (Andrew Biggs and Matthew Jensen Thursday, July 14, 2011, American)

In December 2010, we released a working paper on fiscal consolidations accompanied by a Wall Street Journal op-ed, both co-authored with our AEI colleague Kevin Hassett. The goal was to analyze what worked--and what didn't--in balancing national budgets. The paper's findings have generated some interest, including being cited approvingly by congressional Republicans and critiqued by one of the Economist magazine's Free Exchange bloggers.

Our methodology was straightforward. We studied over 20 Organization for Economic Cooperation and Development countries for a period spanning nearly four decades. We first isolated instances in which countries took steps to address their budget gaps. These steps are referred to as "fiscal consolidations." The literature prescribes two ways to identify fiscal consolidations, one popularized by Harvard economist Alberto Alesina and the other established by the International Monetary Fund. We used both. Some of the fiscal consolidations were spending-based, others relied more on taxes.

Second, we analyzed these countries three years after the consolidation to see which countries had succeeded in significantly reducing debt. We found that countries that succeeded in reducing their deficits and debt tended to do so principally by cutting spending rather than increasing taxes.

In the academic literature, there isn't much disagreement on this basic point. [...]

As one of us noted in recent congressional testimony, even the IMF seems to agree that fiscal consolidations based on spending cuts will produce superior economic outcomes--meaning, higher economic growth and lower unemployment--than those based on tax increases. The IMF argues, contrary to some other economists, that both spending and tax-based fiscal consolidations will tend to reduce economic growth in the short term. But the IMF concludes that a spending-based fiscal consolidation will have smaller negative short-term effects than a tax-based fiscal consolidation. Moreover, the IMF projected that a consolidation focused on reducing transfer payments--which would mostly be entitlement payments in the U.S. context--could increase economic growth even in the short term.

In fact, one of the least contested points in the fiscal consolidation literature is that reduced transfer payments correlate with more successful fiscal consolidations and higher economic growth. And the United States' fiscal problem is, essentially, an entitlements issue. Without rising entitlement costs, the federal budget would be more or less in balance over the long term. It's as if the United States is ripe for a consolidation. Entitlement problems are easiest to fix, and that's what we've got.

While Third Way reforms--HSAs, personal SS accounts, O'Neill accounts, personal unemployment insurance, school vouchers, housing vouchers, etc.--are superior policy, the fact is that you can fix the financial stability of the current entitlement system so easily that it'
s silly not to, even if it removes some pressure for further reform. With the entire Anglosphere headed in the same direction, it may mean we take a tad longer, but we get there eventually anyway.

Posted by at July 23, 2011 8:19 AM

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