BY ALBERTO ALESINA
Should debt-ridden and
economically struggling Western governments be doing everything possible to
reduce their deficits? The debate over that question has become increasingly
confusing—not only in Europe, where the matter is particularly urgent, but in
the United States, too. Those in favor of immediate deficit reduction argue
that it is a necessary precondition of economic growth. Today’s deficits become
tomorrow’s debt, they say, and too much debt can bring fiscal crises, including
government defaults. Markets, worried about solvency, will require high
interest rates on government bonds, making it more costly for countries to
service their debts. Defaults could cause banks holding government bonds to
collapse, possibly leading to another financial meltdown. There can be no
sustained growth, say the deficit hawks, unless we start balancing our books.
Their opponents
agree that we should eventually rein in deficits—but right
now, when economies worldwide are weak, is the wrong time. To shrink a deficit,
this argument goes, you need to raise taxes or to cut spending. Taking either
of those steps reduces aggregate demand, making an already faltering economy
sputter and sink into serious recession. The all-important debt-to-GDP ratio
swells because GDP growth slows more than the measures taken reduce debt.
Therefore the approach is self-defeating. Governments should instead continue
to run deficits and paper them over with borrowed money, waiting to balance
their budgets until economies get stronger.
The deficit debate
is often misleading, however, because it tends to ignore a huge difference
between the two kinds of deficit reduction. The evidence speaks loud and clear:
when governments reduce deficits by raising taxes, they are indeed likely to
witness deep, prolonged recessions. But when governments attack deficits by
cutting spending, the results are very different.
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.
With this evidence
in hand, let’s go back to the two views with which we started. People who
support deficit reductions are correct, so long as those reductions are
accomplished by cutting spending and, ideally, accompanied by other pro-growth
policies. The broader idea that any deficit reduction is
beneficial—that all you need in order to calm a market is a smaller deficit—is
simplistic.
The opposite
idea—that any immediate deficit reduction will slow the
economy and prove self-defeating—is equally simplistic. A deficit-reduction
program of carefully designed spending cuts can reduce debt without killing growth,
so there’s no need to be so protective even of today’s weak economies. But the
deficit doves are right to be wary of tax-hiking deficit reductions, as Italy,
which has struggled with a high debt-to-GDP ratio for the last 20 years,
demonstrates. Various Italian governments have repeatedly tried to reduce that
ratio by raising more revenue, a course that has crippled the Italian economy
and left the ratio firmly in place, just as the deficit doves would predict.
Last November, Italy’s current government passed a very large tax hike; the
country’s economy promptly nose-dived and is expected to show negative 2.6
percent growth for 2012. (Italy is finally starting to realize its errors: it
has initiated a “spending review,” which should lead to spending cuts in the
near future, and passed labor-market reforms.)
The deficit hawks are right
about something else: America urgently needs to reduce its national debt.
Recent work by economists Carmen Reinhart and Kenneth Rogoff shows convincingly
that when debt reaches about 90 percent of GDP, it becomes a burden on growth.
Today, America’s debt is almost 80 percent of GDP—a number that’s on track to
reach 120 percent in the not-too-distant future, thanks to health-care
spending, Medicare in particular.
In Europe, where
debt-to-GDP ratios are even higher than in America, deficit reduction is still
more pressing. If Greece, Spain, Portugal, Ireland, and Italy do nothing about
their finances, they run the risk of defaulting on their debt—a disastrous
event not just for them but for the euro, which would implode, and thus for the
global economy. They certainly won’t be able to borrow at reasonable rates
without some kind of fiscal adjustment. Sure, you can debate how much the
European Central Bank should help these countries, but clearly they have to
do something to put their own houses in order. Raising taxes
and depressing growth isn’t the answer; cutting spending is.
For the time
being, markets seem to trust the United States, and Treasury bonds are still in
demand, which lets us borrow cheaply. But we have to fix our debt trajectory
soon. The idea that everything will be fine without fiscal adjustments isn’t
merely wishful thinking; it’s an abandonment of our children, who will have to
bear a crushing fiscal burden. The longer we wait, the higher the cost of
fixing the problem will be.
Cutting spending isn’t easy, of
course, because the recipients of government subsidies and benefits—public
employees, early retirees, large companies getting expensive favors, local
governments with no fiscal discipline, and on and on—are well represented in
the political arena, while taxpayers are not. Nevertheless, the conventional
wisdom that fiscally prudent governments will invariably suffer electoral
losses seems to be wrong. In a recent paper, Dorian Carloni, Giampaolo Lecce,
and I show that even governments that have drastically slashed spending haven’t
systematically lost office in the elections that followed. Sometimes—though not
always—voters do understand the need to retrench, rewarding governments that
ignore the lobbies’ pleas, especially when those governments speak clearly to
voters and are fair in how they cut spending.
But if we cut
spending, do we necessarily hurt the poor? Not in such countries as Greece,
Portugal, Spain, and Italy, whose public sectors are so inefficient and
wasteful that they can certainly spend less without affecting basic services.
Even in countries with better-functioning public sectors—such as France, where
public spending is nearly 60 percent of GDP—there’s a lot of room to economize
without hurting the poorest and most vulnerable. And even in America, public
spending is about 43 percent of GDP, a level common in Europe not long ago, and
up from 34 percent in 2000. Western governments can save money and avoid
inflicting injury by improving the way welfare programs are targeted; scaling
back programs, such as Medicare, that use taxes that were raised, in part, from
the middle class to give public services right back to the middle class; and
gradually raising the retirement age to 70. If the French think that they can keep
retiring at 60, they’re kidding themselves.
Once we cut
spending, the tax burden can lighten. The question then becomes how to
distribute the reduced tax burden among taxpayers. Above all, does heavily
taxing the wealthiest people harm economic growth? And if so, how much? Honest
economists will confess that they aren’t sure. We aren’t even sure how much the
rich currently pay, thanks to the complexity of tax systems
like the American one. Every other day, it seems, you read what looks like a
perfectly researched article in the New York Times showing
that the rich pay proportionally less than the middle class does. The next day,
what seems an equally rigorous article in the Wall Street Journal tells
you that the United States has the most progressive tax system in the world.
My own view is
that reducing the size of government is more important than protecting every
dollar in the pockets of the wealthiest 1 percent. But however the resulting
tax burden is distributed, the important thing is that we cut spending. Whoever
wins the next presidential election in the United States will need to present a
plan that changes the trajectory of the country’s debt-to-GDP ratio. It’s
exceedingly important that he do it the right way.
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