The Truth About Spending Cuts

Separating economic myth from economic fact

Editor's Note: Reason columnist and Mercatus Center economist Veronique de Rugy appears weekly on Bloomberg TV to separate economic fact from economic myth.

Myth 1: Spending cuts will derail the economy.

Fact 1: The academic literature shows that successful cases of fiscal adjustment relied overwhelmingly on spending cuts, not tax increases.

While the political debate heats up over the short-term effects of spending cuts, there is a wide academic consensus that spending cuts are a major factor for achieving lasting debt reduction. In particular, empirical studies have shown that fiscal consolidations based upon spending cuts have been more effective than tax-based consolidations.

This chart consolidates data from five peer-reviewed studies examining the ratio of spending cuts to revenue measures in successful fiscal consolidations. It illustrates that the average successful fiscal consolidation was comprised of 80 percent spending cuts and 20 percent revenue measures.

An independent analysis performed by the American Enterprise Institute economists Andrew Biggs, Kevin Hassett, and Matthew Jensen confirms the literature's finding that fiscal consolidations that reduce ratios of debt to GDP tend to be based upon reduced government outlays rather than increased tax revenues. This result holds whether fiscal consolidations are defined in terms of improvements in the cyclically-adjusted primary budget deficit or in terms of pre-meditated policy changes designed to improve the budget balance.

Biggs, Hassett, and Jensen reviewed the extensive existing literature on fiscal consolidations. They also conducted their own data analysis to study that question. They used a large data set covering over 20 Organization for Economic Co-Operation and Development countries and spanning nearly four decades to isolate over 100 instances where countries took steps to address their budget gaps. Some of these fiscal consolidations were spending-based while others relied more on taxes. Here is what they found:

Our findings are striking: countries that addressed their budget shortfalls through reduced spending were far more likely to reduce their debt than countries whose budget-balancing strategies depended upon higher taxes.

The typical unsuccessful fiscal consolidation consisted of 53 percent tax increases and 47 percent spending cuts. By contrast, the typical successful fiscal consolidation consisted of 85 percent spending cuts. These results are consistent with a large body of peer-reviewed research.

These findings are also consistent with the research of Harvard's Alberto Alesina and Silvia Ardagna (here is another paper by Alesina on the issue).

The debate, of course, is far from settled. Yet as Biggs explained in his March 30, 2011 testimony before the House Ways and Means Committee:

[The debate] is not about whether spending-based fiscal consolidations are more likely to succeed than tax-based consolidations. Even using the IMF study's methods, spending-based consolidations are more likely to reduce deficits and debt than tax-based consolidations.

Second, the IMF study does not dispute that spending-based fiscal consolidations generate superior short-term economic outcomes than tax-based consolidations.

In other words, the least we can say about fiscal consolidations comprised primarily of spending cuts is that they shrink both deficits and the debt. In that context it is worth pointing to the work of former Obama administration Council of Economic Advisers Chair Christina Romer and her economist husband David Romer, which shows that increasing taxes by 1 percent of GDP for deficit-reduction purposes leads to a 3 percent reduction in GDP.

Myth 2: We can't balance the budget without raising taxes.

Fact 2: We can balance the budget simply by holding spending constant.

Fiscal balance can be achieved by holding spending constant, and by driving it toward its historical equilibrium.

In Reason magazine's March issue, Nick Gillespie and I proposed a 10-year balanced budget plan that would systematically reduce the projected growth in outlays (spending that hasn't occurred yet and hasn't even been appropriated) so that it equals the 19 percent of GDP that the Congressional Budget Office projects the federal government will raise as revenue if the current tax system is left unchanged. Effectively, under this plan, spending is frozen at its current levels and allowed to grow only for inflation. See the chart below.

In other words, we can balance the budget over the next decade without raising taxes if we ratchet down spending from its current level of 25 percent of GDP to 19 percent -- a figure that would still leave spending well above the 18.2 percent of GDP that President Bill Clinton spent in his last year in office, a time when no one was complaining about a skin-flint federal government.

Another solution would be for Congress and the president to agree to reduce 1 percent from the federal budget each year until balance is reached. As my Mercatus Center colleague Jason Fichtner explains in this paper, the 1 percent reduction would be a real cut in spending, not just a reduction in the rate of growth of government. Once a balanced budget is reached, then spending could again be allowed to grow, but at rates consistent with the growth in the overall economy so that relative fiscal balance is maintained. A 1 percent reduction in spending does not necessarily mean a 1 percent cut across the board. Under this plan, Congress could still set priorities.

As Gillespie and I explained earlier this week in our piece assessing Rep. Paul Ryan's (R-Wisc.) Path To Prosperity plan,

if cuts such as these are not possible, it would be better to give up any pretense that we will ever restore the barest semblance of sanity to the federal budget and get on with fiddling as Rome burns. If we're going to continue hosting a party whose bill is unpayable, we might as well enjoy ourselves.

Myth 3: Paul Ryan's plan will dramatically cut spending.

Fact 3: Ryan's plan reduces spending between FY2011 and FY2012. After that it reduces the growth of spending. But overall spending grows by $1.1 trillion over 10 years under Ryan's plan.

At first glance, House Budget Chairman Paul Ryan's FY2012 Budget Resolution is a step in the right direction. With a determined moniker, "The Path to Prosperity," the Republican roadmap is oriented on spending cuts, debt reduction, and credible revenue expectations.

The plan is not too surprising to those of us who have followed Ryan's previous budget crusades. It concentrates on cutting government spending--reforming two of our three largest autopilot programs, Medicare and Medicaid--while recognizing that attempts at raising tax revenue will not support economic growth or fix our spending problem.

The new plan realistically projects that tax revenue as a percentage of the economy will grow as a result of economic growth and not from tax rate hikes. Under Ryan's plan tax revenue will consume 17.1 percent of the wealth created by American families, a number that is more in line with the government's abilities to collect money. This is a serious improvement over the Deficit Commission's plan, which called for reducing the deficit by raising tax revenue to an unprecedented 21 percent of GDP--an approach that is little more than wishful thinking on the part of its authors.

However, a look at the data shows that while the Ryan plan will cut spending the first year, it then proceeds to slow down the rate of spending. In nominal terms, spending increases from $3.6 trillion in 2011 to $4.7 trillion in 2021. That equates to a $1.1 trillion increase over that period.

Of course, you wouldn't know that anything about those spending increases under the Ryan plan if you only read the recent headlines wailing about "the end of progressive government."

All things considered, Ryan's proposal is a definite improvement over the Deficit Commission's plan to increase spending by $1.6 trillion over 10 years and it's also a big improvement over the president's budget which increases spending by $1.9 trillion over the same period.

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