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.
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.