Raising the debt limit might put off a downgrade disaster in August, but that still isn’t enough—as Standard & Poor’s recent warning made clear. Perhaps the most important shot not heard around the world was S&P’s other admonition: Namely, that the U.S. bond rating will be downgraded in three months, if not sooner, unless we do something about government spending. Beyond raising the debt limit, S&P laid out clear criteria for avoiding a downgrade: 1) reduce the debt by about $4 trillion; 2) agree to a credible plan within three months; and 3) guarantee that this newfound fiscal discipline will actually stick.
If S&P isn’t bluffing, then lawmakers should get serious about reducing the debt-to-GDP ratio, and they should do it quickly. But how do we achieve such a task?
Myth 1: You cannot reduce the deficit to an appropriate level without also raising taxes.
Fact 1: Spending cuts are the most effective way to reduce the debt-to-GDP ratio.
We are not the first nation to struggle with a dangerous debt-to-GDP ratio, and thankfully, the academic world has already produced great insights into what can be done to reduce this ratio without hurting the economy.
Take the work of Harvard’s Alberto Alesina and Silvia Ardagna. They examined 107 efforts to reduce the debt in 21 OECD nations between 1970–2007. Their findings suggest that tax cuts are more expansionary than spending increases in the cases of a fiscal stimulus. Also, they found that spending cuts are a more effective way to reduce the debt-to-GDP ratio:
For fiscal adjustments we show that spending cuts are much more effective than tax increases in stabilizing the debt and avoiding economic downturns. In fact, we uncover several episodes in which spending cuts adopted to reduce deficits have been associated with economic expansions rather than recessions. We also investigate which components of taxes and spending affect the economy more in these large episodes and we try to uncover channels running through private consumption and/or investment.
As you can see in this chart, in cases of successful fiscal adjustments—defined by the cumulative reduction in debt-to-GDP ratio three years after fiscal adjustment greater than 4.5 percentage points—spending as a share of GDP fell by about 2 percentage points while revenue also fell by half a percentage point (left bars). On the other hand, unsuccessful fiscal adjustment packages—cumulative increases in debt-to-GDP ratio—were made of smaller spending reductions (only 0.8 percentage-point reduction) and large revenue increases (right bars).
The IMF found similar results and reports that fiscal adjustment on the requisite scale of what we need today is actually not unprecedented:
During the past three decades, there were 14 episodes in advanced economies and 26 in emerging economies when individual countries adjusted their structural primary balance by more than 7 percentage points of GDP. Several economies were also able to sustain large primary surpluses for five or more years afterwards, though the record is more mixed in this regard.
For those who are not ideologically inclined toward austerity measures, it is key to remember that this research is consistent with the work of former Obama Council of Economic Advisers chairman 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. In fact, Alesina and Ardagna discuss the work of Romer and Romer starting on page five of their paper.
Myth 2: Lawmakers facing economic catastrophe forget about politics and adopt measures that address genuine fiscal issues.