The Effect of Tax Increases and Spending Cuts on Economic Growth

Senate testimony explains the difference between good austerity and bad.

Editor's Note: Reason columnist and Mercatus Center researcher Veronique de Rugy presented the following testimony to the Senate Budget Committee yesterday as part of a hearing titled "Supporting Broad-Based Economic Growth and Fiscal Responsibility through Tax Reform." More information and video of the hearing is online here.

Good morning, Chairman Murray, Ranking Member Sessions, and members of the committee. Thank you for the chance to discuss the effect of tax increases and spending cuts on economic growth. I appreciate the opportunity to testify today.

Last week the Congressional Budget Office released a revision of its budget outlook for FY 2013. According to CBO, our short-term outlook seems to be improving, at least on a superficial level, with this year’s deficit now expected to be $642 billion. That is $200 billion lower than projected in February, which would make it the smallest deficit since 2008.

There are many reasons for continued pessimism, however. At 76 percent, the debt-to-GDP ratio is still much higher than the 2008 level of 36 percent. Unfortunately, even under the new projections the debt-to-GDP ratio will still be around 74 percent at the end of the decade. And that’s assuming Congress doesn’t overturn sequestration and all of CBO’s assumptions hold true. In CBO’s alternative scenario, debt will be above 83 percent of GDP by the end of the decade.

The explosion of spending from programs such as Social Security, Medicare, and Medicaid will trigger even higher levels of debt in the years outside the 10-year budget window. Unfortunately, high debt levels are problematic. As CBO explains,

Such high and rising debt later in the coming decade would have serious negative consequences: When interest rates return to higher (more typical) levels, federal spending on interest payments would increase substantially. Moreover, because federal borrowing reduces national saving, over time the capital stock would be smaller and total wages would be lower than they would be if the debt was reduced. In addition, lawmakers would have less flexibility than they would have if debt levels were lower to use tax and spending policy to respond to unexpected challenges. Finally, a large debt increases the risk of a fiscal crisis, during which investors would lose so much confidence in the government’s ability to manage its budget that the government would be unable to borrow at affordable rates.

In other words, a brief dip in the deficit is no reason to be complacent. The federal government should continue to work on addressing its long-term debt problem. However, in the pursuit of debt reduction, it is important to remember that the type of fiscal adjustment that we implement is more important than its size.

In theory, debt reduction can be achieved by cutting spending or by raising taxes, or by adopting a mix of spending cuts and tax increases.

When anti-austerity policymakers or critics talk about austerity without even alluding to this distinction in how deficit reduction is achieved, they do a disservice to the clarity of the issues at hand, since different types of austerity measures produce very different results.

This testimony is based on a paper I wrote with Harvard University economist Alberto Alesina, called “Austerity: The Relative Effects of Tax Increases versus Spending Cuts.” As we explain in detail in that paper, the consensus in the academic literature is that the composition of fiscal adjustment is a key factor in achieving successful and lasting reductions in the debt-to-GDP ratio. The general consensus is that fiscal adjustment packages comprising mostly spending cuts are more likely to lead to lasting debt reduction than those composed of tax increases.

There is still significant debate about the short-term economic impact of fiscal adjustments, but some important lessons have emerged. First, fiscal adjustments and economic growth are not incompatible. Second, while fiscal adjustments may not always trigger immediate economic growth, spending-based adjustments are much less costly in terms of output than tax-based ones. In fact, when governments try to reduce their debt by raising taxes, the policy is more likely to result in deep and pronounced recessions, possibly making the fiscal adjustment counterproductive. Finally, there is some evidence that expansionary fiscal adjustments are more likely to occur when they are accompanied by growth-oriented policies, such as policies liberalizing both labor regulations and markets for goods and services, in addition to a monetary policy that keeps interest rates low.

These findings are key to designing proper policies for the United States. They also suggest that the budget plans proposed by both President Obama and Chairman Murray are unlikely to reduce the country’s debt and may also slow economic growth if implemented as proposed.

1. How To Reduce Debt-to-GDP Ratios

The United States is not the first nation to struggle with a worrisomely high debt-to-GDP ratio. The evidence suggests that the types of fiscal adjustment packages that are most likely to reduce debt are those that are heavily weighted toward spending reductions, not tax increases.

One of the difficulties of studying the impact of large fiscal adjustments on both debt and economic growth involves the definition and identification of successful and expansionary episodes. For a long time, the identification criteria were based on observed outcomes: a large fiscal adjustment was one where the cyclically adjusted primary-deficit-over-GDP ratio fell by a certain amount (normally at least 1.5 percent of GDP). Following the approach pioneered by University of California, Berkeley, economists Christina Romer and David Romer, IMF economists suggested a different way to identify large exogenous fiscal adjustments: a large fiscal adjustment is an explicit attempt by the government to reduce the debt aggressively and it is unrelated to the economic cycle. This new approach was meant to guarantee the “exogeneity” of the fiscal adjustments.

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  • Fist of Etiquette||

    The Senate Budget Committee no doubt wishes de Rugy had pleaded the Fifth.

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  • Penis Carrot||

    The snoring in the room must have been unbearable. 3 cheers for de Rugy for not being sidetracked by it.

  • CE||

    There hasn't been any austerity anywhere, so it's pretty moot.

  • Acosmist||

    This.

    What austerity?

  • Pro Libertate||

    That's for damned sure.

  • John||

    IN all seriousness, didn't Iceland go broke? And hasn't Greece had to stop spending money? I think Iceland actually did cut government out of necessity.

  • derpules||

    OT: Listening to the Illinois General Assembly discuss [IMO] decent CCW legislation. I shit you not, the House opened with a prayer: "government is a gift from God, it's how he provides for us"

  • NeonCat||

    It's true. Some of the IL House members probably would starve without government porkortunities.

  • derpules||

    I always suspected that these people thought they were a gift from God. I never expected to hear them explicitly state it.

  • Mark22||

    Yeah, more specifically, a "white elephant".

  • John||

    Veronica has the geek chic look down.

  • some guy||

    I'm glad she mentions regulations in this. Cutting taxes/spending is great, but if you have a stifling regulatory environment you're probably not going to see much growth.

  • John||

    The regulations do more damage than the taxes. The taxes are unjust and aggravating. But they don't kill business the way the regulations do.

  • DarrenM||

    spending-based fiscal adjustments are not only more likely to reduce the debt-to-GDP ratio than tax-based ones but also less likely to trigger a recession

    Is this supposed to be some great insight?

  • Eric Bana||

    Wait a minute. Krugman says we need trillions more in debt and that we can just print the money when we need to. I mean, what's the worse that could come from destroying the average person's savings and purchasing power?

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  • Emily Oliver||

    Expansionary austerity is just a dream! Why won't our politicians and bureaucrats realize and accept it! They have to take the advice of the true professionals in the economic crisis. They should contact the Orlando Bisegna Index, economic crisis specialists who have already improved the situation for many counties. They have helped a lot of families by dealing with business failures, unemployment and debt problems.

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