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The authors also suggest that a difference in the way fiscal adjustments are measured would change the overall results. However, the difference in the way fiscal adjustments are defined does not change the overall result. A 2012 study by Alberto Alesina and Goldman Sachs’s economist Silvia Ardagna shows that spending-based adjustments are more likely to reduce the debt-to-GDP ratio, regardless of whether fiscal adjustments are defined in terms of improvements in the cyclically adjusted primary budget deficit or in terms of premeditated policy changes designed to improve a country’s fiscal outlook. Similar results with more advanced technical tools using the IMF episodes are also reached by Alberto Alesina and Bocconi University economists Carlo A. Favero and Francesco Giavazzi.
Other research has found that fiscal adjustments based mostly on the spending side are less likely to be reversed and, consequently, have led to more long-lasting reductions in debt-to-GDP ratios. Beyond showing whether spending-based adjustments or revenue-based ones are more effective at reducing debt, the literature has also looked at which components of expenditures and revenue are more important. The results on these points are not as clear-cut, partly due to the wide differences in countries’ tax and spending systems. With that caveat in mind, successful fiscal adjustments are often rooted in reform of social programs and reductions to the size and pay of the government workforce rather than in other types of spending cuts. Results about which type of revenue increases contribute to successful fiscal adjustment are much less clear.
Also, while successfully reducing the debt-to-GDP ratio is possible, a majority of historical fiscal adjustment episodes fail to do so. Data from studies by Alesina and Ardagna and by Andrew Biggs and his colleagues show that roughly 80 percent of the adjustments studied were failures. One explanation is that even (or especially) in a time of crisis, lawmakers are driven more by politics than by good public policy. Countries in fiscal trouble generally get there through years of catering to pro-spending constituencies, be they senior citizens or members of the military industrial complex, and their fiscal adjustments tend to make too many of the same mistakes. As a result, failed fiscal consolidations are more the rule than the exception.
2. Fiscal Adjustments and Economic Growth
While there is little debate over the fact that sound fiscal balance and restraints in government spending have a positive impact on GDP in the long run, the question of whether, in the short term, budget cuts shrink or expand GDP is far from settled. This is an especially important question for countries where government spending as a share of GDP is close to or above 50 percent. A few uncontroversial points have emerged, however, despite the differences in approaches and in the definitions of successful or expansionary episodes.
First, expansionary fiscal adjustments are not impossible. There is now a long trail of academic papers that have studied and documented the impact of fiscal adjustments on economic growth. The first in the series was by Francesco Giavazzi and Marco Pagano in 1990. It was followed by a large literature, which was reviewed in depth by Alesina and Ardagna in 2010. However, today the question is not whether expansionary fiscal adjustments are possible, but whether in the current circumstances it is possible to design fiscal adjustments with as little cost as possible to the economy, given that monetary conditions will provide little additional help. It is perfectly possible that fiscal adjustment today might be on average more costly than in the past, but this does not mean that the medicine is not necessary.
Second, while not all fiscal adjustments lead to economic expansion, spending-based adjustments are less recessionary than those achieved through tax increases. Moreover, when successful spending-based adjustments were not expansionary, they were associated with mild and short-lived recessions, while tax increases were unsuccessful at reducing the debt and associated with large recessions. These findings hold even when using the IMF definitions of fiscal adjustments.
In fact, these findings are consistent with IMF studies themselves. For instance, IMF economists Jaime Guajardo, Daniel Leigh, and Andrea Pescatori study 173 fiscal consolidations in rich countries and find that “nations that mostly raised taxes suffered about twice as much as nations that mostly cut spending.”
Third, successful and expansionary fiscal adjustments were those based mostly on spending cuts rather than tax increases. Also, these adjustments lasted slightly longer and were associated with higher growth during the adjustment. Using data from Organisation for Economic Co-operation and Development countries from 1970 to 2010, Alesina and Ardagna find that successful fiscal adjustments on average reduced the debt-to-GDP ratio by 0.19 percentage points of GDP in a given year. GDP grew by 3.47 percentage points in total, which is 0.58 percentage points higher than the average growth of G7 countries. Successful adjustments lasted for three years on average.
How can we explain the fact that spending-based adjustments can result in lower output costs for the economy than tax-based ones, or in no output costs at all? IMF economists Prakash Kannan, Alasdair Scott, and Marco Terrones argue that this difference in outcomes is not a result of the composition of the fiscal adjustment packages, but rather a result of the business cycle having picked up because of other forms of government interventions, such as expansionary monetary policy. However, Alesina, Favero, and Giavazzi’s work shows that taking the business cycle and monetary policy into account does not change the main finding.
If the difference between tax-based and spending-based fiscal adjustments is not the result of the business cycle or of monetary policy, what explains it? The standard explanation is that lower spending reduces the expectation of higher taxes in the future, with positive effects on consumers and investors. In particular, there might be a boost in the confidence of the latter—as Alesina, Favero, and Giavazzi have shown. But there is more. As is often the case, the devil is in the details. Studies by Alesina and Ardagna and by Roberto Perotti have noted that fiscal adjustments are multiyear rich policy packages. Austerity measures are often undertaken at the same time that other growth-enhancing policy changes are made, and, as such, there is much to learn by looking into the details of each successful episode.
One important lesson is that several accompanying policies can moderate the contractionary effects of fiscal adjustments on the economy and enhance their chances of success. For instance, spending-based fiscal adjustment accompanied by supply-side reforms, such as liberalization of markets for labor, goods, and services; readjustments of public sector size and pay; public pension reform; and other structural changes tend to be less recessionary or even to have positive economic growth.
Such reforms signal a credible commitment to more market-friendly policies: less taxation, fewer impediments to trade, fewer barriers to entry, less labor market and business regulation. And, of course, with enhanced economic freedom, unit labor costs fall and productivity improves, making an expansionary fiscal adjustment more likely than a contractionary one.