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Yes, You Really Can Cut Your Way to Prosperity

Thursday, July 14, 2011

The literature is clear: spending cuts, not tax increases, are more likely to succeed in reducing deficits and debt and are more friendly to economic growth.

In December 2010, we released a working paper on fiscal consolidations accompanied by a Wall Street Journal op-ed, both co-authored with our AEI colleague Kevin Hassett. The goal was to analyze what worked—and what didn't—in balancing national budgets. The paper’s findings have generated some interest, including being cited approvingly by congressional Republicans and critiqued by one of the Economist magazine’s Free Exchange bloggers.  

Our methodology was straightforward. We studied over 20 Organization for Economic Cooperation and Development countries for a period spanning nearly four decades. We first isolated instances in which countries took steps to address their budget gaps. These steps are referred to as “fiscal consolidations.” The literature prescribes two ways to identify fiscal consolidations, one popularized by Harvard economist Alberto Alesina and the other established by the International Monetary Fund. We used both. Some of the fiscal consolidations were spending-based, others relied more on taxes.  

Second, we analyzed these countries three years after the consolidation to see which countries had succeeded in significantly reducing debt. We found that countries that succeeded in reducing their deficits and debt tended to do so principally by cutting spending rather than increasing taxes.

It’s as if the United States is ripe for a consolidation. Entitlement problems are easiest to fix, and that’s what we’ve got.

In the academic literature, there isn't much disagreement on this basic point. While the Economist several times argues that ours is but "a single study," our paper cites a large number of studies coming to broadly similar conclusions. There are no studies, to our knowledge, that argue that budgets should be balanced principally on the revenue side.

There has been debate over how large a role spending cuts should play. As the Economist points out, our baseline result—that on average successful fiscal consolidations were around 85 percent spending cuts and 15 percent tax increases—is the most cited part of our paper. But the precise share allocated to spending cuts versus tax increases varied by how we defined a fiscal consolidation and what we counted as a successful one.

These variations range along a number of axes:

— What constitutes a fiscal consolidation? We identified fiscal consolidations using two different methods. The average result of the two methods generated the 85 percent spending share, but each method by itself produced different results. One method showed an average spending share of 66 percent, the other showed an average spending share of 103 percent.

— What constitutes success? Following the literature, we called a fiscal consolidation successful if it reduced the debt-to-GDP-ratio by 4.5 percentage points. There is nothing sacred about this threshold for success. We will note, however, that the higher the threshold for success, the larger the expenditure share of successful consolidations. For instance, if we set the bar for success at 6.5 percentage points of GDP, the expenditure share of the average successful fiscal consolidation rose from 85 percent to around 100 percent.

Given that the Congressional Budget Office is projecting an increase in the debt-to-GDP ratio exceeding 30 percentage points over the next decade, an 85 percent expenditure share might be seen as a floor rather than a ceiling.

The higher probability of success for expenditure-based consolidations is not the only factor we should consider. We also should consider growth effects and the unique aspects of the United States’ fiscal situation.

We found that countries that succeeded in reducing their deficits and debt tended to do so principally by cutting spending rather than increasing taxes.

As one of us noted in recent congressional testimony, even the IMF seems to agree that fiscal consolidations based on spending cuts will produce superior economic outcomes—meaning, higher economic growth and lower unemployment—than those based on tax increases. The IMF argues, contrary to some other economists, that both spending and tax-based fiscal consolidations will tend to reduce economic growth in the short term. But the IMF concludes that a spending-based fiscal consolidation will have smaller negative short-term effects than a tax-based fiscal consolidation. Moreover, the IMF projected that a consolidation focused on reducing transfer payments—which would mostly be entitlement payments in the U.S. context—could increase economic growth even in the short term.

In fact, one of the least contested points in the fiscal consolidation literature is that reduced transfer payments correlate with more successful fiscal consolidations and higher economic growth. And the United States’ fiscal problem is, essentially, an entitlements issue. Without rising entitlement costs, the federal budget would be more or less in balance over the long term. It’s as if the United States is ripe for a consolidation. Entitlement problems are easiest to fix, and that’s what we’ve got.

One of the least contested points in the fiscal consolidation literature is that reduced transfer payments correlate with more successful fiscal consolidations and higher economic growth.

The academic debate over fiscal consolidations and economic growth concerns whether the positive "expectational effects" of fiscal consolidations—that is, the increased consumer and investor confidence generated by the belief that adverse fiscal outcomes have been avoided down the road—outweigh the short-term negative Keynesian effects of reduced government spending. Entitlement reform, however, would generate new confidence in the near term while the contractionary reductions to actual spending would not occur for years to come. For instance, many Social Security reform plans raise the retirement age, but all do so over the space of many years, and the effects are gradual. This combination is ideal in our current times of high unemployment and low growth.

This fact is particularly salient given that the Democratic congressional leadership—in particular, House minority leader Nancy Pelosi—has argued for no cuts to Social Security or Medicare. This implies that the long-term fiscal gap would be filled almost entirely by new revenues or draconian cuts to the military and discretionary spending. The academic literature suggests that a consolidation based on raising tax rates or cutting government investment would be practically doomed to failure.

Rather than focus on any given number—be it 85 percent, or 100 percent, or something else—policy makers should heed the broad lessons of the fiscal consolidation literature: that spending cuts, not tax increases, are more likely to succeed in reducing deficits and debt and are more friendly to economic growth; that the larger the debt we need to reduce, the larger the role for spending cuts; and that the most effective spending cuts are in transfer payments, such as entitlement programs, not in areas such as government investment.

Andrew G. Biggs is a resident scholar at the American Enterprise Institute, where Matthew Jensen is a research assistant.

FURTHER READING: Biggs and Jensen have also collaborated with Kevin A. Hassett on “A Guide for Deficit Reduction in the United States Based on Historical Consolidations That Worked.” Biggs has recently written “Is Social Security Middle-Class Welfare?,” “Public Pensions Roll the Dice,” and “Means and Extremes: How Not to Balance the Budget.” Related articles include Andrew Rugg’s “Maybe Americans Really Are Ready for Spending Cuts.”

Image by Darren Wamboldt/Bergman Group. 

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