Cut deficits by cutting spending

Alberto Alesina 30 November 2012

Should debt-ridden and economically struggling Western governments be doing everything

possible to reduce their deficits? Should we cut spending or hike taxes to reduce our debt-to-
GDP ratios? This column argues that the answer is obvious: the cheapest, most effective and
confidence-inspiring route is to cut spending. Coupled with other pro-growth policies, the
evidence suggests that it is only really spending cuts that will spur private investment and
economic recovery in Europe.

Should debt-ridden and economically struggling Western governments be doing everything

possible to reduce their deficits? The debate over that question has become increasingly
confusing – not only in Europe, where the matter is particularly urgent – but in the US, too.
Those in favour of immediate deficit reduction argue that it is a necessary precondition of
economic growth. Today’s deficits become tomorrow’s debt, they say, and too much debt can
bring fiscal crises, including government defaults. Markets, worried about solvency, will require
high interest rates on government bonds, making it more costly for countries to service their
debts. Defaults could cause banks holding government bonds to collapse, possibly leading to
another financial meltdown. There can be no sustained growth, say the deficit hawks, unless we
start balancing our books.

Their opponents agree that we should eventually rein in deficits, but right now, when economies
worldwide are weak, is the wrong time. To shrink a deficit, this argument goes, you need to
raise taxes or cut spending. Taking either of those steps reduces aggregate demand, making an
already faltering economy sputter and sink into serious recession. The all-important debt-to-
GDP ratio swells because GDP growth slows more than the measures taken to reduce debt.
Therefore the approach is self defeating. Governments should instead continue to run deficits
and paper them over with borrowed money, waiting to balance their budgets until economies
get stronger.

Two kinds of deficit reduction

The deficit debate is often misleading, however, because it tends to ignore a huge difference
between the two kinds of deficit reduction. The evidence is clear; yes, when governments
reduce deficits by raising taxes, they are indeed likely to witness deep, prolonged recessions.
But when governments attack deficits by cutting spending, the results are very different.

In 2011, the IMF identified episodes from 1980 to 2005 in which 17 developed countries had
aggressively reduced deficits. The IMF classified each episode as either ‘expenditure-based’ or
'tax-based', depending on whether the government had mainly cut spending or hiked taxes.
When Carlo Favero, Francesco Giavazzi, and I studied the results (2012), it turned out that the
two kinds of deficit reduction had starkly different effects; cutting spending resulted in very
small, short-lived recessions (if any), and raising taxes resulted in prolonged recessions.

We weren’t the first people to distinguish between the two kinds of deficit-cutting, of course. In
the past, critics such as Paul Krugman, Christina Romer, and some economists at the IMF have
responded to this claim, arguing that the two approaches don’t have different results. When an
economy performs well after government spending cuts, they say, it’s actually because the
business cycle has picked up, or else because the government’s monetary policy happened to
be more expansionary at the time. But my colleagues and I took both factors into account in our
research, carefully analysing the business cycle and monetary policy in relation to each fiscal
episode, and concluded that the difference between expenditure-based and tax-based actions
remained.

Spurring private investment

The obvious economic challenge to our contention is: What keeps an economy from slumping
when government spending, a major component of aggregate demand, goes down? That is, if
the economy doesn’t enter recession, some other component of aggregate demand must
necessarily be rising to make up for the reduced government spending – and what is it? The
answer: private investment. Our research found that private-sector capital accumulation rose
after the spending-cut deficit reductions, with firms investing more in productive activities, for
example buying machinery and opening new plants. After the tax-hike deficit reductions, capital
accumulation dropped.

The reason may involve business confidence, which, we found, plummeted during the tax-
based adjustments and rose (or at least didn’t fall) during the expenditure-based ones. When
governments cut spending, they may signal that tax rates won’t have to rise in the future, thus
spurring investors (and possibly consumers) to be more active. Our findings on business
confidence are consistent with the broader argument that US firms, though profitable, aren’t
investing or hiring as much as they might right now because they’re uncertain about future fiscal
policy, taxation, and regulation.

Spending cuts bundled with pro-growth policy

But there’s a second reason that private investment rises when governments cut spending; the
cuts are often just part of a larger reform package that includes other pro-growth measures. In
another study, Silvia Ardagna and I (2009) showed that the deficit reductions that successfully
lower debt-to-GDP ratios without sparking recessions are those that combine spending
reductions with such measures as deregulation, the liberalisation of labor markets (including, in
some cases, explicit agreement with unions for more moderate wages), and tax reforms that
increase labor participation.

Spending cuts are less costly than tax hikes

Let’s be clear: this body of evidence doesn’t mean that cutting government spending always
leads to economic booms. Rather, it shows that spending cuts are much less costly for the
economy than tax hikes and that a carefully designed deficit-reduction plan, based on spending
cuts and pro-growth policies, may completely eliminate the output loss that you’d expect from
such cuts. Tax-based deficit reduction, by contrast, is always recessionary.
The devil is in the details

With this evidence in hand, let’s go back to the two views with which we started. People who
support deficit reductions are correct, so long as those reductions are accomplished by cutting
spending and, ideally, accompanied by other pro-growth policies. The broader idea that any
deficit reduction is beneficial, that all you need in order to calm a market is a smaller deficit, is
simplistic.

The opposite idea, that any immediate deficit reduction will slow the economy and prove self-
defeating, is equally simplistic. A deficit-reduction program of carefully designed spending cuts
can reduce debt without killing growth, so there’s no need to be so protective even of today’s
weak economies. But the deficit doves are right to be wary of tax-hiking deficit reductions, as
Italy, which has struggled with a high debt-to-GDP ratio for the last 20 years, demonstrates.
Various Italian governments have repeatedly tried to reduce that ratio by raising more revenue,
a course that has crippled the Italian economy and left the ratio firmly in place, just as the deficit
doves would predict. Last November, Italy’s current government passed a very large tax hike;
the country’s economy promptly nosedived and is expected to show negative 2.6% growth for
2012 (Italy is finally starting to realise its errors; it has initiated a ‘spending review’ which should
lead to spending cuts in the near future, and has also passed labour-market reforms).

The deficit hawks are right about something else; America urgently needs to reduce its national
debt. Recent work by economists Carmen Reinhart and Kenneth Rogoff convincingly shows
that when debt reaches about 90% of GDP, it becomes a burden on growth (2010). Today, the
US’s debt is almost 80% of GDP, a number that is on track to reach 120% in the not too distant
future, thanks to healthcare spending, Medicare in particular.

A matter of urgency in Europe

In Europe, where debt-to-GDP ratios are even higher than in the US, deficit reduction is still
more pressing. If Greece, Spain, Portugal, Ireland, and Italy do nothing about their finances,
they run the risk of defaulting on their debt – a disastrous event not just for them but for the
euro, which would implode and develop into a disaster for the global economy. They certainly
won’t be able to borrow at reasonable rates without some kind of fiscal adjustment. Sure, we
can debate how much the ECB should help these countries, but clearly they have to do
something to put their own houses in order. Raising taxes and depressing growth isn’t the
answer; cutting spending is.

The longer the US waits, the higher the cost

For the time being, markets seem to trust the US, and treasury bonds are still in demand, which
lets us borrow cheaply. But we have to fix our debt trajectory soon. The idea that everything will
be fine without fiscal adjustments isn’t merely wishful thinking; it’s an abandonment of our
children, who will have to bear a crushing fiscal burden. The longer we wait, the higher the cost
of fixing the problem will be.
Cutting spending is not easy, of course, because the recipients of government subsidies and
benefits – public employees, early retirees, large companies getting expensive favours, local
governments with no fiscal discipline, and so on – are well represented in the political arena,
while taxpayers are not. Nevertheless, the conventional wisdom that fiscally prudent
governments will invariably suffer electoral losses seems to be wrong. In a recent paper, Dorian
Carloni, Giampaolo Lecce, and I (2011) show that even governments that have drastically
slashed spending haven’t systematically lost office in the elections that followed. Sometimes,
though not always, voters do understand the need to retrench, rewarding governments that
ignore the lobbies’ pleas, especially when those governments speak clearly to voters and are
fair in how they cut spending.

Will spending cuts hurt the poor?

Not in such countries as Greece, Portugal, Spain, and Italy, whose public sectors are so
inefficient and wasteful that they can certainly spend less without affecting basic services. Even
in countries with better-functioning public sectors – such as France, where public spending is
nearly 60% of GDP – there’s a lot of room to economise without hurting the poorest and most
vulnerable. And even in America, public spending is about 43% of GDP, a level common in
Europe not long ago, and up from 34% in 2000. Western governments can save money and
avoid inflicting injury by improving the way welfare programs are targeted; scaling back
programs, such as Medicare, that use taxes that were raised, in part, from the middle class to
give public services right back to the middle class; and gradually raising the retirement age to
70. If the French think that they can keep retiring at 60, they’re kidding themselves.

Taxing the 1%?

Once we cut spending, the tax burden can lighten. The question then becomes how to distribute
the reduced tax burden among taxpayers. Above all, does heavily taxing the wealthiest people
harm economic growth? And if so, how much? Honest economists will confess that they aren’t
sure. We aren’t even sure how much the rich currently pay, thanks to the complexity of tax
systems like the American one. Every other day, it seems, you read what looks like a perfectly
researched article in The New York Times showing that the rich pay proportionally less than the
middle class does. The next day, what seems an equally rigorous article in The Wall Street
Journal tells you that the US has the most progressive tax system in the world.

It’s all about the debt-to-GDP ratio

My own view is that reducing the size of government is more important than protecting every
dollar in the pockets of the wealthiest 1%. However the resulting tax burden is distributed, the
important thing is that we cut spending. Whoever wins the next presidential election in the US
will need to present a plan that changes the trajectory of the country’s debt-to-GDP ratio. It’s
exceedingly important that they do it the right way.