Don’t Cut Deficits, Cut Taxes

That’s what one can conclude from a recent paper by Alesina and Ardagna (“Large Changes in Fiscal Policy: Taxes Versus Spending”, NBER Working Paper n° 15438, October 2009). The authors “examine the evidence on episodes of large stances in fiscal policy, both in case of fiscal stimuli and in that of fiscal adjustments in OECD countries from 1970 to 2007. Fiscal stimuli based upon tax cuts are more likely to increase growth than those based upon spending increases. As for fiscal adjustments, those based upon spending cuts and no tax increases are more likely to reduce deficits and debt over GDP ratios than those based upon tax increases. In addition, adjustments on the spending side rather than on the tax side are less likely to create recessions.”

Now what we need at present, both in Europe and in the U.S., is a continued fiscal stimulus to sustain the recovery, to be followed later by a reduction of the Debt/GDP ratio inflated by the public spending policies adopted during the crisis. If Alesina and Ardagna are right, and they may well be, a tax reduction now, followed by a public spending reduction (without tax increase) later, when private spending will have picked up, would be the best macroeconomic policy to adhere to.

The “deficit hysteria” (the excessive fear of deficits) currently fashionable would lead, on the contrary, to increase taxes that would damage recovery prospects, while the pursuing of public spending policies, which were useful during the crisis when private spending was contracting, would not add significantly to growth when expansion returns, and would on the other hand incite governments to increase taxes permanently, thus jeopardizing future growth.

Cutting taxes now would also give governments time enough to devise a well prepared future public spending cut program.