A good advice for deficit ridden governments.
“The experience of Italy in the 1990s is consistent with three lessons that we have learned from examining examples of large fiscal consolidation in OECD countries with a government sector that accounts for well over 40% of GDP:
1. Only fiscal adjustments based on structural reductions in spending (as opposed to temporary cuts) can have a lasting effect on the debit-to-GDP ratio.
Tax-based adjustments simply keep filling the holes in the budget opened by automatic increases in spending.
2. Cuts to government spending have smaller recessionary effects than tax increases.
3. To the extent that spending cuts have a negative effect of output, this can be offset by enacting structural, growth-enhancing measures.”
My comment: I am not too sure about point 3, either about what they mean or if they are right in general.
Point 2 however is straightforward, but usually not understood by policymakers: since the welfare losses from taxes increase as the square of the marginal tax rate, reducing taxes in general exerts a powerful positive effect on production. The same for a tax cut that accompanies a spending cut, leaving the budget deficit unchanged. This is the expansionary effect of a balanced budget reduction (the inverse of the so-called “Haavelmo theorem” of the expansionary effect of a balanced budget increase, in an economy with much unemployed resources).
This effect should be especially strong in the European economies where overall tax rates are high (a discussion of which taxes should be reduced for maximum result is of course in order).
Accordingly, making one more step in the right direction, one should advise European governments not to try to reduce too hastily budget deficits (as Ms. Lagarde admonishes them) but to cut spending resolutely while cutting taxes even more, not less.
But maybe this is too complex for the limited economic understanding of politicians (and their advisers).
The Alesina and Giavazzi paper concerns Italy but the conclusions are also of value for other European economies. It is downloadable here .
Further reading: Alberto Alesina and Silivia Ardagna, “Large changes in fiscal policy: taxes versus spending”, revised October 2009, on Alesina’s Harvard website.