No. of Recommendations: 20
Does austerity work? If so, what works better -- tax hikes or spending cuts?

You decide.

For studies on taxes and economic growth:


Can Severe Fiscal Contractions be Expansionary? Tales of Two Small European Countries
Francesco Giavazzi, Marco Pagano
NBER Working Paper No. 3372

"According to conventional wisdom, a fiscal consolidation is likely to contract real aggregate demand. It has often been argued, however, that this conclusion is misleading as it neglects the role of expectations of future policy: if the fiscal consolidation is read by the private sector as a signal that the share of government spending in GDP is being permanently reduced, households will revise upwards their estimate of their permanent income, and will raise current and planned consumption. Only the empirical evidence can sort out which of these two contending views about fiscal policy is more appropriate -- i.e how often the contractionary effect of a fiscal consolidation prevails on its expansionary expectational effect. This paper brings new evidence to bear on this issue drawing on the European exercise in fiscal rectitude of the 1980s, and focusing, in particulars on its two most extreme cases -- Denmark and Ireland. We find that at least in the experience of these two countries the expectations' view has a serious claim to empirical relevance."

Fiscal Expansions and Adjustments in OECD Countries
Alberto Alexina, Harvard University
Roberto Perotti, Columbia University

"We find that large fiscal expansions typically are biased towards increases in expenditure, while large fiscal adjustments on average rely more on tax increases. However, we find a large and fundamental difference between fiscal adjustments that lead to permanent improvements in the fiscal balance and those that are reversed in a short time. The former are implemented mainly via cuts in two types of expenditure: transfer programs and compensation of government employees. The latter are carried out almost exclusively via tax increases. We also find that coalition governments, although they often try to make substantial fiscal adjustments, are much less likely than other governments to carry out the two types of expenditure cuts that make an adjustment successful.

Our findings convey a clear message: the composition of a fiscal adjustment is of fundamental importance in determining its success. A fiscal adjustment cannot have long-lasting effects unless it tackles two expenditures - government employment and social programs - often regarded as untouchable by policymakers and their advisors."

Reducing Budget Deficits
Alberto Alesina, Harvard University
Roberto Perotti, Columbia University

"In a previous paper (Alesina and Perotti 1995a) we have begun to address, amongst many others, the first question. In that paper, we found a significant difference in the composition of successful and unsuccessful adjustments. Successful ones rely mostly on cuts in transfer programs and in government wages and employment.

On the contrary, in unsuccessful adjustments, these two components of the expenditure side are left virtually untouched and most of the adjustment occur in the revenue side. In the present paper, after reviewing these results, we look at the macroeconomic consequences of fiscal adjustments, successful or not. Our conclusion on this point is somewhat optimistic. First of all, we do not find that "hell breaks loose" as a result of even major, multi-year fiscal adjustments. On the contrary, successful fiscal adjustments are often associated with increases in growth, crowding in of private investments and reduction in unemployment.


In any case, we see enough in this paper to encourage even the most reluctant policymakers to engage in fiscal adjustments on the expenditure side, and specifically on transfer programs and the government wage bill."

Non-Keynesian Effects of Fiscal Policy Changes: International Evidence and the Swedish Experience
Francesco Giavazzi, Marco Pagano
NBER Working Paper No. 5332 (Also Reprint No. r2082)

"In earlier work we documented two episodes in which a sharp fiscal consolidation was associated with a very large expansions in private domestic demand. In this paper we draw on further evidence to investigate if and when fiscal policy changes can have such non-Keynesian effects. In the first part of the paper, we analyze cross-country data for 19 OECD countries. In the second, we concentrate on the Swedish fiscal expansion of the early 1990s. The cross-country evidence on private consumption confirms that fiscal policy changes - both contractions and expansions - can have non-Keynesian effects if they are sufficiently large and persistent, and suggests that these effects can result not only from changes in public consumption but to some extent also from changes in taxes and transfers. The latter result is consistent with the Swedish experience where a decrease in net taxes (with almost no change in public consumption) was associated with a dramatic fall in private domestic demand. Our evidence and that from other studies agree that during the Swedish fiscal expansion of the early 1990s a large negative error appears in the consumption function. There is less consensus about how this error should be interpreted, but it is clear that the most obvious candidates (wealth effects and after-tax real interest rate effects) are not sufficient to explain it. This error may reflect a large downward revision of permanent disposable income, which affected the consumption of Swedish households over and beyond the negative effects of the drop in real asset prices. We suggest that this revision in permanent income may have been triggered, at least partly, by the fiscal expansion of the early 1990s."

An Empirical Analysis of Fiscal Adjustments
C. John McDermott
Reserve Bank of New Zealand
Robert Wescott
International Monetary Fund (IMF) - European Department

"This study uses the fiscal expansion and consolidation experiences of the industrial countries over the period 1970 to 1995 to examine the interplay between fiscal adjustments and economic performance. A key finding is that fiscal consolidation need not trigger an economic slowdown.

Fiscal consolidation that concentrates on the expenditure side, and especially on transfers and government wages, is more likely to succeed in reducing the public debt ratio than tax-based consolidation. Also, the greater the magnitude of the fiscal consolidation, the more likely it is to succeed in reducing the debt ratio."

Fiscal Adjustments in OECD Countries: Composition and Macroeconomic Effects
Alberto Alesina
Roberto Perotti

"This paper studies how the composition of fiscal adjustments influences their likelihood of success, defined as a long lasting deficit reduction, and their macroeconomic consequences. We find that fiscal adjustments which rely primarily on spending cuts on transfers and the government wage bill have a better chance of being successful and are expansionary. On the contrary fiscal adjustments which rely primarily on tax increases and cuts in public investment tend not to last and are contractionary. We discuss alternate explanations for these findings by studying both a full sample of OECD countries and by focusing on three case studies: Denmark, Ireland and Italy."

Budgetary Consolidation in EMU
Jürgen von Hagen (ZEI, University of Bonn, Indiana University, and CEPR)
Andrew Hughes Hallett (Strathclyde University, Glasgow, and CEPR)
Rolf Strauch (ZEI, University of Bonn)

"Consolidations are more likely to be successful, if governments achieve them by way of reducing expenditures rather than raising additional revenues, and if governments tackle politically sensitive issues such as transfers, subsidies, and government wages.


Our results also suggest that should not rely too much on the expectation that governments use “good times” – periods of strong economic growth – to solve problems of fiscal policy. Consolidations started in good times typically do not last long and do not achieve much. Significantly, they tend to lead to an increase in the tax burden on the economy and, therefore, may reduce the potential for satisfactory growth and high employment in the longer run. In contrast, consolidations started in difficult times are more likely to be successful, if only because the commitment to consolidation is higher."

Tales of Fiscal Adjustments
Alberto Alesina
Harvard University, CEPR and NBER
Silvia Ardagna
Boston College

"Our main conclusions can be summarized as follows. Two non mutually exclusive views have emerged as for an explanation of expansionary fiscal adjustments. One emphasizes the interaction of wealth effects on consumption and expectations of future tax liabilities. In addition, private demand would react to the perceived "credibility" of the adjustment.

According to this view initial conditions are important: fiscal adjustments are expansionary when they occur following a fiscal crisis. The second view emphasizes more the composition of the adjustment (tax increases versus spending cuts, share of different cuts) and its interaction with labor market institutions affecting labor costs. Our evidence is generally more consistent with the second view although in no way we can exclude a role for the first channel.

Three ingredients seem to be important for a successful, long lasting and expansionary fiscal adjustment. A composition of the adjustments which emphasizes spending cuts on transfers, welfare programs and the government wage bill. Some form of wage agreement with the unions which insures wage moderation. A devaluation immediately before the fiscal tightening. Instead, no large tax based fiscal adjustments are expansionary even if they are accompanied by a devaluation. Finally, governments that implement large fiscal adjustments typically remain in office. Interestingly, this evidence on fiscal adjustments is “confirmed” by our analysis of episodes of very loose fiscal policy. In fact, in many respects episodes of loose fiscal policy behave in a specular way to fiscal adjustments. For instance, not all cases of loose fiscal policy are expansionary."

Fiscal Policy in Good Times and Bad
Roberto Perotti
Columbia University and CEPR

"In the eighties, several countries with large government debt or deficit implemented substantial, and in some cases drastic, deficit cuts. Contrary to widespread expectations, in many cases private consumption boomed rather than contract. This paper shows that in times of “fiscal stress” shocks to government revenues and, especially, expenditure have very different effects on private consumption than in “normal” times."

Fiscal Policy, Profits, and Investment

"This paper shows that in OECD countries changes in fiscal policy play an important role for private business investment. Interestingly, the strongest effects arise from changes in primary government spending, especially in the government wage bill. We provide evidence consistent with a labor market channel through which fiscal policy influences
labor costs, profits, and, as a consequence, investment. Increases in public wages and/or employment put upward pressure on private sector wages; this is consistent with competitive or unionized labor-market models. Also, workers in the private sector may react to tax hikes or more generous transfers by decreasing the labor supply or asking for higher pretax real wages, once again leading to declining profits and investment.

These effects on investment go a long way toward explaining those episodes of fiscal contractions associated with higher growth that have recently attracted considerable attention. According to our results, the surge in private investment that accompanies the large spending cuts during these episodes is exactly what one should expect. In fact, we find very little evidence that private investment reacts differently during these large fiscal adjustments than in “normal” circumstances. This result questions the need for “special theories” for large versus small changes in fiscal policy."

Fiscal Stabilizations: When Do They Work and Why
Silvia Ardagna
Wellesley College

"This paper studies the determinants and channels through which fiscal contractions influence the dynamics of the debt-to-GDP ratio and GDP growth. Using data from a panel of OECD countries, the paper shows that the success of fiscal adjustments in decreasing the debt-to-GDP ratio depends on the size of the fiscal contraction and less on its composition. The rate of growth of output matters too, but higher GDP growth does not drive the success of a fiscal stabilization. In contrast, whether a fiscal adjustment is expansionary depends largely on the composition of the fiscal manoeuvre. In particular, stabilizations implemented by cutting public spending lead to higher GDP growth rates. The effects of the composition on growth work mostly through the labor market rather than through agents’ expectations of future fiscal policy. Finally, the evidence suggests that successful and expansionary fiscal contractions are not the result of accompanying expansionary monetary policy or exchange rate devaluations."

Restoring Fiscal Sustainability in the Euro Area: Raise Taxes or Curb Spending?
Boris Cournède
Frédéric Gonand

"With population ageing, fiscal consolidation has become of paramount importance for euro area countries. Consolidation can be pursued in various ways, with different effects on potential growth, which itself will be dragged down by ageing. A dynamic general equilibrium model with overlapping generations and a public finance block (including a pay-as-you-go pension regime, a health care system, non ageingrelated public spending and a stock of debt to be repaid) is used to compare the macroeconomic impact of four scenarios: a) increasing taxes to finance unchanged pensions and repay public debt, b) lowering future pension replacement rates and repaying public debt through a lower ratio of non ageing-related outlays to GDP, c) raising the retirement age by 1.25 years per decade and increasing taxes only to pay off debt, and d) increasing the retirement age by 1.25 years per decade and paying off debt through a lower ratio of non ageing related expenditure to GDP. This last scenario is the one where growth is strongest: with gradual increases in the retirement age and spending restraint, average GDP growth in the 2010s would be 0.34 percentage point stronger than in a scenario where fiscal consolidation is achieved exclusively through tax hikes. The appropriate conclusion from the model is not that public spending is bad per se, but that cuts to lower-priority spending items can deliver surprisingly large income gains compared with the alternative of raising taxes."

What Promotes Fiscal Consolidation: OECD Country Experiences
Stéphanie Guichard
Mike Kennedy
Eckhard Wurzel
Christophe André

“Fiscal consolidation is required in most OECD countries. This is especially so in view of medium and long-term spending pressures on public finances, related, inter alia, to ageing. Based on a dataset covering a large number of OECD fiscal consolidation episodes starting in the late 1970s, the paper presents evidence, both descriptive and econometric, on macroeconomic conditions and policy set-ups that have been effective in triggering and sustaining fiscal consolidation. Main findings include: Large initial deficits and high interest rates have been important in prompting fiscal adjustment and also in boosting the overall size and duration of consolidation. Concerning the quality of fiscal policies, an emphasis on cutting current expenditures has been associated with overall larger consolidation. Fiscal rules with embedded expenditure targets tended to be associated with larger and longer adjustments, pointing to institutional features playing a potentially important role in generating successful consolation efforts. Experience across countries also shows that certain design features such as transparency, flexibility to face shocks and effective enforcement mechanisms seem important for the effectiveness of fiscal rules.”

A Guide for Deficit Reduction in the United States Based on Historical Consolidations That Worked
Andrew G. Biggs
Kevin A. Hassett
Matthew Jensen

“This article reviews the literature regarding fiscal consolidations, conducts new analysis of consolidations occurring in OECD countries over the period 1970-2007, and outlines a stylized plan to address long-term budget challenges in the U.S. that is designed to be consistent with conclusions drawn from successful consolidations in the OECD. The independent analysis confirms the literature’s finding that fiscal consolidations that reduce ratios of debt to GDP tend to be based upon reduced government outlays rather than increased tax revenues. This result holds whether fiscal consolidations are defined in terms of improvements in the cyclically-adjusted primary budget deficit or in terms of pre-meditated policy changes designed to improve the budget balance.”

Limiting the Fall-Out from Fiscal Adjustment
Global Economics Paper No: 195
Goldman Sachs Global Economics, Commodities and Strategy Research

“In a review of every major fiscal correction in the OECD since 1975, we find that decisive budgetary adjustments that have focused on reducing government expenditure have (i) been successful in correcting fiscal imbalances; (ii) typically boosted growth; and (iii) resulted in significant bond and equity market outperformance. Tax-driven fiscal adjustments, by contrast, typically fail to correct fiscal imbalances and are damaging for growth.”

Will It Hurt? Macroeconomic Effects of Fiscal Consolidation

“This chapter examines the effects of fiscal consolidation —tax hikes and government spending cuts—on economic activity. Based on a historical analysis of fiscal consolidation in advanced economies, and on simulations of the IMF’s Global Integrated Monetary and Fiscal Model (GIMF), it finds that fiscal consolidation typically reduces output and raises unemployment in the short term. At the same time, interest rate cuts, a fall in the value of the currency, and a rise in net exports usually soften the contractionary impact. Consolidation is more painful when it relies primarily on tax hikes; this occurs largely because central banks typically provide less monetary stimulus during such episodes, particularly when they involve indirect tax hikes that raise inflation. Also, fiscal consolidation is more costly when the perceived risk of sovereign default is low. These findings suggest that budget deficit cuts are likely to be more painful if they occur simultaneously across many countries, and if monetary policy is not in a position to offset them. Over the long term, reducing government debt is likely to raise output, as real interest rates decline and the lighter burden of interest payments permits cuts to distortionary taxes.”

Fiscal Consolidations in Currency Unions: Spending Cuts Vs. Tax Hikes
Christopher J. Erceg
Federal Reserve Board
Jesper Lindé
Federal Reserve Board and CEPR

“This paper investigates the effectiveness of fiscal consolidations via spending cuts or increases in labor income taxes within a currency union in a New Keynesian general equilibrium framework which takes explicit account of the zero bound constraint on policy rates. In this environment, we document that fiscal consolidations via government spending cuts tend to have less adverse impact on output in the medium term in comparison to labor-income tax hikes when monetary policy can be used to offset the drag on demand. Accordingly, government spending cuts are more effective than labor tax hikes to reduce government debt in the medium term, consistent with empirical studies on fiscal consolidations. However, for a small member of a currency union, we find that consolidation via labor-tax hikes can be more effective in the near term as they depend less on monetary accommodation. Finally, we study the impact of fiscal retrechment in a liquidity trap when a larger subset of the currency union members consolidate simultaneously. In this case, our results mimics the small open economy case by suggesting that labor tax hikes are more effective than front-loaded spending cuts to reduce government debt quickly if the liquidity trap is expected to be sufficiently long-lived absent any fiscal actions.”
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