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InsiderOnline Blog: March 2013

Austerity via Spending Cuts Works Better than Austerity via Tax Increases

Alberto Alesina and Veronique de Rugy review the economic literature:

[W]hile not all fiscal adjustments lead to economic expansion, spending-based adjustments are less recessionary than those achieved through tax increases. Moreover, when successful spending-based adjustments were not expansionary, they were associated with mild and short-lived recessions, while tax increases were unsuccessful at reducing the debt and associated with large recessions. These findings hold even when using the IMF definitions of fiscal adjustments.

In fact, these findings are consistent with IMF studies themselves. For instance, IMF economists Jaime Guajardo, Daniel Leigh, and Andrea Pescatori studied 173 fiscal consolidations in rich countries and found that “nations that mostly raised taxes suffered about twice as much as nations that mostly cut spending. “IMF researchers, however, downplay this result and incorrectly attribute it—as shown by Alesina, Favero, and Giavazzi—to different reactions of monetary policy to different types of fiscal adjustments.

[…] [S]uccessful and expansionary fiscal adjustments are those based mostly on spending cuts rather than tax increases. Also, these adjustments lasted slightly longer and were associated with higher growth during the adjustment. Using data from 21 Organisation for Economic Co-operation and Development (OECD) countries from 1970 to 2010, Alesina and Ardagna find that successful fiscal adjustments on average reduced debt-to-GDP ratio by 0.19 percentage points of GDP in a given year. GDP grew by 3.47 percentage points in total, which is 0.58 percentage points higher than the average growth of G7 countries. Successful adjustments lasted for three years on average. […] Alesina, Favero, and Giavazzi’s work shows that taking the business cycle and monetary policy into account does not change the main finding. [Internal citations omitted.]

And: “Besides, it is not clear that the alternative to reducing spending is more economic growth. In fact, the alternative for certain countries could be a very messy debt crisis.” [“Austerity: The Relative Effects of Tax Increases versus Spending Cuts,” by Alberto Alesina and Veronique de Rugy,” Mercatus Center, March 7]

Posted on 03/19/13 04:03 PM by Alex Adrianson

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