« A review of over 200 fiscal adjustments in 21 countries shows that spending discipline and tax cuts are the best ways to spur economic growth. »

Wall Street Journal
Tax Cuts vs. ‘Stimulus’: The Evidence Is In
By ALBERTO ALESINA

Libertarien Politicians argue for increased stimulus spending, as opposed to spending cuts, on the grounds that it would speed up economic recovery. This argument might have it exactly backward. Indeed, history shows that cutting spending in order to reduce deficits may be the key to promoting economic recovery.

In Europe today, the risk of a renewed recession comes not from the spending cuts that some governments have enacted, but from a sovereign debt overhang and multiple bank failures. July’s stress tests were not reassuring because they didn’t test the exposure of European banks to sovereign debt; had they done so, many banks would have failed. Those banks remain a threat to the European economy.

In the U.S., meanwhile, recent stimulus packages have proven that the « multiplier »—the effect on GDP per one dollar of increased government spending—is small. Stimulus spending also means that tax increases are coming in the future; such increases will further threaten economic growth.

Economic history shows that even large adjustments in fiscal policy, if based on well-targeted spending cuts, have often led to expansions, not recessions. Fiscal adjustments based on higher taxes, on the other hand, have generally been recessionary.

My colleague Silvia Ardagna and I recently co-authored a paper examining this pattern, as have many studies over the past 20 years. Our paper looks at the 107 large fiscal adjustments—defined as a cyclically adjusted deficit reduction of at least 1.5% in one year—that took place in 21 Organization for Economic Cooperation and Development (OECD) countries between 1970 and 2007.

According to our model, a country experienced an expansionary fiscal adjustment when its rate of GDP growth in the year of the adjustment and the next year was in the top 25% of the OECD. A recessionary period, then, was when a country’s growth rate was in the bottom 75% of the OECD.

Our results were striking: Over nearly 40 years, expansionary adjustments were based mostly on spending cuts, while recessionary adjustments were based mostly on tax increases. And these results would have been even stronger had our definition of an expansionary period been more lenient (extending, for example, to the top 50% of the OECD). In addition, adjustments based on spending cuts were accompanied by longer-lasting reductions in ratios of debt to GDP.

In the same paper we also examined years of large fiscal expansions, defined as increases in the cyclically adjusted deficit by at least 1.5% of GDP. Over 91 such cases, we found that tax cuts were much more expansionary than spending increases.

How can spending cuts be expansionary? First, they signal that tax increases will not occur in the future, or that if they do they will be smaller. A credible plan to reduce government outlays significantly changes expectations of future tax liabilities. This, in turn, shifts people’s behavior. Consumers and especially investors are more willing to spend if they expect that spending and taxes will remain limited over a sustained period of time.

On the other hand, fiscal adjustments based on tax increases reduce consumers’ disposable income and reduce incentives for productivity.

American firms today are profitable and have large unspent resources. But their uncertainty over regulation and taxes discourages them from risk-taking, investment and consumption. In Europe, governments would strengthen the banking sector if they cut spending and reduced their default risk. This, in turn, would ease the flow of credit into the private sector.

The composition of fiscal adjustments is therefore critical. Based on what we know, the U.S. and Europe are currently at greater risk from increased stimulus spending than from gradual but credible spending cuts.

Europe seems to have learned the lessons of the past decades: In fact, all the countries currently adjusting their fiscal policy are focusing on spending cuts, not tax hikes. Yet fiscal policy in the U.S. will sooner or later imply higher taxes if spending is not soon reduced.

The evidence from the last 40 years suggests that spending increases meant to stimulate the economy and tax increases meant to reduce deficits are unlikely to achieve their goals. The opposite combination might.

Mr. Alesina is a professor of political economy at Harvard.