Spending cuts, not tax hikes, best way to tackle deficits
More than six years after the recession of 2008-09, budget deficits remain an ongoing fiscal policy issue in Canada. Eight out of 10 provinces (including Alberta, which released its budget yesterday) are currently in deficit, and the newly formed federal government has committed to falling back into deficit.
However, deficit elimination is important for a variety of reasons. For instance, it gives governments the room they need to improve tax competiveness.
There are fundamentally three ways governments can try to eliminate their deficits: further tax hikes, spending cuts, or some combination of both. But which approach imposes the least damage to the economy?
Two prominent fiscal policy experts—Harvard professor Alberto Alesina and Bocconi University professor Francesco Giavazzi—recently penned an article for the National Bureau of Economic Research (NBER) summarizing the latest research on so-called “fiscal austerity.” The insights are relevant for Canada.
Prof. Alesina co-authored many of the referenced studies. To evaluate which deficit elimination approach is the least damaging to the economy, Alesina and his colleagues distinguish between “tax-based” fiscal plans that predominantly rely on tax increases and “expenditure-based” fiscal plans that rely mostly on spending cuts. In three separate studies, they examine the impact of fiscal plans in several countries over different periods.
In one study, they estimate that in 14 countries (including Canada) over the period 1981 to 2007, the average tax-based fiscal plan with an initial size of one per cent of GDP led to a contraction of GDP by two to three per cent in the following three years. By contrast, the impact of an expenditure-based plan on GDP was not statistically significant.
Alesina and Giavazzi describe the main findings as showing that “fiscal adjustments based upon cuts in spending are much less costly, in terms of [economic] output losses, than those based upon tax increases.”
In another study, professor Alesina and his co-authors estimate the impact of more recent fiscal plans, from 2010 to 2013, in 12 countries. They again find that tax-based plans are more economically damaging. For example, they argue that the recession experienced in Italy from 2011 to 2012 (around a two per cent drop in GDP in each year) can be explained by the country’s tax-based fiscal plan implemented from 2010 to 2013. Expenditure-based plans in the United Kingdom and Denmark were associated with “much milder recessions.”
Alesina and his colleagues dig even deeper in a more recent study, in part by dividing spending cuts into two categories: cuts in transfers to individuals and organizations, and cuts in government consumption and investment. Government consumption includes spending on paying government workers and other costs related to managing government services. Government investment spending is defined as expenditures made with the expectation of having a positive return and includes capital spending on infrastructure.
The authors find that while spending cuts to government transfers are generally less harmful to the economy than tax increases, they are relatively more harmful than cuts to government consumption and investment spending. In other words, the least costly way to eliminate a deficit is to cut back on the cost of government services and government investment spending.
Overall, the evidence summarized by professors Aleisna and Giavazzi suggests the best way for Canadian governments to eliminate deficits is by cutting spending.
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