Economics, Pethokoukis

There’s a smart way to cut debt, and there’s a dumb way to cut debt. Guess which one the U.S. is doing

At last check, President Obama is offering $1.3 trillion in revenue increases and $930 billion in spending cuts, not including saved interest expense, in his fiscal cliff negotiations with House Speaker Boehner. To the president, this is a “balanced” offer.

But he’s going it all wrong. What needs to be balanced is not tax hikes and spending cuts, but debt vs. growth. You want to cut the debt in a way that does the least possible damage to economic growth in the short term. Economist Alberto Alesina:

In 2011, the IMF identified episodes from 1980 to 2005 in which 17 developed countries had aggressively reduced deficits. The IMF classified each episode as either ‘expenditure-based’ or ‘tax-based’, depending on whether the government had mainly cut spending or hiked taxes. When Carlo Favero, Francesco Giavazzi, and I studied the results (2012), it turned out that the two kinds of deficit reduction had starkly different effects; cutting spending resulted in very small, short-lived recessions (if any), and raising taxes resulted in prolonged recessions.

Why did austerity heavy on spending cuts outperform austerity heavy on tax hikes? One reason is that private investment rose after spending-cut deficit reduction but dropped after the tax-hike deficit reductions. Alesina speculates that “when governments cut spending, they may signal that tax rates won’t have to rise in the future, thus spurring investors (and possibly consumers) to be more active.”

A second reason is that that governments combined spending cuts with pro-growth measures such as “deregulation, the liberalization of labor markets, and tax reforms that increase labor participation.”

I would also add that easy monetary policy can help no matter which course of austerity is chosen. Given the Fed’s evolving stance on quantitative easing, even Obama’s tax-hike austerity might not be as harmful as it would be otherwise. But it could be less painful by easing up on the tax hikes, particularly those on capital income.

One thought on “There’s a smart way to cut debt, and there’s a dumb way to cut debt. Guess which one the U.S. is doing

  1. Once again, the uncontrolled variables are what kind of recession and what kind of country. In the U.S. the lowest effective federal tax rates since the 1950s are not rebooting the economy. Does anyone believe that more of the same or yet lower rates will help?

    The second part, busted bubbles, is more prevalent, as in Mexico in 1994 and Russia, Indonesia and Thailand in 1999, and Greece and Spain in 2006.

    But none of those countries is the US; the IMF is not calling, and creditors and investors are not pulling out. The lone comparable is Japan in 1991, and it is an ugly one because Japan still struggles 20 years later. Japan’s mistake was to allow deflation to linger and to encourage an attitude that says ‘hey, no worries. It will be cheaper next month.’

    So how does it help to lay off federal workers, trim Social Security and retrench Medicare AT THIS MOMENT? And the question here is timing rather than need. I have a very recent authority here: http://www.aei.org/article/economics/fiscal-policy/inflation-is-better-than-deflation/

    Yes, tax hikes are a mistake as well, although perhaps an unavoidable one given the trip to the woodshed that Shiite Rs so richly deserve. There’s room here to lighten the blow on the other side. Entitlements are by definition a problem of the future, and Rs have considerable skill at manipulating CBO scores. The lesson of Japan is that it is not us and them. It is just us.

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