Fiscal Policy and Economic Growth

Alberto Alesina has an op-ed in the WSJ today summarizing results from his research on fiscal adjustments:

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.

2 responses to “Fiscal Policy and Economic Growth

  1. Your interesting findings are presumably short-term responses. Over a longer time period a government which cuts taxes will find itself with less income and hence will have to reduce the number of its own employees. Similarly, when the taxes are raised the long-term result is that more government jobs can be met whilst the worker/consumer has less to spend. Consequently, the long-term result of making changes to the amount of taxation is nil.
    Keynesian Theory does not look at the whole picture over sufficient time before supporting your findings, but the “lesson” from Henry Hazlitt’s “Economics in One Lesson” (in 1946) is directly opposed to this conclusion.
    Could you not extend the time period over which your studies are being made so as to present a better explanation of what actually occurs?

  2. This article originally appeared in the Washington Post along with a whole series of comments. Most of these were in opposion to the claim that reduced taxation is beneficial to the overall macroeconomy. I agree, they do not affect the long-term progress. Which raises the interesting question as to what really does? (P.S. I know the answer, do you?)

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