Paul L. Caron
Dean


Wednesday, September 15, 2010

Alesina: Spending and Tax Cuts, Not Spending Increases, Drive Economic Recovery

Wall Street Journal op-ed, Tax Cuts vs. 'Stimulus': The Evidence Is In, by Alberto Alesina (Harvard University, Department of Economics):

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. ...

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 [Large Changes in Fiscal Policy: Taxes Versus Spending], 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 OECD countries between 1970 and 2007. ...

Over nearly 40 years, expansionary adjustments were based mostly on spending cuts, while recessionary adjustments were based mostly on tax increases. ...

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

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.

https://taxprof.typepad.com/taxprof_blog/2010/09/alesina-spending-and-tax-cuts-not-spending-increases-drive-economic-recovery-.html

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