No pain, no gain? Perhaps for some, but not for all
Civitas, 28 February 2011
Today the Cobden Centre blog covered a new research paper by two Harvard Economists, Alberto Alesina and Silvia Ardagna. The paper examined fiscal stimuli and fiscal adjustments, and what factors were correlated with their success.
They worked on the assumption that the decision to carry out a fiscal stimulus, or a fiscal adjustment, was the result of economic considerations, however the form that the stimulus or adjustment would take, would be the result of political and ideological decisions. Motivated by the current state of the global economy, and the fact that many developed countries were considering, or were carrying out, fiscal adjustments and, at least in the case of the US, fiscal stimuli, the authors wanted to see whether historical evidence provided any insights into how best to carry out such action. They find that:
‘Fiscal stimuli based upon tax cuts are more likely to increase growth than those based upon spending increases. As for fiscal adjustments those based upon spending cuts and no tax increases are more likely to reduce deficits and debt over GDP ratios than those based upon tax increases. In addition, adjustments on the spending side rather than on the tax side are less likely to create recessions.’
The result would seem a positive endorsement of the Coalition’s policy of fiscal adjustment primarily based upon spending cuts, rather than tax increases. However, an examination of the paper and the results provides a more nuanced insight into what affects, and what are the effects of, a successful fiscal adjustment.
The authors define a ‘successful’ fiscal adjustment in two separate, but related, ways. Firstly, an adjustment is primarily successful if it manages to reduce the debt to GDP ratio significantly (which the authors define as greater than 4.5 percentage points) in 3 years. Second, an adjustment is considered a success if it results in above-average economic growth (above-average is measured in relation to the level of growth across the G7 countries). The current Government appears determined to cut the debt to GDP ratio and has been criticised for not concentrating enough on growth. The evidence from the study indicates that reductions in spending generally accompany both reductions in debt and increases in economic growth. This could question the assumption, voiced by some, that the Government needs to increase, or at least retain, current levels of spending to stimulate growth.
The report, while providing encouraging evidence for the current Government, does also provide an insight into the process of fiscal adjustment which could be of concern. In particular successful fiscal adjustments, both those that reduce debt and increase growth, see a fall in income taxes as a percentage of GDP, which could indicate a fall in earnings. Conversely, successful fiscal adjustments see an increase in business taxes as a percentage of GDP, perhaps indicating that companies are paying more tax as corporate profits increase. Together these results could indicate that successful fiscal adjustments are accompanied reductions in earnings, while at the same time business profits increase. This could be unpalatable for some and could be a concern for the government.
Although one should always be careful about applying generalizable findings to specific situations, the paper by Alesina and Ardagna could act as both an endorsement and a warning for the current Government. While reductions in spending do seem to be the recommended course of action when attempting fiscal adjustments, such action could see earnings decrease while corporate profits rise. If this happens in the UK, it may be hard for the current Government to make the case that ‘we’re all in this together’.