There’s an interesting new paper out by Alberto Alesina, Carlo Favero and Francesco Giavazzi, who examine the effects of fiscal consolidation on output.
Here’s their conclusion:
“We find that it matters crucially how the fiscal correction occurs. Adjustments based upon spending cuts are much less costly in terms of output losses than tax-based ones. Spending-based adjustments have been associated with mild and short-lived recessions, in many cases with no recession at all. Tax-based adjustments have been associated with prolonged and deep recessions. The difference cannot be explained by different monetary policies during the two types of adjustments.”
At first sight this seems supportive of the Chancellor George Osborne’s deficit reduction plan. Remember, when the plan was first put together, we were promised that 80% of the consolidation would come from spending restraint and 20% from tax rises.
However, when you look at the detail of what the rest of the paper says, it is far less supportive of what the Chancellor has actually done so far. As our paper this week explained, current expenditure has continued to rise in real terms, and the lack of cuts to it have meant that as a proportion of GDP it has barely fallen. In contrast, there have been significant front-loaded increases in the tax burden (VAT, CGT, stamp duty etc) and significant cuts to government investment spending.
The paper states clearly that:
“the expansionary spending-based adjustments are those in which current spending, rather than public investment is reduced”.
Finally, the paper explains how the most effective adjustments are those accompanied by a pro-market reform agenda:
“what makes successful spending-based adjustments different from recessionary tax-based adjustments is not monetary policy but a more general "pro-reform" stance of the government, on the supply side as well as on the spending side.”
In contrast to what Janan Ganesh wrote for the FT this week, this appears to show that the Tory right’s critique of the Chancellor’s economic policy has been broadly right. Cuts to government expenditure should have preceded economically damaging hikes to taxation, and the Chancellor needs an accompanying bold, radical supply-side agenda to both inject confidence that he is serious about growth, and to liberate the private sector to deliver the much-needed recovery.
It also suggests the Labour party’s policies for the economy are misguided. Not only were the investment spending cuts we are currently seeing inherited from the Labour plans, but they seem to think that it is ‘spending cuts’, presumably beyond what they would have done, which have caused the recession. In addition, they barely mention the economically damaging effect of taxation or the need for supply-side reforms. Ed Miliband has even stated on occasion that he would shift the balance of deficit reduction in favour yet more taxation.