How Do Spending Cuts Affect an Economic Recovery?

September 4, 2012

Many Organization for Economic Cooperation and Development (OECD) countries will have to reduce their public debts in near future.  As a result, many policy debates are centered on how best to accomplish this. Reducing deficits and government debt (labeled as fiscal adjustments) have been known to cause large output losses. But it may seem that fiscal adjustments based upon spending cuts are much less costly in terms of output losses than tax-based ones, according to researchers Alberto Alesina, Carlo Favero and Francesco Giavazzi.

Alesina, Favero and Giavazzi study the overall effect of fiscal consolidations on the economy rather than the effects of individual shifts in taxes and spending as most other studies do. By studying the combination of tax increases and spending cuts, policymakers have a better estimate of tax and spending multipliers.

Alesina, Favero and Giavazzi find that it matters greatly how the consolidation occurs.

  • Spending-based adjustments are followed by mild, short-lived recessions and in many cases no recession at all.
  • Furthermore, these adjustments have less of an impact on output losses.
  • Yet tax-based adjustments create deep and prolonged recessions.
  • The difference is explained by the asymmetrical response of private investment into the economy based on the two different approaches.
  • In addition, business confidence picks up immediately after spending-based adjustments.

Source: Alberto Alesina, Carlo Favero and Francesco Giavazzi, "The Output Effect of Fiscal Consolidations," National Bureau of Economic Research, August 2012.

 

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