There’s A Smart Way And A Dumb Way To Cut The Federal Debt


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At last check, President Obama is offering $1.3 trillion in revenue increases and $930 billion in spending cuts, not including saved interest expense, in his fiscal cliff negotiations with House Speaker Boehner.To the president, this is a “balanced” offer.

But he’s going it all wrong. What needs to be balanced is not tax hikes and spending cuts, but debt vs. growth.

You want to cut the debt in a way that does the least possible damage to economic growth in the short term.

Economist Alberto Alesina:

In 2011, the IMF identified episodes from 1980 to 2005 in which 17 developed countries had aggressively reduced deficits. The IMF classified each episode as either ‘expenditure-based’ or ‘tax-based’, depending on whether the government had mainly cut spending or hiked taxes.

When Carlo Favero, Francesco Giavazzi, and I studied the results (2012), it turned out that the two kinds of deficit reduction had starkly different effects; cutting spending resulted in very small, short-lived recessions (if any), and raising taxes resulted in prolonged recessions.

Why did austerity heavy on spending cuts outperform austerity heavy on tax hikes? One reason is that private investment rose after spending-cut deficit reduction but dropped after the tax-hike deficit reductions.

Alesina speculates that “when governments cut spending, they may signal that tax rates won’t have to rise in the future, thus spurring investors (and possibly consumers) to be more active.”

A second reason is that that governments combined spending cuts with pro-growth measures such as “deregulation, the liberalization of labour markets, and tax reforms that increase labour participation.”

I would also add that easy monetary policy can help no matter which course of austerity is chosen. Given the Fed’s evolving stance on quantitative easing, even Obama’s tax-hike austerity might not be as harmful as it would be otherwise. But it could be less painful by easing up on the tax hikes, particularly those on capital income.