Government Spending vs. Tax Cuts

Part I: The Opposing Schools

Politicians, commentators, aunts and uncles, and other constituents of my favorite demographic—the questionably qualified—have been telling us we have a spending problem; they assert that we are running up a catastrophic deficit that will compromise the future for our children and send us, inexorably, down the ruinous path towards Greece.

Curiously, few of these commentators have economic backgrounds. Or read economic journals. Or participate in economic forums. Good gov’ner! Where then are these diagnoses about our destructive path, and the prognoses for its reconciliation, coming from! This whirlwind broaches two primary questions.

First, is our deficit actually that dangerous? Will we be able to service our debt obligations, or are we already facing the imminent demise of the full faith and credit of the United States? Second, if our deficit is indeed dangerous and requires immediate and significant action, how do we curtail it?  

We’ll start by looking at question two. Whether its warranted or not, the federal deficit is in the windshield of political discourse; it’s portrayed as the steadily approaching iceberg that will debilitate our economic system. So let’s pretend we’ve looked into question one and found that yes, we need to seriously chip away at our growing national debt. So, how do we do it?

Fiscal policy offers two approaches: We can cut spending and raise taxes. Through these approaches, we could stem the tide of our growing deficit by spending less, and pay down our debt by raising revenue through taxation. But this is complicated by the fact that our economy is still depressed. Cutting spending and raising taxes will curb growth, sending us further into depression. Thus, we are faced with a difficult balancing act: how do we continue to stimulate our economy while paying down our debt?

Harvard professor Christina Romer asserts that both spending cuts and tax hikes will damage our already frail economy. In deciding which fiscal policy measure to employ, we need to ask: “what will hurt more, raising taxes or cutting spending?”  According to Romer, “both tax increases and spending cuts will tend to slow the recovery in the near term, but spending cuts will likely slow it more.” In her view “if federal policy makers do decide to reduce the deficit immediately, reducing spending alone would probably be the most damaging to the recovery. Raising taxes for the wealthy would be least likely to reduce overall demand and raise unemployment.”

Romer cites a number of studies from economic forecasters who “estimate that a tax increase equivalent to 1 percent of the nation’s economic output usually reduces gross domestic product by about 1 percent after 18 months. A spending cut of that size, by contrast, reduces G.D.P. by about 1.5 percent — substantially more.”

Tax cuts can be hoarded, especially in a deflation-prone economy, preventing banks from greasing the wheels of investment. Moreover, financial intermediaries are bogged down with bad mortgages and—skeptical about demand—are hesitant to lend, thereby creating a self-fulfilling prophesy. Government expenditure, on the other hand, is paid directly to firms, leading to a larger and more effective multiplier.

Ultimately, Romer takes a balanced approach to deficit reduction, focusing on a combination of spending cuts and tax increases. She argues that to curb our deficit while simultaneously bolstering the recovery, it is necessary to cut wasteful government consumption and to focus on government investment in basic research, education and infrastructure. For these activities are essential to future productive capacity. Furthermore, Romer is unequivocal about taxation. “Nearly every economist I know agrees that the best way to raise revenue would be to limit tax breaks for households and corporations…the bottom line is that tax increases should be part of any comprehensive budget plan.”

However, her Harvard colleague and fellow economist, Alberto Alesina has a different opinion. Alesina espouses comprehensive cuts in government expenditure, stating that curtailing government spending is the essential ingredient for curbing the deficit and catalyzing 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.”

Citing his research with Silvia Ardagna, Alesina asserts that “over nearly 40 years, expansionary adjustments were based mostly on spending cuts, while recessionary adjustments were based mostly on tax increases.” Moreover, he argues that government spending signals impending tax increases, which will cause investors and consumers to tighten their purses. According to Alesina, “Stimulus spending means that tax increases are coming in the future; such increases will further threaten economic growth.”

According to Alesina, “Europe seems to have learned the lessons of the past decades: In fact, all the countries currently adjusting their fiscal policy are focusing on spending cuts, not tax hikes. 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.”

Romer and Alesina represent the polarized debate among economists and politicians. Europe has tended more towards Alesina, whereas North America has leaned more towards Romer. Part II will bring some more economists into the mix and investigate to what extent our increased deficit spending threatens future growth and prosperity.