Tax hikes are not the only thing that makes fiscal consolidation work

Interest rates are predicted to go down as inflation goes down, but the Congressional Budget Office (CBO) says that the government's interest costs will almost double over the next ten years, reaching 3.6% of GDP in 2033.

The current interest rate is the highest as a percentage of income since 1996. By next year, interest costs alone are expected to be higher than the total defense budget. Because of the dangers of rising interest rates, lawmakers need to cut deficits and at least keep debt stable.

It's too bad that the current argument is mostly about raising taxes on income to cut down on deficits. It might be harder for the U.S. government to pay its bills if income taxes go up because they will hurt economic growth. There will be some tax hikes as a result of any economic consolidation, but some taxes are worse than others. This finding is supported by both our modeling of different ways to bring in more money and the large body of empirical research that looks at fiscal consolidations around the world. In earlier blog posts, we looked at some of the literature that was out there. It's also worth looking at case studies of countries that have lowered their debt, both successfully and unsuccessfully.

View from Above: Ingredients of Successful Fiscal Consolidations

As we’ve written before here:

Tax-based deficit reductions tend to have a more negative impact on the economy and less successful track record than spending-based ones. The difference is primarily due to the response of private investment, as business confidence falls to a greater degree and for a much longer duration after tax-based plans.
Overall, successful fiscal adjustments primarily cut spending and modestly increase taxes. A rough guideline for an expenditure-based plan is for at least 60 percent of its savings to come from spending cuts and 40 percent or less from revenues.

And here:

Further, other economists have concluded that fiscal consolidations based on spending cuts have had fewer negative effects on GDP than tax increases.
Looking at 16 OECD countries over a 30-year period, Alberto Alesina and his coauthors found that, on average, spending cuts were associated with mild recessions and in some cases no downturns at all, while almost all fiscal reforms based on tax increases were followed by “prolonged and deep recessions.”
In a study of 17 OECD countries over a 30-year period, Norman Gemmell and other academics showed that reducing deficits by raising distortionary taxes, such as income taxes, consistently reduced economic growth, while raising less distortionary taxes, such as consumption taxes, was more growth-enhancing.


Under the Hood: Case Studies of Successful Fiscal Consolidations

Looking at individual countries specifically offers additional insight into fiscal reforms that worked and those that did not. The examples below are drawn from a paper by economists at the European Central Bank, and they reveal that successful fiscal reforms largely rely on spending reductions and modestly rely on certain types of tax increases, while less successful reforms largely rely on income tax hikes.


In 1982, Ireland's inflation hit 17%, its deficit was more than 15% of its GDP, and its debt-to-GDP ratio reached almost 85%. In the 1980s and 1990s, Ireland went through two big changes because of its budget problems and persistently low GDP growth.

In the early 1980s, Ireland picked a mix of reforms to both spending and income. But by 1986, its debt had grown even more and was now equal to 113% of its GDP. Ireland then started cutting back on spending, which included lowering the number of government workers and their pay, stopping new hires, and cutting back on handouts and social welfare payments. In the first part, primary spending dropped by 12% of GDP. Ireland's economy stopped stagnating because of changes that went on until the end of the decade. These reforms also led to big budget surpluses and smaller public debt.

In 1994, Ireland's second round of changes put more limits on spending that people didn't have to pay for. The deficit was gone by 1996, and the debt was less than 40% of GDP by 2000. Specifically, Ireland's better financial situation gave it the fiscal room to lower taxes that hurt the economy, like income and business taxes. Starting in 1996, Ireland slowly lowered its company tax rate. Over the next 10 years, it also lowered the tax wedge on labor from 43% to 35%. Because of the changes, the real GDP grew by an average of 7.4 percent from 1992 to 1999.


Sweden also made a good set of changes to its finances in the 1990s, when unemployment, inflation, and deficits of more than 10% of GDP were all on the rise. From 1993 to 2000, the country had to make big cuts to its public spending, which dropped by almost sixteen percent of its GDP. The changes were mostly made to transfers, pensions, and government jobs. For instance, over a seven-year time, transfers and subsidies fell from 27% of GDP to 19% of GDP. A special committee suggested that Sweden's budget process should be changed by making it more like other countries'. This is what happened.

Sweden made big cuts to public spending (almost 16 percent of GDP) while also bringing in a little more money (0.81 percent of GDP). Sweden's higher tax revenues, on the other hand, came from a carbon tax and tax reforms that lowered individual income tax rates to even out the tax system. Sweden's deficits and debt were cut down by the spending-based reforms, which were also followed by a quick rise in economic growth. In just seven years, their cyclically adjusted primary balance (CAPB), which is the deficit that doesn't include interest, got better to 9.2 percent, and real GDP growth averaged 6.3 percent during that time.


In the early 1990s, when the economy was bad, Canada tried to lower its debt-to-GDP ratio, which had grown to more than 100% of GDP and had deficits of more than 9% of GDP.

Starting in 1993, Canada worked on a fiscal adjustment that was mostly based on spending cuts. During the rest of the decade, total spending fell by 11% of GDP. Cutting back on government salaries and staffing was responsible for almost half of the change. In the other half, transfers were cut, and some programs were turned into "block grants" for provinces. Also, some state-owned businesses, like the air traffic control system, were partly privatized. Canada's legislature also put limits on government spending to make sure that spending would not rise too quickly over the next ten years.

Like Ireland and Sweden, Canada was able to lower personal income taxes while increasing the size of the tax base, which made the total tax burden lower. This was done by balancing the budget by cutting spending. Over the decade, revenues fell by 0.3% of GDP. The spending and tax changes had a cumulative effect of resuming economic growth, which averaged 4.7% during this time.

Lessons from Europe following the Global Financial Crisis

In the 1980s and 1990s, there were many more successful expenditure-based budget consolidations. But it's also important to look at examples of fiscal consolidations that didn't work as well because they depended too much on tax increases and didn't keep their promises to cut government spending over time.

After the 2008 global financial crisis, a lot of European countries had big problems with their debt. At the time, most people thought that "austerity" policies, like raising taxes and cutting spending, would make these countries' recessions worse. The story is only partly true, though. When you look more closely, you can see that these countries did have slow growth after the crisis, but that was mostly because they had to raise taxes to pay off their debt.

At first, as an economic stimulus, many European countries raised their spending. It wasn't until 2010 that most of these countries started to focus on cutting their spending. At that time, 19 of the 27 countries in the European Union raised their value-added taxes (VATs) by an average of 2.7 percentage points from 2007 to 2014. People think that value-added taxes (VATs) are one of the least damaging ways to bring in money, but when taxes went up a lot, spending usually went down by only a small amount. In fact, the cuts in spending usually only undid half of the earlier increases in government spending. In fact, some countries that raised their VATs actually spent more during this time.

Some of these countries also raised taxes on income. Seven European countries that are having trouble with their sovereign debt have raised the top tax rate on private income by between 6 and 11 percentage points. Some of these were Portugal, Spain, and Greece, whose economies were some of the fastest during this time. These countries also cut spending, and Portugal in particular did get back on its feet, but tax hikes made up a bigger part of their fiscal adjustments than those made by countries like the UK and Ireland, which mostly focused on cutting spending and had shorter downturns as a result. Many of Greece's pension changes were undone, and the country still has some of the highest debts in the world. This puts it at risk.

Overall, past examples of successful fiscal consolidations show that they should be slow and focused on spending, while taking into account how different policies will affect growth. International experience shows that if tax hikes are part of a package, they should be aimed at increasing consumption taxes, streamlining tax expenditures, and expanding the tax base, not income taxes. As important as it is for U.S. lawmakers to deal with deficits and interest rates that are growing too quickly, it is just as important for them to avoid tax increases that hurt economic growth the most.
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