Tax increases wreck business confidence

Our second finding is that reductions in entitlement programs and other government transfers were less harmful to growth than tax increases. Such cuts were accompanied by mild and short-lived economic downturns, probably because taxpayers perceived them as permanent and so expected that the taxes needed to fund the programs would be lower in the future. Thus, the data suggest that reforms of social security rules aimed at reducing government spending are more like normal spending cuts than tax increases. Because social security reforms tend to be persistent, especially in countries with aging populations, they entail some of the smallest costs in terms of lost output. Private investment also responded very differently to the two types of austerity plans—positively to spending-based plans and negatively to tax-based plans. Business confidence behaved consistently with private investment. On the other hand, household consumption and net exports (the difference between exports and imports) did not appear to differ on average during the two types of adjustments. What about recent episodes of austerity that occurred after the crisis and started during a recession? Although the sheer size of some of these austerity plans was exceptional—not only in Greece but also in Ireland, Portugal, and Spain and to a lesser extent in Italy and the United Kingdom—the outcomes did not differ significantly from those of previous episodes. Countries that chose tax-based austerity suffered deeper recessions than those that chose to cut spending. Among the latter are Ireland, despite a massive bank bailout program, and the United Kingdom, whose economic performance was much stronger than the IMF had predicted. The UK plan consisted almost completely of spending cuts. These included cuts in government consumption and public investment; reductions in transfers, including more restrictive policies on employers’ pension contributions; support allowances; and public service pensions. Spending cuts (planned or immediately implemented) between 2010 and 2014 amounted to 2.9 percent of GDP—about 0.6 percent a year on average. Of all these measures, 87 percent were implemented within this five-year interval, with the rest deferred. The result: growth in the United Kingdom was higher than the European average. Investment growth recovered from the 21 percent drop of 2009 and increased almost 6 percent in 2010. Possible explanations There are at least three possible explanations for these striking results. One is that the difference between tax- and spending-based plans is due to a difference in accompanying policies. The most obvious candidate is monetary policy. Guajardo, Leigh, and Pescatori (2014) argue that differences in the response of monetary policy are largely responsible for the different effects of the tax- and spending-based corrections they analyzed. We, however, find only a small fraction of the difference to be related to monetary policy. A second possibility relates to the behavior of the exchange rate. A fiscal correction could be less harmful if preceded by a currency devaluation, which would make exports more competitive and support growth. We find that this was not the case: there was no systematic difference in the behavior of the exchange rate before the two types of fiscal adjustment. If the exchange rate had been a significant factor, then the difference between the two cases in terms of GDP growth should have been associated with higher growth of net exports following a devaluation, independently of the type of fiscal plan adopted. This was not the case. As mentioned above, the driving force was domestic private investment. Finally, large fiscal adjustments are often periods of deep structural reforms, which may include the liberalization of product and/or labor markets. If these were systematically occurring at the time of spending cuts, they might explain our finding. But in fact, these reforms did not occur systematically during periods of spending cuts. A more promising explanation points to the role of confidence and expectations. Imagine an economy on an unsustainable path with exploding public debt. Rising interest rates in countries with high debt may generate exactly this scenario. Sooner or later fiscal stabilization must occur. The longer the delay, the more taxes must be raised (or spending cut) in the future. Stabilization, when it occurs, removes uncertainty about further delays that would have increased the costs even more. Blanchard (1990) provides a simple model that illustrates this point. Stabilization that eliminates uncertainty about higher fiscal costs in the future stimulates demand today—especially from investors, who are more sensitive to uncertainty given the long-term nature of their plans. In their models, Blanchard (1990) and Alesina and Drazen (1991) do not distinguish between stabilization on the tax and the spending side. However, it is quite likely that the benefits of removing uncertainty are more likely to occur with spending-based, rather than tax-based, austerity plans. A tax-based plan that does not address the automatic growth of entitlements and other programs over time is much less likely to produce a long-lasting effect on the budget. If the plan doesn’t address automatic spending increases, taxes must be continually raised to cover the additional outlays. So the confidence effect is likely to be much smaller for tax-based plans, because of rising expectations of future taxes. Spending-based plans, on the other hand, produce the opposite effects. Our finding for the response of business confidence to austerity supports this view. Business confidence increases immediately at the start of a spending-based austerity plan, in contrast to what happens at the beginning of a tax-based plan.