Taxes destroys business confidence AND cause deeper recessions.

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.

Another set of explanations relates to the supply side of the economy, which reacts very differently to tax hikes and spending cuts. The persistence of the fiscal policy change is also crucial to any austerity plan and works in opposite directions depending on the type of plan. We found that a tax-based plan that lasts longer produces a deeper recession. One explanation is that without a reduction in spending, tax hikes must be long-lasting, producing long-lasting negative effects—for instance, on labor supply and investment—because of higher distortionary taxes. In contrast, a longer-lasting spending cut produces a milder recession because it signals that sooner or later it will be possible to cut taxes and the associated distortions.