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What is the best way to reduce a government’s budget deficit?
A new working paper by European Central Bank economist Maria Grazia Attinasi and International Monetary Fund economist Alexander Klemm once again confirms what we’ve long argued: when it comes to preserving the prospects for economic growth, cutting government spending is a much more effective way to go about reducing a government’s budget deficit than is increasing taxes.
Attinasi and Klemm came to that conclusion after reviewing the impact of discretionary fiscal policy on the economic growth of 18 countries in the European Union over the years from 1998 through 2011, finding that “expenditure-based adjustments” (spending cuts) are much less harmful to economic growth than “revenue-based adjustments” (tax hikes). In particular, they found that indirect tax increases, such as those associated with excise taxes and the kind of Value Added Tax that is levied in most E.U. nations against consumer goods and services, have a “particularly strong negative impact” upon economic growth when nations are experiencing recessionary conditions.
But their findings go well beyond that basic insight. They also found that although cutting government spending can have a small negative impact on economic growth in the short term (less than one year), it has a minimal impact at longer terms and that front-loading spending cuts is much less harmful than dragging them out over longer periods of time.
What’s more interesting is that they found that most of the negative impact of government spending cuts in the short term has to do with cuts to programs that involve investments in things like public infrastructure. Other types of government spending cuts, such as cuts in government subsidies that support consumption and the compensation of public employees, turned out to have no statistically significant impact upon economic growth.
What that means is that these two things, government subsidies and public employee compensation, are the first two things that should be cut when reducing a government’s budget deficit is necessary, because they are nearly free of pain where the nation’s economy and economic growth prospects are concerned.
Eighteen nations in the European Union have taken more than a decade to learn that lesson, backed by science, the hard way. And still, the leaders of some of those nations haven’t learned from the sad examples of their neighbors’ experiences and are still far from becoming illuminated, even as their neighbors recover from their mistakes.
Much less across the Atlantic Ocean, where economic growth forecasts for 2014 are now being slashed because those important lessons are continuing to be denied.