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The Best Path for Shrinking Deficits: Cut Spending

Thursday December 22nd, 2016   •   Posted by Craig Eyermann at 6:27am PST   •  

spendingcut “Is it the ‘how’ or the ‘when’ that matters in fiscal adjustments?”

That’s the title of a new paper by a team of five economists that really answers a different question: What is the best way for a government to reduce its budgetary red ink, when the alternatives are to raise taxes, cut spending, or do some combination of both?

To answer that question, the paper’s authors examined data from 16 countries from 1981 through 2014, taking into account the unique economic conditions that applied for each country. Dan Mitchell summarizes the results of their analysis:

The economists crunched the numbers and found that tax increases impose considerable damage, whereas spending cuts cause very little harm to short-run performance.

We find that the composition of fiscal adjustments is more important than the state of the cycle in determining their effect on output. Fiscal adjustments based upon spending cuts are much less costly in terms of short run output losses – such losses are in fact on average close to zero – than those based upon tax increases which are associated with large and prolonged recessions regardless of whether the adjustment starts in a recession or not…. what matters for the short run output cost of fiscal consolidations is the composition of the adjustment. Tax-based adjustments are costly in terms of output losses. Expenditure-based ones have on average very low costs.

These findings are remarkable. Even I’m willing to accept that spending cuts may be painful in the short run (not because of Keynesian reasons, but simply because resources don’t instantaneously get reallocated to more productive uses).

So if the economists who wrote this comprehensive study find that there is very little short-run dislocation associated with spending cuts, that’s powerful evidence.

And when you then consider all the data and research showing the positive long-run effects of smaller government, this certainly suggests that the top fiscal priority should be shrinking the size and scope of government.

Shrinking the government through significant spending cuts is a promise that many politicians make, but few ever try to keep. Too often, the promise is broken because the politicians prove to be unwilling to face up to the loud cries and political influence of the few who benefit the most from the continuation of high government expenditures: special interests who are often also the politicians’ biggest campaign contributors.

Nevertheless, if politicians need to stop burdening the people with excessive national debt, the latest economic research indicates that cutting government spending should be the preferred path to putting their country’s fiscal house in order.

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December 2016