Do Revenues Need to be Part of the Debt Solution?

“You can’t reduce the deficit to the levels that it needs to be reduced without having some revenues in the mix.”

So said President Obama in his press conference yesterday. Is the President correct?

We are not the first nation to wrestle with unsustainable debts. And fortunately for us, we can learn from the measures that others have taken. That is why the work of Harvard’s Alberto Alesina and Silvia Ardagna is so important. Examining 37 years of data from 21 similarly-situated nations (fellow members of the OECD) they identified 107 episodes of “fiscal adjustment” (basically efforts to get debt levels under control).  They then broke these down according to how successful they were (did they manage to rein in the debt?) and how they impacted the economy (did they cause the economy to expand or to contract?). 

Let’s first look at the instances in which austerity worked. As shown by the two left bars in the graph below, in cases where austerity actually succeeded in reducing debts, spending as a share of GDP fell by about 2 percentage points while revenue also fell by half a percentage point. In other words, contrary to the President’s assertion, successful austerity does not seem to require a revenue increase. Contrast this with the instances in which austerity failed to reduce debts. This is shown by the two right bars below. Among the instances in which austerity didn’t work, the spending reductions were more modest (only .8 percentage point reduction) and revenue increased—rather substantially (1.41 percent of GDP). 

Alesina and Ardagna also looked at what happened to the economy after austerity. Sometimes it expanded rapidly; sometimes it didn’t. The results of their analysis is below. Among the instances in which austerity was followed by significant economic growth, spending had been reduced by about 2.19 percentage points as a share of GDP while revenue had only been raised 0.34 percentage points. Meanwhile, among the instances in which austerity was not followed by significant growth, spending was reduced much less (0.7 percent of GDP) and revenue was increased much more (1.2 percent of GDP). 

 

 I should make one more point. Republicans sometimes use the phrase “cut and grow” to imply that spending reductions will give the economy a lift. I think this overstates the case. As Alesina put it in his Mercatus Working Paper (p. 5):

Fiscal adjustments (reductions) on the spending side are almost as likely to be associated with high growth (i.e. a successful episode) as fiscal expansions on the spending side.

In other words, spending cuts are about as likely as spending increases to lead to rapid growth. Readers of this blog probably know that spending increases typically don’t lead to large and sustainable growth spurts. So we shouldn’t cut spending because we think it will make the economy grow. We should cut spending because it is mathematically impossible for government to constantly outpace the growth of the private sector on which it depends. And as Herbert Stein famously remarked, something that can’t go on forever, won’t.