A few days ago, the president announced that he would be holding firm on his demand for $1.6 trillion in new tax revenue from the rich as part of any deal he would make to address the "fiscal cliff" and our debt problem. In theory, the president promises some spending cuts. That's what he calls the "balanced approach," and it is a recipe for disaster because it will both fail to address our debt problem and hurt the economy.
Over the years, many economists have looked at what other countries facing our current debt problems have done. A review of the academic literature on this issue shows that successful debt reduction measures are mostly made of spending cuts rather than a mix of spending cuts and tax increases. For instance, in a new paper, “The Design of Fiscal Adjustments,” Harvard economists Alberto Alesina and Silvia Ardagna provide yet new more evidence that fiscal consolidation based mostly on the spending side are more likely to lead to a permanent and long-lasting reduction in debt-to-GDP.
Second, successful reforms cut in two areas: social transfers (entitlements in the American context) and the size and pay of the government workforce. If you think about it, this makes sense. These are the types of spending cuts that prove a country is serious about getting its fiscal house in order, because they take on two of the biggest special interests in any country -- government employees and seniors.
As Kevin Hassett and Andrew Biggs of the American Enterprise Institute have shown, a staggering eight of every 10 attempts by countries to reduce their debt-to-GDP ratios are failures. This means that even in a time of crisis (or especially in a time of crisis), lawmakers prefer politics over solid, pro-growth policy. Countries experiencing fiscal trouble generally get there through years of catering to interest groups and constituencies that favor spending (on both sides of the political aisle), and their fiscal adjustments tend to make too many of these same mistakes. The United States seems poised to do the same.
What is the impact of spending cuts or tax increases on the economy? First, agreement among economists on the impact of budget cuts on growth is far from being settled. However, a few lessons have emerged. Fiscal adjustments achieved through spending cuts rather than tax increases are less recessionary than those achieved through tax increases. Alesina and Ardagna's research also reveals that private investment tends to react more positively to spending-based adjustments. Thus, they argue that spending cuts are more sustainable and effective in reducing debt and raising economic growth; thus expansionary fiscal policy becomes possible again.
Second, tax cuts are more expansionary than spending increases in the case of a fiscal stimulus. The work of former Obama Council of Economic Advisers Chairwoman Christina Romer and her economist husband, David Romer, shows, for instance, that increasing taxes by 1 percent of GDP for deficit-reduction purposes leads to a 3 percent reduction in GDP. Third, research from the International Monetary Fund in particular finds that fiscal adjustment based mostly on tax increases will hurt the economy the most.
The bottom line is that Obama's "balanced approach" more closely resembles the historic failures -- the fiscal adjustments that don't successfully reduce a nation's debt-to-GDP ratio. What's more, history reveals that the balanced approach generally results in tax increases but rarely delivers on the spending cuts. That's unfortunate, considering that if the government could actually collect $1.6 trillion over 10 years from tax increases, this amount still wouldn't be enough to fill in the projected $6 trillion cumulative deficit over the period.
Moreover, as Obama himself once said, a tax increase will likely hurt the economy -- and hence should be avoided, especially in this weak economy.
Here's to hoping that Congress will give spending cuts a chance.