Higher taxes are not the right way to achieve a balanced budget

Most countries of Western Europe used various types of austerity programs aimed at reducing the budget deficit in order to get out of economic trouble. Professor Alberto Alesina, an economist from Harvard University, examined which of these measures worked best.

CE Financial Observer: What exactly does the famous “austerity” mean? Usually they are called „savings programs”, „budget cuts”, or „budget balancing”.

Alberto Alesina: To put it simply, austerity is a policy of reducing the budget deficit and, as a result, reducing the increase in public debt. This effect can be achieved in two ways: by raising taxes or by reducing spending. Often this objective is achieved using a hybrid of these two solutions.

Many left-leaning economists argue that in recent years this reduction has been too harsh, which delayed the economic recovery in several countries. More market-oriented economists argue that these were in reality only cosmetic changes which had no major impact on GDP growth. Who is right?

In one of the publications, together with my colleagues, we have analyzed the effects of up to 3,500 budget balancing measures of various types that were implemented in the years 1978-2014 in 16 OECD member states. I understand, however, that you want to talk about the period after the last economic crisis. In this case, there is no doubt that many countries have introduced genuine, far-reaching deficit reduction programs. These include, among others, Portugal, Spain, the United Kingdom, Ireland, Greece, and Italy. I don’t know the situation in Central and Southeast Europe, but in Western Europe austerity was a popular anti-crisis remedy. And it is true that a dispute has arisen, with some people asking whether these policies weren’t excessively harsh. Some have even claimed, that had it not been for these policies, the crisis would have been staved off faster. These voices are coming from various Keynesian schools, convinced that deficits should be increased during times of crisis, because that is supposed to stimulate economic growth. However, it seems to me that they have no evidence confirming that such stimulation was possible during the last public debt crisis in Europe.

Has Keynesianism been falsified?

This is not the point. There are times when you can stimulate the economy, and there are other times when you shouldn’t do it. However, even the most extreme supporters of Keynesianism will not say that a policy of budget deficits should be maintained constantly. A common view in this economic school is that it is acceptable and advisable to stimulate the economy during a recession, and that in times of prosperity it is better to maintain a budget surplus, i.e. save money. Either way, any economic policy should be adapted to the relevant time context and the specific circumstances. For example, if you are already exhausting the available anti-crisis monetary policy tools, you can reach for a fiscal stimulus, but only if it is safe for the budget, that is, if there is no danger that the markets will no longer provide you with financing. Because of that, it seems to me that during the financial crisis of 2008, the policy of stimulating the economy, pursued by George Bush and then by Barack Obama, was justified, although I would have preferred if they stimulated the economy through a reduction of taxes rather than an increase in spending. But the United States could afford to pursue the latter policy, because it was not facing the threat of a budget crisis. The markets still considered it to be a reliable borrower.

I understand that the United States can get away with more than Europe?

Few European countries affected by the crisis had a credit situation as stable as the US. Therefore, if they decided in Europe that instead of introducing austerity they would be increasing deficits, it would be more difficult to finance this new debt on the market. The governments would be forced to introduce large tax hikes, which in turn would trigger recessions. Meanwhile, our research shows that in view of the events of the past 8 years, the policy of austerity has had a positive effect on economic growth. This could mean that people who claim that austerity has saved Europe from a domino effect during the debt crisis are in fact right. In such a scenario subsequent countries would become insolvent due to the increasing deficits, banks would collapse and we would enter the next stage of the crisis, that is, a more serious and a deeper recession. Of course, it is not entirely certain that this would happen. This is merely a substantiated conjecture.

Could we therefore say that the reduction of the deficit during the crisis has gained economic justification?

There is evidence that it is beneficial. Now we have to reflect on how to pursue such deficit reductions. It is known that both excessive and sudden cuts in public spending, as well as excessive tax increases, can lead to a recession. After all, there are studies demonstrating the negative impact that each additional 1 per cent increase in budget revenues has on GDP growth.

Fortunately, we are now closer to solving this dilemma. The fiscal multiplier, that is the economic effect that changes in particular fiscal policies have on GDP, is lower in the case of expenditure reductions than in the case of tax increases.

This means that the government is hurting GDP statistics less by reducing spending than by raising taxes?

That’s right.

Despite this, many continue to insist, for example, that such a vision of austerity policy has hurt the British economy.

This is not true. Such claims are motivated by ideology. The United Kingdom is a success story — after the austerity policy had been implemented, its economy started growing relatively quickly. Let us recall that the International Monetary Fund (IMF) tried to discourage the British government from taking such bold steps towards spending cuts. However, the British did not listen to that advice and they were proven right. On the other hand, in countries such as Portugal and Spain, austerity was introduced as a hybrid program. Half of the intended effect was to be achieved on the side of the expenditures, which were reduced. The other half was supposed to be achieved on the side of the taxes, which were raised. As a result, these countries went through pretty serious recessions within a short period of time.

So Brits were right?

That’s correct. The IMF’s authorities even publicly apologized to the British for their poor advice.

Speaking of the IMF. It’s difficult not to mention this institution in the context of anti-crisis policies. After 2008, that institution’s activities in the economy also became political ones. Some have even claimed that in exchange for emergency loans the IMF forces the borrowers to implement certain policies that are not supported by the local populations. In other words — the IMF promotes anti-democratic attitudes. Do you agree with such opinion?

International financial organizations can and do make mistakes. However, when it comes to Greece, it is the Greeks themselves who made the biggest mistakes by manipulating their budget statistics and by misleading the lenders. In the end, however, it simply had to come out that Greece’s real budget deficit amounted to 15 per cent of its GDP. And then everything collapsed. I agree that no one had any idea on how to stop the catastrophe, and that programs of spending cuts and tax increases, recommended to the Greek government by the lenders, were probably developed and implemented too hastily. Had they focused on the expenditure side and not on the taxes, the recession could have been shorter.

Was it possible for Greece to just ignore the IMF’s advice, as did the United Kingdom?

Each country is in a different situation. When you’re in trouble, the lenders are not knocking on your door offering help. The sequence of events is as follows: country X pursues a given economic policy, which arouses the distrust of the markets. This, in turn, makes it harder for that country to borrow money. The country X then approaches a given institution, for example the IMF, and asks for help. The usual answer is: put your public finances in order and then we will help you finance your commitments together with the „markets”. The choice is yours. This is no different from a situation in which you go to a bank and you want to get a loan, but the bank discovers that you already have a lot of loans to pay back. The bank does not dismiss you, but it tells you: we need to be sure that you will reduce your spending, save more, and maintain a steady income. If you guarantee this, then we will grant you a loan. Is this equivalent to imposing something on someone? I don’t think so.

The policy of austerity can be interpreted as a return to business as usual after years of budget debauchery. But how can we define or determine what is normal for the budget in an era when it has to finance so many expensive functions of the state?

Economists generally agree that over the long run the budget deficit should amount to 0 per cent. Then it will be possible to reduce taxes and to gently increase expenses during crises, in order to facilitate economic recovery. Such a policy provides a necessary safety cushion. In the long term, maintaining a balanced budget guarantees that a given country will not have to implement austerity programs. The problem is that governments run deficits even during periods of prosperity and incur debt in order to finance new spending. Because of that they lack the fiscal room for maneuver during recessions.

However, the famous Maastricht criteria, which countries have to meet in order to be admitted to the Eurozone, allow for a budget deficit of 3 per cent of GDP. Is that bad?

These criteria constitute a compromise between the position that the budget must always be balanced and the position that sometimes it can sustain anti-crisis deficits or run surpluses as a preventive measure. Economists are still wondering about the limits of such permissible deficits or surpluses. This debate is still going on. In political practice, the Maastricht criteria have even turned out to be too strict compared to the positions of many European governments. They are also frequently violated and each violation encourages more countries to follow suit.

The new Italian cabinet, led by Giuseppe Conte, is one of the governments which do not like the fact that the criteria only allow for a deficit of 3 per cent of GDP. How do you see the economic future of your native country?

Italy suffers from very serious structural problems which have been hampering its development for the past 20 years. We should not expect that anyone will solve them anytime soon. These problems are further aggravated by the poor condition of our budget. In this respect, I actually had some concerns when the new government, regarded as populist, came to power. Its representatives announced, among other things, that they would attempt to leave the Eurozone, and that created a lot of uncertainty. However, now that I’m observing the government’s actual decisions, I’m much calmer, as they seem to be quite reasonable. You could say that I’m a pessimist when it comes to the possibility of fixing the Italian economy in the long term, but I’m an optimist in the sense that I’m not afraid of an immediate crisis.

Could we say that Europe is now getting back on its feet? That the public debt crisis has been resolved?

We can’t say that it has been resolved. But we can say that it has been alleviated, among other things, thanks to the activities of the European Central Bank. I think that at present a bigger problem is the trade war that the United States is trying to start with the European Union and China.

Is it possible that protectionism could lead to another crisis?

Yes. If the threat of a trade war materializes, then international trade turnovers will decrease, which will lead to a decrease in tax revenues. China could also stop investing in the US Treasury bonds in protest. Then we will truly face the specter of a global crisis.

Professor Alberto Alesina is an Italian economist and a lecturer at Harvard University. He specializes in fiscal policy, currency unions and economic integration.

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