Do sharp reductions of deficits and government debts cause large output losses?

By Paul Walker 15/09/2012

This is a question that is being asked in many countries around the world. This is because at some point many countries will have to reduce their public debts. What is the best way to do this?

According to a new working paper, The output effect of fiscal consolidations by Alberto Alesina, Carlo Favero and Francesco Giavazzi what matters crucially is how the consolidation occurs:

Fiscal adjustments based upon spending cuts are much less costly in terms of output losses than taxbased ones. In particular, spending-based adjustments have been associated with mild and short-lived recessions, in many cases with no recession at all. Instead, tax-based adjustments have been followed but prolonged and deep recessions. The difference is remarkable in its size and cannot be explained by different monetary policies during the two type of adjustments. In fact, we find that the mild asymmetric (and lagged) response of short-term rates cannot explain the difference between the two types of adjustments: heterogeneity in the response of monetary policy appears with a lag of one to two years, while the heterogenous response of output growth to EB and TB adjustments is immediate. We find that the heterogeneity in the effects of the two types of fiscal adjustment (tax-based and spending-based) is mainly due to the response of private investment, rather than that to consumption growth. Interestingly, the responses of business and consumers’ confidence to different types of fiscal adjustment show the same asymmetry as investment and consumption: business confidence (unlike consumer confidence) picks up immediately after expenditure-based adjustments.

Thus fiscal consolidations tend to have much more favourable effects on the economy if they are done via spending cuts alone, not via increased taxation.