Austerity in the European Union: Keynesian stimulus versus fiscal

consolidationby

Gordon L. BradyFor presentation at the

International Atlantic Economic Society Madrid, Spain, 5 April 2014

On March 26, 2014, The Wall Street Journal article “ECB set to mull heavier stimulus.”

“ECB officials sent strong signals” that they are willing to consider “dramatic steps to guard against dangerously low inflation, suggesting the bank is prepared to shed some of its traditionally cautious approach.” The dramatic steps include negative interest rates and asset purchases to combat indications of deflation.

The organization of this paper:• Discussion of current EU issues • Fiscal consolidation research.• Non-Keynesian expansions.• Unfounded fears of political consequences of fiscal

consolidation • Summary and conclusion

European Union IssuesThe main causes of the sovereign debt crises in Europe varied by country. In Ireland and Spain, they were mainly due to the private sector, particularly housing. Those crises were similar to what occurred in the US, namely the savings and loan crisis of the 1980s, the agricultural crisis in the 1980s, and the mortgage crisis in 2007-08.

In Greece and Portugal, the cyclically adjusted structural deficit was among the major causes. In Ireland and Spain, domestic housing booms were financed from foreign borrowing as creditors failed to require a risk premium related to the probability of default. Debts were excessive and the actual debt exceeded the optimal debt derived from any rational calculations or analysis. When the return on capital fell below the rate of interest, the borrowers in the housing industry defaulted. Their creditors were the banks, which in turn, were debtors to the international lenders.

To address the problems associated with the financial meltdown of 2008, many governments initiated Keynesian “stimulus” programs containing one-time rebates, increased transfer payments to households, transfers to state and local governments to shore up budgetary shortfalls, and additional government spending on infrastructure.

Consequently, government budget deficits and government debt as a percentage of GDP rose sharply.

Getting worse - government debt as percent of GDP

2009 2012Greece 115.1% 161%Italy 115.8% 126%France 77.6% 90%Portugal 76.8% 124%Germany 73.2% 80%Spain 53.2% 85%

Recognition of need for major fiscal changecame early

Beginning as early as November 2009, the International Monetary Fund and other international organizations called upon countries to create a “credible plan for a fiscal exit” in order to avoid a looming government debt crisis.

Fiscal consolidation program:(1) reduce government budget deficits, (2) stabilize government debt as a percentage of GDP.

Enforcement of the EU’s 3% budget deficit became politically expedient as did the “continuing, continuing resolutions” which allowed the US congress to “kick the can” (ever larger federal deficits) to future generations.

Budget deficits -- 2009

Germany 3.0 %Greece 13.6 %Italy 5.3 %France 7.5 %Spain 11.1 %Portugal 9.3 %

Tiring of austerity, a recent Economist article noted that some European policy makers are seriously considering major tax reforms in France, Italy, Spain.

In January, France announced plans to cut payroll taxes by €30 billion ($42 billion).

In March, Italy unveiled income-tax cuts worth €10 billion for those earning less than €25,000 a year.

Most recently Britain proposed tax cuts for most low or medium income brackets. Ireland and Spain are also planning tax cuts later this year.

Politicians, such as Italy's new prime minister, Matteo Renzi, realize that taxpayers are fed up with paying ever higher rates. France now levies nearly 55% of its GDP in tax.

In several EU economies, particularly Greece, higher rates are no longer fulfilling expectations of bringing in the additional revenue they counted on. Greece appears to have awakened to the fact that taxes dampen the supply and encourage tax “avoision,” a term coined by Arthur Seldon, the co-founder of the Institute of Economic Affairs.

So now to a pro-growth agenda

Cutting tax expenditures and various tax breaks are important. But some fiscal measures may be more effective in generating growth.

Go for those that decrease labor costs, but caveats to tax cuts.

Current US budget proposalHouse Ways and Means Committee

Chair David Camp (R-MI)   The median income in the US is 4.4% lower than when recession ended.

• Objective - Lower tax and fairness, but general focus• Attempt to shift debate from redistribution o economic

growth• Reduces 7 top income tax brackets into 3 groups of

payers of 10% or 25% • Top decreased from 40% to 35% for those over $400K

or joint $450K• Cut deductions, credits and interest group carve outs• Raises standard deduction to $11K and $22K for joint. • Lowers the mortgage interest deduction to $500K from

$1 million.• Corporate rate falls to 25% from 35% 

Tax cut caveats

Buchanan and Wagner (1977) argued that taxpayers may view tax cuts as reflecting a decrease in the cost of government which leads them to increase demand for the now cheaper public sector programs. They suggest that the complicated nature of tax systems causes fiscal illusion and may result in greater public expenditure than would be the case in a system in which everyone is aware of their share of the costs of government . The Italian public finance theorist Amilcare Puviani recognized this point in his 1903 book.

Reforming taxes on laborSome economists doubt that cutting the income tax, Italy’s approach, is the best way to stimulate growth. Instead, they favor slashing Europe’s high employer-paid social-security charges, as proposed by France. The US successfully did this in 2010. This would directly lower labor costs and thereby encourage companies to hire extra workers as well as to increase investment in plant and equipment.

Increasing the returns to hiring would also boost growth. The IMF argues that Italy could raise its present growth rate by at least half a percentage point a year if it shifted the burden of taxes away from firms and onto consumption. For Italy’s new government, cutting the burden on employers should be an important action in order to increase growth.

However, deeper tax reform in Europe is needed than that those currently discussed. High employer social-security contributions compared to the rest of the OECD are a problem but not the main contributor to concerns about competitiveness.

Other taxes like the Italy’s Regional Production Tax (IRAP) should also be discussed. At this time, taxing what firms produce, rather than profits after expenses as most countries do, raises business costs and reduces the incentives to hire and invest.

As for coming up with ways to pay for tax cuts, there are options. Many commentators argue that tax expenditures should be cut all over the continent.

These include such outdated tax breaks as currently provided to French journalists, German night-workers and Italian farmers high on the list.

Overall, such tax programs are costly. Italy now spends 8.1% of its GDP on tax breaks each year. Cutting tax expenditure programs could be used to reduce income tax rates. It would boost economic growth without increasing budget deficits, according to an IMF study by Tyson. These efforts should be pursued although politicians fear it might cost their reelection. There is ample empirical evidence supporting taking these political risks. However, there may be more effective courses of action as argued by Buchanan and Wagner (1977) and demonstrated in a number of studies by Alberto Alesina and others,

Empirical evidence on fiscal consolidationHarvard economist and former president of the IAES)

Alberto Alesina and others show that fiscal consolidations based predominately or exclusively on government spending reductions are more likely to lead to economic expansion and growth than fiscal consolidations in which revenue increases play a significant role.

These are basically supply side approaches. Alesina, his co-authors, and others found that for a government with a large, persistent budget deficit and a high level of government debt, reducing government spending as a percentage of GDP boosts the expected after-tax rate of return on investment for several reasons.

The payoffs from spending reductions.

• Spending reductions lower real interest rates by decreasing the government’s current and future demand for credit.

• Large and persistent government budget deficits and a high and rising level of government debt cause the public to expect large tax increases in the future.

• Spending reductions diminish the prospects for future tax increases which stimulate consumer spending and business investment.

Non-Keynesian” effects of fiscal consolidations

Keynesians assert that reducing government spending as a percentage of GDP would be contractionary in the short term, but expansionary in the long term.

Alesina and other neoclassical economists revived the traditional view that fiscal consolidation programs based predominately or entirely on government spending reductions have expansionary “non-Keynesian” effects that may offset some or all of the contractionary “Keynesian” reduction in aggregate demand in the short term.

Giavazzi and Pagano (1990), Perotti (1999), and Giavazzi et al. (2000) found that fiscal consolidation programs based predominately or entirely on government spending reductions provide a short-term boost to personal consumption expenditures and residential fixed investment.

Alesina et al. (2002) found that “[f]iscal adjustments which rely mostly on spending cuts, particularly in transfers and government wages, are associated with a surge in growth during and immediately after the adjustment changes in business investment explain a large part of the change in GDP growth around these large fiscal stabilizations.”

Examining data for 18 OECD member-countries from 1960–1986, Alesina et al. (2002) estimated how an increase in primary government spending and its major components—government employee compensation, transfer payments, and government consumption—would affect private investment as a percent of GDP.

An increase in primary government spending equal to one percentage point of GDP would decrease private investment by 0.15 percent of GDP in the same period and by 0.74 percent of GDP cumulatively over five years.

Reducing government

Certain government spending reductions generate significantly larger pro-growth effects than others. For “non-Keynesian” factors to be significant, government spending reductions must be viewed as large, credible, and politically difficult to reverse once made. Some examples of such reductions are:• Decreasing the number and compensation of

government workers.• Eliminating unnecessary agencies and programs.• Eliminating transfer payments to firms – corporate

welfare• Reforming and reducing transfer payments to

households• Asset sales and privatization

Lilico, Holmes, and Sameen (2009) found that successful fiscal consolidation programs were comprised of at least 80% government spending reductions and no more than 20% tax increases.

Alesina and Ardagna (2009) examined 107 large fiscal adjustments (defined as a cyclically adjusted improvement in the primary balance of at least 1.5% of GDP in one year) in 21 OECD member-countries (Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, the United Kingdom, and the United States) from 1970 to 2007.

Alesina and Ardagna (1998) concluded that “regardless of the initial level of debt, a large fiscal adjustment that is expenditure-based and is accompanied by wage moderation and devaluation is expansionary.

Biggs, Hassett, and Jensen (2010) found that government spending reductions outweigh revenue increases in successful consolidations regardless of the methodology used to identify consolidations.

Giudice, Turrini and Veld (2003) studied the fiscal policy conducted by 14 EU member-states over a period of 33 years.

There have been 49 (based on size) and 74 (based on duration) episodes of fiscal consolidation. About half of them (24 and 43, respectively) have been connected with higher economic growth.

Keys for success – “the cold shower”

Barrios, Langedijk, and Pench (2010) found that quick, decisive government spending reductions (called “cold showers”) are effective in achieving successful fiscal consolidations because they send a signal about “political will.”

Hitting all marginsVon Hagen, Hughes-Hallet, and Strauch (2002) found that the likelihood of sustaining a fiscal consolidation program increases when governments simultaneously address all politically sensitive budget reductions (e.g., transfer payments to households and firms, subsidies, and the number and compensation of government workers).

Fear of the political consequences of fiscal consolidation are not well grounded.

Alesina and Ardagna (1998) found that successful fiscal consolidations were not politically fatal to the governments that enacted them.

“[I]t is not the case that governments which engage in large fiscal adjustments are systematically kicked out of office. Just the opposite: in the vast majority of cases, the government that implemented the adjustment was reappointed. This result is consistent with the statistical results of Alesina, Perotti, and Tavares (1998).”

Conclusion

A complicated story, but a simple message for fiscal consolidation to focus primarily on spending cuts.