Spending and cutting, no, spending, no, cutting, no taxing. Ah… no taxing.
Consider this…
Fine Gael said last night it would back the Government’s four year economic strategy to reduce the deficit, but insisted it favoured cutting spending rather than raising taxes.
The party’s communications spokesman Leo Varadkar told the Dublin Economics Workshop in Kenmare last night that his party is committed to reducing Ireland’s deficit to 3 per cent of GDP by 2014.
And…
“Savings in public spending do less damage to the economic growth and employment than tax increases,” he said. “Increasing taxes is the easy political option but it is not the right one.
However…
“Cuts, tax increases and retrenchment alone will not resolve Ireland’s economic crisis. Indeed, they could push Ireland deeper into recession,” he said. “That’s why we need a four year growth plan as well as a four year budget deficit plan.”
Whereas if we consider the IMF research (which you can most conveniently download from here) linked to a piece in the Sunday Independent mentioned by Garibaldy (on Cedar Lounge Revolution) and first referenced in the Irish Independent by Brendan Keenan on Thursday last we learn something slightly different.
As the original piece by Keenan notes:
The research suggests that members of the eurozone suffer a bigger than average impact from fiscal correction. This could be because the ECB is not able to respond in the way a national central bank could, by cutting interest rates.
Well, that’s not good.
It gets worse.
A €4bn adjustment in next year’s Budget would probably knock €2bn off economic growth, (the IMF research) suggests.
And even worse again…
Although the research does not deal specifically with Ireland, it found a consistent pattern across 170 historical episodes that a 1pc of GDP adjustment produced a 0.5pc fall in growth.
The example of Ireland in 1987 - and Denmark in 1983 - where budget correction was followed by growth, appear to be exceptions. They may even be the only two of their kind.
So, we’re set on a course that out of 170 historical examples worked 1% or so of the time.
And the Irish example may have been in 1987, as seems likely on consideration, to be linked to events to our direct East.
“We don’t really know the reason,” Daniel Leigh, one of the IMF researchers said yesterday.
“There are suggestions Ireland was helped by the ‘Lawson boom’ policies of Chancellor Nigel Lawson and by a devaluation of the Irish pound.”
The relevant chapter in the IMF research entitled ‘Will it Hurt’ notes that:
Based on a historical analysis of fiscal consolidation in advanced economies, and on simulations of the IMF’s Global Integrated Monetary and Fiscal Model (GIMF), it finds that fiscal consolidation typically reduces output and raises unemployment in the short term. At the same time, interest rate cuts, a fall in the value of the currency, and a rise in net exports usually soften the contractionary impact.
Except as noted above, interest rates can effectively fall no further. Nor can the value of the currency assist us. We instead face a situation almost entirely the opposite.
And what of the issue of spending cuts over tax increases?
Keenan argues that:
The second [piece of conventional wisdom] is that, in terms of economic damage, it is better to cut public spending than to raise taxes. The IMF research seems to challenge both bits of conventional wisdom - albeit with different degrees of certainty.
The evidence is stronger on the first: that the famous “expansionary fiscal correction” is a myth.
First up the IMF discovers that:
Spending-based adjustments are less contractionary than tax-based adjustments. In the case of tax-based programs, the effect of a fiscal consolidation of 1 percent of GDP on GDP is -1.3 percent after two years (Figure 3.5). In the case of spending-based programs, the effect is -0.3 percent after two years, and is not statistically significant.24 Similarly, while deficit cuts that rely on tax hikes raise the unemployment rate by about 0.6 percentage point, spending-based deficit cuts raise the unemployment rate only by about 0.2 percentage point (see Figure 3.5).
However, as will be shown below, a key reason the costs of spending-based deficit cuts are relatively small is that they typically benefit from a large dose of monetary stimulus, as well as an expansion in exports.
•• Domestic demand contracts for both types of fiscal consolidation, but by more in the case of tax-based packages. In particular, in the case of spending-based measures, domestic demand falls by about 0.9 percent after two years, whereas the decline exceeds 1.8 percent in the case of taxbased packages (see Figure 3.5).
•• A rise in net exports mitigates the impact of the consolidation on GDP in both cases. However, there is a considerably larger improvement in exports associated with spending-based measures than with tax-based measures, whereas imports fall more for tax-based adjustments (see Figure 3.5).
But wait, that means that spending cuts are more optimal than tax increases? Not necessarily:
Much of the difference is due to the response of monetary conditions to fiscal consolidation: interest rates and the value of the currency tend to fall more following spending-based consolidation
Which as we know we cannot do.
Thus, it appears that the difference in monetary policy responses accounts for much, though probably not all, of the difference in output performance.
And sentiment, such a player in all this, appears again:
These findings are in line with the notion that central banks view spending-based deficit cuts more favorably, possibly because they interpret them as a signal of a stronger commitment to fiscal discipline, and are therefore more willing to provide monetary stimulus following spending-based adjustments. It is also plausible that an increase in taxes, if it involves indirect tax hikes (sales and excise taxes, VAT), raises inflation on impact, making interest rate cuts
And there’s more. The report considers that:
spending-based adjustments have relatively benign effects if they involve cuts to politically sensitive items, such as transfer programs, or government consumption, such as the public sector wage bill.
One must stand in awe of the masterful use of the term ‘relatively benign’.
Now note the following:
The key idea is that cutting politically sensitive items may signal a credible commitment to long-term deficit reduction and that, in these cases, positive “non-Keynesian” confidence effects offset the negative “Keynesian” impact on aggregate demand. On the other hand, cuts to less politically sensitive items, such as government investment, might have weaker confidence effects.
So, once more, it’s not about the reality of whether these cuts are - in objective terms, or at least as objective as one can find - effective, and the report continues:
…these results should be interpreted with caution. In particular, even for the cases of consolidation based on transfer cuts, there is no strong evidence of expansionary effects, as the results are statistically indistinguishable from zero.
If that is correct then the social effects of such a course are such that one would hope that any government would think long and hard about prioritising them over tax increases. Indeed, and Keenan makes this point, given that we can’t do the ‘damage’ through increasing interest rates (since as he says the ECB has little interest in Irish inflation) if tax rates increase and prices consequently increase, the effects of one or the other would appear in fiscal terms to be near-identical.
But to add further troubles and woes the report notes that fiscal retrenchment far from triggering faster growth and lower unemployment actually appears to lead to the opposite. And more… in situations where interest rates are close to zero…
…the output cost of fiscal consolidation doubles to about 1 percent after two years (see Figure 3.11). Here, the simulation assumes that the zero lower bound holds for two years.37 During this time, the central bank is powerless to offset the slump in aggregate demand and inflation induced by the cut in government spending. The resulting fall in inflation raises the real interest rate, which in turn exacerbates the decline in aggregate demand, amplifying the short-term contractionary effect of fiscal consolidation.
All this is interesting, because at the very least it throws some doubt on the certainty that tax increases are ‘worse’ than spending cuts (even if one factors out social costs of the latter), and it points to basic problems with the position we find ourselves in and the policies being pursued. However, as always with the IMF it’s in the throw away remarks that one finds the most intriguing aspects. Consider the final paragraph:
Finally, as discussed in Chapter 1, a number of policy actions could enhance the credibility of fiscal adjustment programs, thereby mitigating the adverse effects of fiscal consolidation in the short term. Such actions could include strengthening fiscal institutions and reforming pension entitlements and public health care systems. To the extent that such measures improve household and business confidence and raise expectations about future income, they could help support activity during the process of fiscal adjustment.
Precisely what sort of reforms are these that are mooted? And to whose benefit? It would be interesting to know.
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Comment by: William Wall
Oct 19th 2010 at 17:10
My favourite phrase here is: “statistically indistinguishable from zero”. I have to find a way to use it.
Comment by: WorldbyStorm
Oct 19th 2010 at 18:10
Unfortunately it’s a classic of its kind.