Tax Cuts vs. 'Stimulus': The Evidence Is In
Politicians argue for increased stimulus spending, as opposed to spending cuts, on the grounds that it would speed up economic recovery. This argument might have it exactly backward. Indeed, history shows that cutting spending in order to reduce deficits may be the key to promoting economic recovery.</br></br>In Europe today, the risk of a renewed recession comes not from the spending cuts that some governments have enacted, but from a sovereign debt overhang and multiple bank failures. July's stress tests were not reassuring because they didn't test the exposure of European banks to sovereign debt; had they done so, many banks would have failed. Those banks remain a threat to the European economy.</br></br>In the U.S., meanwhile, recent stimulus packages have proven that the "multiplier" -- the effect on GDP per one dollar of increased government spending -- is small. Stimulus spending also means that tax increases are coming in the future; such increases will further threaten economic growth.</br></br>Economic history shows that even large adjustments in fiscal policy, if based on well-targeted spending cuts, have often led to expansions, not recessions. Fiscal adjustments based on higher taxes, on the other hand, have generally been recessionary.</br></br>My colleague Silvia Ardagna and I recently co-authored a paper examining this pattern, as have many studies over the past 20 years. Our paper looks at the 107 large fiscal adjustments -- defined as a cyclically adjusted deficit reduction of at least 1.5% in one year -- that took place in 21 Organization for Economic Cooperation and Development (OECD) countries between 1970 and 2007.