Europe's Fiscal Crisis Revealed: Growth Effects of Taxation and Spending
The following is an excerpt from The Heritage Foundation's recent report, Europe's Fiscal Crisis Revealed: An In-Depth Analysis of Spending, Austerity, and Growth.
The experience of the global
crisis and aftermath confirms the findings of previous research. As detailed by Andrew Biggs, Kevin Hassett, and Matthew Jensen, among others, there is a substantial research consensus that fiscal consolidation through spending cuts is less contractionary than fiscal consolidation through tax increases. Robert Barro and Charles Redlick found that tax multipliers were larger than the multiplier for military purchases, and Christina Romer and David Romer defend a tax multiplier considerably higher than the usual range of spending multipliers.
Thus, a finding that tax policy was more potent than spending policy is not unexpected: Tax cuts aided the recovery more, and tax increases were more harmful in the consolidation. The exception from the primacy of taxes is that spending-focused stimulus was slightly more expansionary during the first years of the recession. Although all of the estimates are imprecise, they are consistent with most of the literature on fiscal policy: Government spending boosts GDP instantly and then crowds out private spending slowly. The incentive effects of taxation may take effect over several years, but they are permanent and especially pronounced in investment. If anything, this recent crisis shows how brief the short run is: Countries whose spending-focused stimulus put them one step ahead in 2010 were already two steps behind in 2012.
Making policy based only on one recent and incomplete historic episode would be a mistake. Nonetheless, it is comforting to know that the data from the most recent years are broadly consistent with economic theory and empirics from prior decades.
Salim Furth is a Senior Policy Analyst at the Heritage Foundation. You can follow him on Twitter here.
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