Spending cuts impose less economic damage than tax hikes

Among Ottawa and the 10 provinces, eight governments are currently in deficit, spending more than the revenues they collect. As Canadian governments seek to eliminate their budget deficits, they should take note of a new study by a group of fiscal policy experts, led by Harvard economics professor Alberto Alesina. In short, the study provides a roadmap about whether deficit fighting initiatives should focus on cutting spending or raising taxes.

The study, published by the National Bureau of Economic Research, examines how the composition and timing of fiscal policies aimed at reducing government deficits affect the economy. Fiscal consolidations can differ in their composition (whether they are made up mostly of tax hikes or spending cuts) and timing (whether they are implemented during a recession or economic expansion).

To test the effects of each on the economy, the study analyzes data from 16 industrialized countries (including Canada) over the period 1981 to 2014. The authors summarize the findings as follows:

We find that the composition of fiscal adjustments is more important than the state of the [business] cycle in determining their effect on output. Fiscal adjustments based upon spending cuts are much less costly in terms of short run output losses—such losses are in fact on average close to zero—than those based upon tax increases which are associated with large and prolonged recessions regardless of whether the adjustment starts in a recession or not. The dynamic response of the economy to a consolidation program does depend on whether this is adopted in a period of economic expansion or contraction, but the quantitative significance of this source of non-linearity is small relative to the one which depends on the type of consolidation.

In other words, the study finds that attempts to balance the budget based mainly on spending cuts result in less economic damage than those based primarily on tax hikes. In fact, attempts based on tax hikes can result in prolonged periods of weak economic performance regardless of when they are implemented. While the timing of fiscal consolidations matters, the effect is much less significant than the composition.

These findings are critically relevant to ongoing fiscal policy debates about how governments should tackle their deficits. The evidence clearly suggests that if Canadian government want to impose the least amount of economic damage, they should structure their deficit elimination plans around spending cuts, not tax hikes.