Tackle Alberta’s deficit by cutting spending—not raising taxes

On Tuesday, the Alberta government will release a budget with a projected deficit of at least $5.9 billion this year, the seventh deficit in eight years. And just the other day, the government announced the budget won’t be balanced until 2019/20.

But deficit elimination is important, as it would enable the government to re-focus on tax competitiveness and saving for the future while avoiding a position where the total value of government debt exceeds financial assets.

The important question is how the government should begin tackling the deficit. Notably, a recent Fraser Institute study found that rapid growth in government spending over the past decade is the reason for Alberta’s deficit, so naturally the solution should come from this side of the ledger.

That said there are fundamentally three ways the government can try to eliminate the deficit: further tax hikes, spending cuts, or some combination of both.

But which approach would impose the least damage to Alberta’s economy?

Two prominent fiscal policy experts—Harvard professor Alberto Alesina and Bocconi University professor Francesco Giavazzi—recently penned an article for the National Bureau of Economic Research (NBER) summarizing the latest research on so-called “fiscal austerity.” The insights are certainly relevant to Alberta’s situation and that of many other provinces.

Prof. Alesina co-authored many of the referenced studies. To evaluate which deficit elimination approach is the least damaging to the economy, Alesina and his colleagues distinguish between “tax-based” fiscal plans that predominantly rely on tax increases and “expenditure-based” fiscal plans that rely mostly on spending cuts. In three separate studies, they examine the impact of fiscal plans from several countries and over different periods.

In one study, they estimate that in 14 countries (including Canada) over the period 1981 to 2007, the average tax-based fiscal plan with an initial size of one per cent of GDP led to a contraction of GDP by two to three per cent in the following three years. By contrast, the impact of an expenditure-based plan on GDP was not statistically significant.

In their NBER article, Alesina and Giavazzi describe the main findings as showing that “fiscal adjustments based upon cuts in spending are much less costly, in terms of [economic] output losses, than those based upon tax increases.”

In another study, Prof. Alesina and his co-authors estimate the impact of more recent fiscal plans, from 2010 to 2013, in 12 countries. They again find that tax-based plans are more economically damaging. For example, they argue that the recession experienced in Italy from 2011 to 2012 (around a two per cent drop in GDP in each year) can be explained by the country’s tax-based fiscal plan implemented from 2010 to 2013. Expenditure-based plans in the United Kingdom and Denmark were associated with “much milder recessions.”

Prof. Alesina and his colleagues dig even deeper in a more recent study, in part by dividing spending cuts into two categories: cuts in transfers to individuals and organizations, and cuts in government consumption and investment. Government consumption includes spending on paying government workers and other costs related to managing government services. Government investment spending is defined as expenditures made with the expectation of having a positive return and includes capital spending on infrastructure.

The authors find that while spending cuts to government transfers are generally less harmful to the economy than tax increases, they are relatively more harmful than cuts to government consumption and investment spending. In other words, the findings suggest that the least costly way to eliminate a deficit is to cut back on the costs of government services and government investment spending.

The evidence summarized by professors Alesina and Giavazzi has implications for how Alberta—and indeed other Canadian governments—should approach deficit reduction. In terms of minimizing the adverse effect on economic output, research suggests the best way to eliminate the deficit is by cutting back on government spending.