Although interest rates are expected to fall as inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power. wanes, the Congressional Budget Office (CBO) forecasts the government’s interest costs will nearly double over the next decade, rising to 3.6 percent of gross domestic product (GDP) in 2033. Interest costs alone, currently the highest as a percentage of revenue since 1996, are on track to overtake the entire defense budget by next year. Given the risks of rising interest costs, it is imperative that policymakers reduce deficits and at the very least stabilize debt.
Unfortunately, the current debate is focused on raising income taxes to reduce deficits. Income taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. hikes could be harmful to economic growth and, in turn, make it more difficult for the U.S. government to fulfill its financial obligations. Of course, any fiscal consolidation will include some tax increases, but some taxes are more harmful than others. This conclusion is borne out by our modeling of options to raise revenue and by the vast empirical literature looking at fiscal consolidations across the world. We’ve reviewed the literature in previous blog posts, but it is also worth examining case studies of countries that have successfully—and not so successfully—reduced their debt.
View from Above: Ingredients of Successful Fiscal Consolidations
As we’ve written before here:
Tax-based deficit reductions tend to have a more negative impact on the economy and less successful track record than spending-based ones. The difference is primarily due to the response of private investment, as business confidence falls to a greater degree and for a much longer duration after tax-based plans.
Overall, successful fiscal adjustments primarily cut spending and modestly increase taxes. A rough guideline for an expenditure-based plan is for at least 60 percent of its savings to come from spending cuts and 40 percent or less from revenues.
Further, other economists have concluded that fiscal consolidations based on spending cuts have had fewer negative effects on GDP than tax increases.
Looking at 16 OECD countries over a 30-year period, Alberto Alesina and his coauthors found that, on average, spending cuts were associated with mild recessionA recession is a significant and sustained decline in the economy. Typically, a recession lasts longer than six months, but recovery from a recession can take a few years. s and in some cases no downturns at all, while almost all fiscal reforms based on tax increases were followed by “prolonged and deep recessions.”
In a study of 17 OECD countries over a 30-year period, Norman Gemmell and other academics showed that reducing deficits by raising distortionary taxes, such as income taxes, consistently reduced economic growth, while raising less distortionary taxes, such as consumption taxA consumption tax is typically levied on the purchase of goods or services and is paid directly or indirectly by the consumer in the form of retail sales taxes, excise taxes, tariffs, value-added taxes (VAT), or an income tax where all savings is tax-deductible. es, was more growth-enhancing.
Under the Hood: Case Studies of Successful Fiscal Consolidations
Looking at individual countries specifically offers additional insight into fiscal reforms that worked and those that did not. The examples below are drawn from a paper by economists at the European Central Bank, and they reveal that successful fiscal reforms largely rely on spending reductions and modestly rely on certain types of tax increases, while less successful reforms largely rely on income tax hikes.
In 1982, inflation in Ireland rose to 17 percent, the deficit exceeded 15 percent of GDP, and the debt-to-GDP ratio reached nearly 85 percent. In response to the fiscal situation and persistently low GDP growth, Ireland underwent two large reforms in the 1980s and 1990s.
Initially, Ireland chose a mix of both expenditure and revenue reforms in the early 1980s. But by 1986, its debt had continued to climb up to 113 percent of GDP. Ireland then switched to primarily reducing spending, including reductions in staffing and wages for government employees, a hiring freeze, and cuts to subsidies and social welfare transfers. Over the first phase, primary expenditures fell by 12 percent of GDP. The reforms that continued until the end of the decade reversed Ireland’s economic stagnation and led to significant fiscal surpluses and reductions in its public debt.
Ireland’s second phase of reforms in 1994 implemented tighter controls on discretionary spending. By 1996, the deficit was gone and by 2000, debt was brought below 40 percent of GDP. Notably, Ireland’s improved financial position provided it with the fiscal space to actually reduce economically harmful taxes, such as corporate taxes and income taxes. Ireland began phasing in cuts to its corporate tax rate starting in 1996, and decreased the tax wedgeA tax wedge is the difference between total labor costs to the employer and the corresponding net take-home pay of the employee. It is also an economic term that refers to the economic inefficiency resulting from taxes. on labor from 43 percent to 35 percent over a 10-year period. As a result of the reforms, average real GDP growth reached 7.4 percent from 1992 to 1999.
Sweden also implemented a successful package of fiscal reforms in the 1990s, following a period of rising unemployment, inflation, and deficits in excess of 10 percent of GDP. The country relied heavily on significant cuts to public expenditures, which fell by nearly 16 percent of GDP from 1993 to 2000. The cuts focused on pensions, government employment, and transfers. For example, transfers and subsidies in particular declined as a percentage of GDP from 27 percent to 19 percent over a seven-year period. The changes came about after institutional reforms to Sweden’s budget process, at the recommendation of a special commission.
Sweden combined the steep cuts in public expenditures (nearly 16 percent of GDP) with modest revenue increases (0.8 percent of GDP). Sweden’s higher tax revenues, however, were due to tax reform that reduced marginal income tax rates to reduce distortions and the introduction of a carbon taxA carbon tax is levied on the carbon content of fossil fuels. The term can also refer to taxing other types of greenhouse gas emissions, such as methane. A carbon tax puts a price on those emissions to encourage consumers, businesses, and governments to produce less of them. . The expenditure-based reforms successfully reduced Sweden’s deficits and debt, and were accompanied by a fast rebound in economic growth. Their cyclically adjusted primary balance (CAPB), which is the deficit not counting interest, improved to 9.2 percent within seven years, and real GDP growth averaged 6.3 percent over this same period.
Faced with an economic downturn in the early 1990s, Canada pursued efforts to reduce its debt-to-GDP ratio, which had grown above 100 percent of GDP with deficits exceeding 9 percent of GDP.
Starting in 1993, Canada focused on a chiefly expenditure-based fiscal adjustment, which dropped total spending by 11 percent of GDP over the rest of the decade. Cuts to government employment compensation and staffing were responsible for nearly half of the reform. The other half included cuts to transfers, specifically converting several of its programs to a system of “block grants” to provinces, and the partial privatization of state-owned enterprises, such as its air traffic control system. Canada also enacted spending caps through its legislature to ensure spending growth would be restrained throughout the decade.
Similar to Ireland and Sweden, reaching a balanced budget by reducing spending allowed Canada to reduce personal income taxes while broadening the tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. , reducing the overall tax burden. Revenues declined by 0.3 percent of GDP over the decade, and, in total, both the spending and tax reforms led to a period of resumed economic growth, averaging 4.7 percent over this period.
Lessons from Europe following the Global Financial Crisis
The 1980s and 1990s offer many more examples of successful expenditure-based fiscal consolidations. But it is also worth looking at examples where fiscal consolidations were less successful because they relied primarily on tax increases and did not follow through on their commitments to reduce government spending in the long run.
Following the global financial crisis in 2008, many European countries faced serious debt crises. Conventional wisdom at the time argued “austerity” policies (i.e., tax increases and spending cuts) would deepen the recessions in these countries. But the story is only half true. A closer look shows that while these countries did experience weak growth following the crisis, this was primarily due to their reliance on tax increases to stabilize their debt.
Initially, many European countries increased their spending in the form of economic stimulus, and it was not until 2010 that most of these countries began to focus on spending reductions. Of the 27 European Union countries at the time, 19 raised their value-added taxes (VATs) by an average of 2.7 points between 2007 and 2014. Although VATs are regarded as one of the less harmful ways of raising revenue, the large tax increases were often only accompanied by modest spending reductions at most. In fact, the spending reductions often rolled back no more than half of the earlier increases in government spending, and some countries that raised their VATs actually increased spending over this period.
Some of these countries also increased their income taxes. Seven of the European countries facing a sovereign debt crisis raised their top marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. on individual income between 6 and 11 percentage points. These included Portugal, Spain, and Greece, which were some of the slowest-performing economies over this period. Although these countries did cut spending as well (and Portugal in particular did eventually recover), the tax increases were a larger share of their fiscal adjustments compared to countries such as the UK and Ireland, which pursued mostly expenditure-based consolidations and experienced shorter downturns as a result. Greece continues to remain at risk due to its reversal of several of its pension reforms and still has among the world’s highest debt.
In all, the experience with successful fiscal consolidations suggests they should be gradual and spending-focused, with careful consideration of the growth effects of selected policies. If tax increases are included in a package, international experience points toward raising consumption taxes, rationalizing tax expenditures, and broadening the tax base—not hiking income taxes. While it is imperative for U.S. lawmakers to address unsustainably rising deficits and interest costs, it is just as imperative to avoid tax hikes that are particularly damaging to economic growth.
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