Why Debt Ceiling Negotiations Must Draw On Tax Lessons Learned from Successful Fiscal Consolidations

July 14, 2011

I fastidiously monitor my budget on a monthly basis. Most readers are probably at least equally diligent. We match spending with income as best we can. We circumspectly use debt. Our government does neither.

Here we stand at a legislative impasse, leaders compromising to the point of lunacy. Talks continue to break down, regardless. The eleventh hour is upon us and midnight feels awfully close. However, this urgency should not hasten a deal that fails to take international experience into account.

Fiscal consolidation is defined by the OECD as a policy aimed at reducing government deficits and debt accumulation. The United States is certainly in a predicament requiring plans for a successful fiscal consolidation. Fortunately, plenty of empirical evidence has been compiled which not only suggests the possibility of success, it provides a road map to get there.

Since 1975, 20 countries have needed large budgetary adjustments in order to close large fiscal gaps a total of 44 times (Goldman Sachs Global Economics Paper No:195 2010). The 11 of these which were primarily driven by government expenditure cuts were decidedly more effective. Expenditure Reform In Industrialised Countries authored by Hauptmeier, Heipertz, and Schuknecht and issued by the European Central Bank (ECB) in 2006 also looks closely at expenditure reform as a invaluable tool necessary for successful fiscal consolidation.

In Sweden, for example, the need for fiscal consolidation arose from a recession coupled with the financial crisis of the 1980s bubble economy. As of 1993, public expenditures had increased to an intimidating 73% of GDP while public debt stood at 70% of GDP. Between 1993 and 2000, transfers, subsidies, government consumption, and pensions were reduced by 5.1%, 2.9%, 2.8%, and 1.7% of GDP, respectively. These cuts facilitated an improvement of the cyclically adjusted primary balance of just over 9% within seven years.

A look at the U.K. experience is equally illustrative. A study of the two-phase experience of the United Kingdom is perhaps even more useful to the current U.S. policymaker. Like the United States, the U.K. also spends a large portion of GDP on national defense (3.8%). The U.K. undertook massive consolidation efforts in both 1981 and 1992. In both phases, the fiscal balance was improved by 4.8% and 7.5% of GDP, respectively. Like Sweden, the U.K. made most of its cuts in the areas of public compensation, transfers, and subsidies.

Spending cuts are certainly a necessary step toward fiscal balance, but many argue tax increases are of commensurate importance. The evidence, however, is not so definitive. During the seven years within each consolidation studied by the ECB, various tax rates could have been increased, decreased, or unchanged seven times. Out of the 70 total opportunities to change tax rates:

1. The top marginal individual income tax rate was decreased 11 times, increased 4 times, and unchanged in the remaining years.

2. The top marginal corporate income tax rate was decreased 19 times, increased 1 time, and unchanged in other years.

3. The value-added tax was decreased 1 time, increased 4 times, and left unchanged during other periods.

In addition, during each period of successful fiscal consolidation, concurrent budgetary reforms proved crucial to maintaining fiscal discipline. Spain, for example, tightened eligibility for social benefits and comprehensively overhauled its labor market. These reforms contributed to strong employment increases (Toharia and Malo, The Spanish experiment: pros and cons of the flexibility at the margin, 2000). In addition, extensive tax code reform was employed to enhance transparency and tax collection (Hauptmeier et al. 2006).

Closing the fiscal gap may not be as easy as making cuts across the board. However, it is clear from historical lessons learned that no aspect of spending should be held sacred either. If productive legislation is to make a dent in our public debt, everything must be on the table. Spending cuts alone are not a magic bullet. They must be coupled with structural reforms. However, the evidence definitively shows tax-driven solutions are not the answer. Such lessons are precisely what must guide debt ceiling negotiations and policy design in order to productively prevent further prolongation of this beleaguered crisis.

Follow David Logan on Twitter @Loganomix.

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