The ‘how’ and the ‘when’ in fiscal adjustments

Alberto Alesina, Gualtiero Azzalini, Carlo Favero, Francesco Giavazzi, Armando Miano 16 December 2016

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When a government wants to cut a budget deficit or lower the level of its public debt-to-GDP ratio, two questions immediately arise if it wishes to minimise the short-run costs for GDP growth: how to do it, and when (Ravn and Mertens 2009, Alesina and Giavazzi 2012). ‘How’ relates to whether to cut spending (and which components of spending) or to raise taxes (and which tax rates). ‘When’ relates to whether to start the adjustment when the economy is expanding, or to do it regardless of the state of the business cycle. This ‘when’ is important, because in many cases fiscal adjustments occur when economies are in a recession.

Previous research typically treats the two questions separately. Concerning the ‘how’, a consensus has emerged – although with some variation in emphasis – that fiscal adjustments based on expenditure cuts are much less costly than those made by raising taxes. The most recent paper in this series is by some of us (Alesina et al. 2015). It shows that on average the costs, in terms of output losses, of expenditure-based fiscal adjustments are close to zero. This average is made up of adjustments, some of which had negative effects on output, and some of which were expansionary. In comparison, tax-based adjustments are costly in the sense that they are typically accompanied by recessions lasting several years. In a related paper, Alesina et al. (2015b) have shown that this ‘how’ consensus also applies to the austerity measures adopted after the recent financial crisis.1

Research on the ‘when’ has not been limited to fiscal adjustments. It typically asks whether fiscal multipliers depend on the state of the economy, and considers both fiscal expansions and fiscal corrections. The results are mixed. Auerbach and Gorodnichenko (2012) argued that fiscal multipliers are different during expansions and recessions. They found that multipliers are approximately null in expansions, and much greater than one during recessions. But Owyang et al. (2013) found no difference in the size of the multipliers. One difference was that Auerbach and Gorodnichenko assumed that the state of the economy does not change after a shift in fiscal policy. If the fiscal policy change starts during a recession, for instance, they assumed the economy would remain in recession throughout the adjustment, although this is often not the case. For instance, the large consolidation plan adopted in Belgium in 1982 followed a year of recession, but during implementation the economy returned to growth. The subsequent 1992 multi-year consolidation plan began after a period of expansion, but in 1993 the Belgian economy entered a recession from which it recovered in 1994. Owyang et al. (2013) instead allowed for the state of an economy to evolve.

But, in studying the ‘when’ and the ‘how’ one-at-a-time, we risk attributing effects to one that were created by the other. In a new paper,we are the first to analyse the issue of the ‘how’ and the ‘when’ simultaneously (Alesina et al. 2016a). We also analyse fiscal consolidations by studying multi-year fiscal plans rather than isolated shifts in taxes and spending. This is because real-world fiscal adjustments rarely consist of isolated shifts in fiscal variables. Governments propose - and parliaments vote upon - plans that contain shifts in fiscal variables to be implemented immediately, but also shifts to be implemented in subsequent years. Studying multi-year plans allows us to distinguish between those that are persistent and those that are partially reverting, in the sense that some measures are announced as temporary. We also distinguish between tax-based and expenditure-based plans, looking at the largest component of the fiscal adjustment as a percentage of GDP in the year a plan is announced. Finally, we also allow for the state of the economy to evolve as the fiscal adjustment proceeds.

What, not when

We find that the composition of fiscal adjustments is much more important than the state of the cycle in determining the effect on output. Fiscal adjustments based upon spending cuts are much less costly in terms of short-run output losses than those based upon tax increases. Adjustments based on tax increases are associated with large and prolonged recessions, whether the adjustment starts in a recession or not. The dynamic response of the economy to a consolidation programme does depend on whether it is adopted in a period of economic expansion, but the size of this source of non-linearity is small relative to the effect that depends on whether the consolidation is tax-based or expenditure-based.

This result does is not systematically explained by different reactions of monetary policy and, therefore, it should survive when monetary policy is constrained at the zero lower bound (ZLB), or within monetary unions where monetary policy cannot respond to a member’s fiscal policy. We find, however, that in one case the response of monetary policy appears to make a difference. When the domestic central bank is not part of a currency union and so can set interest rates, it appears to be able to dampen the recessionary effects of tax-based consolidations implemented during a recession. This finding could help understand the recessionary effects of European austerity, which was mostly tax-based, and implemented within a currency union.

Our paper is only about fiscal adjustments. We have nothing to say about fiscal expansions. It is possible (we are silent on this point) that spending increases in recessions would be expansionary while having no effects during booms. We focus only on the opposite case of reducing, rather than increasing, deficits.

References

Alesina, A and F Giavazzi (2012), “The austerity question: ‘How’ is as important as ‘how much’”, VoxEU.org, 3 April. 

Alesina, A, C Favero and F Giavazzi (2015a), "The output effects of fiscal stabilization plans", Journal of International Economics, 96, 1, 19-42.

Alesina A, O Barbiero, C Favero, F Giavazzi and M Paradisi (2015a), "Austerity in 2009-13", Economic Policy, 30.

Alesina, A, G Azzalini, C Favero, F Giavazzi and A Miano (2016) “Is it the "How" or the "When" that Matters in Fiscal Adjustments?” NBER Working Paper, December

Alesina A, O Barbiero, C Favero, F Giavazzi and M Paradisi (2016b),"The output effects of fiscal adjustment plans: disaggregating taxes and spending", mimeo, IGIER.

Auerbach, A and Y Gorodnichenko (2012), "Measuring the Output Responses to Fiscal Policy", American Economic Journal: Economic Policy, 4(2), 1--27.

Owyang, M, V Ramey and S Zubairy (2013), "Are Government Spending Multipliers Greater During Periods of Slack? Evidence from 20th Century Historical Data", American Economic Review, 103(3):129-34.

Ravn, M and K Mertens (2009), “The timing of fiscal interventions: Don’t do tomorrow what you can do today”, VoxEU.org, 26 August. 

Endnotes

[1] A forthcoming paper (Alesina et al. 2016b) disaggregates spending into transfers and other public spending, and analyses the effects of fiscal adjustments, and the impact of changing current expenditure, transfers or taxes.

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Topics:  Macroeconomic policy

Tags:  deficit, fiscal policy, monetary policy, austerity, business cycle, zero lower bound

Nathaniel Ropes Professor of Political Economy, Harvard University; and Research Fellow, CEPR

PhD student in Economics, New York University, Stern School of Business

Head of Finance Department and Deutsche Bank Chair in Asset Pricing and Quantitative Finance, Bocconi University; CEPR Research Fellow

Professor of Economics, Bocconi University; and Research Fellow, CEPR

PhD student in Economics, Harvard University

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