An Incomplete and Misleading Austerity Argument
Veronique de Rugy cites Alesina and Ardagna (A&A) as gospel proving that tax cuts are always better at stimulating the economy than increased government spending, but subsequent papers have seriously called into question the A&A methodology. IMF found A&A’s conclusions to be dramatically incorrect in cases of large spending cuts, which are clearly contractionary; a 1% cut in spending results in a 0.5% reduction in GDP and a 0.3% increase in unemployment in two years. Great Britain’s experience seems to be bearing this out already.
Krugman claims a preference for Amunia et al because they focus on more similar economic situations – specifically zero interest rates. Krugman’s criticism seems valid, as the impact of larger deficits clearly depends on interest rates.
For support, de Rugy then cites an IMF paper titled “Default in Today’s Advanced Economies: Unnecessary, Undesirable, and Unlikely,” incorrectly claiming it “found similar results” when it in fact cites the World Economic Outlook paper so critical of A&A above.
De Rugy also cites Romer and Romer, noting part of their conclusion: “increasing taxes by 1 percent of GDP for deficit-reduction purposes leads to a 3 percent reduction in GDP.” But the Romers clearly state that “failing to account for the reasons for tax changes can lead to substantially biased estimates of the macroeconomic effects of fiscal actions.” They specifically separate tax actions that are “deficit-driven,” concluding that “the response to a deficit-driven tax increase is positive, though not [statistically] significant” [emphasis added]. In other words, when taxes are raised specifically to reduce an inherited budget deficit (such as we have today), GDP doesn’t decline as de Rugy wants us to believe, but actually appears to grow slightly. “This is consistent with the idea that deficit-driven tax increases may have important expansionary effects through expectations and long-term interest rates, or through confidence,” conclude the Romers.
So which tax increases did the Romers include in the “deficit-driven” category that seems to cause GDP to grow? Those of 1982, 1987, 1990, 1993 — every large tax increase in the last 30 years. And any tax increase today would certainly be in the same category.
All in all, not a tour de force de Rugy performance.