Brady-European-Austerity - International Atlantic Economic

Austerity in the European Union:
Keynesian stimulus versus fiscal
Gordon L. Brady
For presentation at the
International Atlantic Economic Society
Madrid, Spain, 5 April 2014
On March 26, 2014, The Wall Street Journal
article “ECB set to mull heavier stimulus.”
“ECB officials sent strong signals” that they are
willing to consider “dramatic steps to guard
against dangerously low inflation, suggesting the
bank is prepared to shed some of its traditionally
cautious approach.” The dramatic steps include
negative interest rates and asset purchases to
combat indications of deflation.
The organization of this paper:
• Discussion of current EU issues
• Fiscal consolidation research.
• Non-Keynesian expansions.
• Unfounded fears of political consequences of fiscal
• Summary and conclusion
European Union Issues
The main causes of the sovereign debt crises in Europe
varied by country. In Ireland and Spain, they were mainly
due to the private sector, particularly housing. Those crises
were similar to what occurred in the US, namely the savings
and loan crisis of the 1980s, the agricultural crisis in the
1980s, and the mortgage crisis in 2007-08.
In Greece and Portugal, the cyclically adjusted structural
deficit was among the major causes. In Ireland and Spain,
domestic housing booms were financed from foreign
borrowing as creditors failed to require a risk premium
related to the probability of default. Debts were excessive
and the actual debt exceeded the optimal debt derived from
any rational calculations or analysis. When the return on
capital fell below the rate of interest, the borrowers in the
housing industry defaulted. Their creditors were the banks,
which in turn, were debtors to the international lenders.
To address the problems associated with the
financial meltdown of 2008, many
governments initiated Keynesian “stimulus”
programs containing one-time rebates,
increased transfer payments to households,
transfers to state and local governments to
shore up budgetary shortfalls, and additional
government spending on infrastructure.
Consequently, government budget deficits and
government debt as a percentage of GDP rose
Getting worse - government debt
as percent of GDP
115.1% 161%
115.8% 126%
76.8% 124%
Recognition of need for major fiscal change
came early
Beginning as early as November 2009, the
International Monetary Fund and other
international organizations called upon
countries to create a “credible plan for a
fiscal exit” in order to avoid a looming
government debt crisis.
Fiscal consolidation program:
(1) reduce government budget deficits,
(2) stabilize government debt as a
percentage of GDP.
Enforcement of the EU’s 3% budget
deficit became politically expedient as
did the “continuing, continuing
resolutions” which allowed the US
congress to “kick the can” (ever larger
federal deficits) to future generations.
Budget deficits -- 2009
3.0 %
13.6 %
5.3 %
7.5 %
11.1 %
9.3 %
Tiring of austerity, a recent Economist
article noted that some European policy
makers are seriously considering major tax
reforms in France, Italy, Spain.
In January, France announced plans to cut
payroll taxes by €30 billion ($42 billion).
In March, Italy unveiled income-tax cuts
worth €10 billion for those earning less than
€25,000 a year.
Most recently Britain proposed tax cuts for
most low or medium income brackets.
Ireland and Spain are also planning tax cuts
later this year.
Politicians, such as Italy's new prime minister,
Matteo Renzi, realize that taxpayers are fed up
with paying ever higher rates. France now
levies nearly 55% of its GDP in tax.
In several EU economies, particularly Greece,
higher rates are no longer fulfilling
expectations of bringing in the additional
revenue they counted on. Greece appears to
have awakened to the fact that taxes dampen
the supply and encourage tax “avoision,” a
term coined by Arthur Seldon, the co-founder
of the Institute of Economic Affairs.
So now to a pro-growth agenda
Cutting tax expenditures and various tax
breaks are important. But some fiscal
measures may be more effective in
generating growth.
Go for those that decrease labor costs,
but caveats to tax cuts.
Current US budget proposal
House Ways and Means Committee
Chair David Camp (R-MI)
The median income in the US is 4.4% lower than when
recession ended.
• Objective - Lower tax and fairness, but general focus
• Attempt to shift debate from redistribution o economic
• Reduces 7 top income tax brackets into 3 groups of
payers of 10% or 25%
• Top decreased from 40% to 35% for those over $400K or
joint $450K
• Cut deductions, credits and interest group carve outs
• Raises standard deduction to $11K and $22K for joint.
• Lowers the mortgage interest deduction to $500K from
$1 million.
• Corporate rate falls to 25% from 35%
Tax cut caveats
Buchanan and Wagner (1977) argued that taxpayers may view tax
cuts as reflecting a decrease in the cost of government which leads
them to increase demand for the now cheaper public sector programs.
They suggest that the complicated nature of tax systems causes fiscal
illusion and may result in greater public expenditure than would be the
case in a system in which everyone is aware of their share of the costs
of government . The Italian public finance theorist Amilcare Puviani
recognized this point in his 1903 book.
Reforming taxes on labor
Some economists doubt that cutting the income tax,
Italy’s approach, is the best way to stimulate
growth. Instead, they favor slashing Europe’s high
employer-paid social-security charges, as proposed
by France. The US successfully did this in 2010.
This would directly lower labor costs and thereby
encourage companies to hire extra workers as well
as to increase investment in plant and equipment.
Increasing the returns to hiring would also boost
growth. The IMF argues that Italy could raise its
present growth rate by at least half a percentage
point a year if it shifted the burden of taxes away
from firms and onto consumption. For Italy’s new
government, cutting the burden on employers
should be an important action in order to increase
However, deeper tax reform in Europe is needed than
that those currently discussed. High employer socialsecurity contributions compared to the rest of the
OECD are a problem but not the main contributor to
concerns about competitiveness.
Other taxes like the Italy’s Regional Production Tax
(IRAP) should also be discussed. At this time,
taxing what firms produce, rather than profits after
expenses as most countries do, raises business costs
and reduces the incentives to hire and invest.
As for coming up with ways to pay for tax cuts, there are
options. Many commentators argue that tax expenditures
should be cut all over the continent.
These include such outdated tax breaks as currently provided
to French journalists, German night-workers and Italian
farmers high on the list.
Overall, such tax programs are costly. Italy now spends 8.1%
of its GDP on tax breaks each year. Cutting tax expenditure
programs could be used to reduce income tax rates.
It would boost economic growth without increasing budget
deficits, according to an IMF study by Tyson. These efforts
should be pursued although politicians fear it might cost their
reelection. There is ample empirical evidence supporting
taking these political risks. However, there may be more
effective courses of action as argued by Buchanan and
Wagner (1977) and demonstrated in a number of studies by
Alberto Alesina and others,
Empirical evidence on fiscal consolidation
Harvard economist and former president of the IAES)
Alberto Alesina and others show that fiscal consolidations
based predominately or exclusively on government
spending reductions are more likely to lead to economic
expansion and growth than fiscal consolidations in which
revenue increases play a significant role.
These are basically supply side approaches. Alesina,
his co-authors, and others found that for a government with
a large, persistent budget deficit and a high level of
government debt, reducing government spending as a
percentage of GDP boosts the expected after-tax rate of
return on investment for several reasons.
The payoffs from spending reductions.
• Spending reductions lower real interest rates by
decreasing the government’s current and future
demand for credit.
• Large and persistent government budget deficits
and a high and rising level of government debt
cause the public to expect large tax increases in
the future.
• Spending reductions diminish the prospects for
future tax increases which stimulate consumer
spending and business investment.
Non-Keynesian” effects of fiscal consolidations
Keynesians assert that reducing government spending as a
percentage of GDP would be contractionary in the short
term, but expansionary in the long term.
Alesina and other neoclassical economists revived the
traditional view that fiscal consolidation programs based
predominately or entirely on government spending
reductions have expansionary “non-Keynesian” effects that
may offset some or all of the contractionary “Keynesian”
reduction in aggregate demand in the short term.
Giavazzi and Pagano (1990), Perotti (1999), and
Giavazzi et al. (2000) found that fiscal consolidation
programs based predominately or entirely on
government spending reductions provide a short-term
boost to personal consumption expenditures and
residential fixed investment.
Alesina et al. (2002) found that “[f]iscal adjustments
which rely mostly on spending cuts, particularly in
transfers and government wages, are associated with a
surge in growth during and immediately after the
adjustment changes in business investment explain a
large part of the change in GDP growth around these
large fiscal stabilizations.”
Examining data for 18 OECD member-countries from
1960–1986, Alesina et al. (2002) estimated how an
increase in primary government spending and its major
components—government employee compensation,
transfer payments, and government consumption—
would affect private investment as a percent of GDP.
An increase in primary government spending equal to
one percentage point of GDP would decrease private
investment by 0.15 percent of GDP in the same period
and by 0.74 percent of GDP cumulatively over five
Reducing government
Certain government spending reductions generate
significantly larger pro-growth effects than others. For
“non-Keynesian” factors to be significant, government
spending reductions must be viewed as large, credible,
and politically difficult to reverse once made. Some
examples of such reductions are:
• Decreasing the number and compensation of
government workers.
• Eliminating unnecessary agencies and programs.
• Eliminating transfer payments to firms – corporate
• Reforming and reducing transfer payments to
• Asset sales and privatization
Lilico, Holmes, and Sameen (2009) found that
successful fiscal consolidation programs were
comprised of at least 80% government spending
reductions and no more than 20% tax increases.
Alesina and Ardagna (2009) examined 107 large
fiscal adjustments (defined as a cyclically adjusted
improvement in the primary balance of at least
1.5% of GDP in one year) in 21 OECD membercountries (Australia, Austria, Belgium, Canada,
Denmark, Finland, France, Germany, Greece,
Ireland, Italy, Japan, the Netherlands, New
Zealand, Norway, Portugal, Spain, Sweden,
Switzerland, the United Kingdom, and the United
States) from 1970 to 2007.
Alesina and Ardagna (1998) concluded
that “regardless of the initial level of debt,
a large fiscal adjustment that is
expenditure-based and is accompanied by
wage moderation and devaluation is
Biggs, Hassett, and Jensen (2010) found that
government spending reductions outweigh revenue
increases in successful consolidations regardless of the
methodology used to identify consolidations.
Giudice, Turrini and Veld (2003) studied the
fiscal policy conducted by 14 EU memberstates over a period of 33 years.
There have been 49 (based on size) and 74
(based on duration) episodes of fiscal
consolidation. About half of them (24 and
43, respectively) have been connected with
higher economic growth.
Keys for success – “the cold shower”
Barrios, Langedijk, and Pench (2010) found
that quick, decisive government spending
reductions (called “cold showers”) are
effective in achieving successful fiscal
consolidations because they send a signal
about “political will.”
Hitting all margins
Von Hagen, Hughes-Hallet, and Strauch
(2002) found that the likelihood of
sustaining a fiscal consolidation program
increases when governments simultaneously
address all politically sensitive budget
reductions (e.g., transfer payments to
households and firms, subsidies, and the
number and compensation of government
Fear of the political consequences of fiscal
consolidation are not well grounded.
Alesina and Ardagna (1998) found that successful fiscal
consolidations were not politically fatal to the
governments that enacted them.
“[I]t is not the case that governments which engage in
large fiscal adjustments are systematically kicked out of
office. Just the opposite: in the vast majority of cases,
the government that implemented the adjustment was
reappointed. This result is consistent with the statistical
results of Alesina, Perotti, and Tavares (1998).”
A complicated story, but a simple
message for fiscal consolidation to
focus primarily on spending cuts.

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