REDUCING DEFICITS: Why Spending Cuts Beat Tax Increases

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At the Cato Institute, Adam N. Michel discusses the very real danger of the accumulating debt and rising deficits America faces today. He explains the research of Alberto Alesina, Carlo Favero, and Francesco Giavazzi on whether it is better to increase taxes or reduce spending to curb deficits. He writes:

In their 2019 book Austerity: When It Works and When It Doesn’t, Alberto Alesina, Carlo Favero, and Francesco Giavazzi summarize more than a decade of research on how countries have reduced budget deficits across 184 distinct austerity plans. The authors conclude: “Tax‐​based plans lead to deep and prolonged recessions, lasting several years. Expenditure‐​based plans on average exhaust their very mild recessionary effect within two years after a plan is introduced.” Because expenditure‐​based plans also usually include some tax increases, it’s worth noting that spending‐​cut‐​only plans may not be recessionary at all.

Major entitlement programs—Medicare and Social Security—are responsible for almost all the projected non‐​interest spending growth over the next three decades. Rapid health and retirement spending growth is neither caused by a lack of revenue nor fixable with tax increases. As I estimated earlier this year, “if Treasury collected as much revenue as it did in 2000 when it had a record 2.3 percent budget surplus, the U.S. would still have a 2022 budget deficit of about 5.1 percent of GDP (compared to the actual 5.5 percent deficit).” The deficit would continue to grow toward 10 percent of GDP over the next 30 years.

Even if Congress wanted to import a European‐​style tax system—raising taxes by thousands of dollars on Americans at every income level—it would still need to rein in spending growth, which is not projected to level off in any current projection.

In addition to being unable to fix the underlying growth rate of spending, tax increases come with economic costs that often worsen fiscal crises. In a 10‐​year review of new empirical research following the financial crisis, Valerie Ramey showed that in a majority of estimates, tax increases reduce GDP by two or three times the amount of revenue they raise.

In a 2020 report, I explained:

“Because tax increases have steep economic costs, they are less effective at reducing deficits. Alesina and his co‐​authors conclude that tax‐​based fiscal adjustments are “self‐​defeating: they slow down the economy and do not reduce the debt ratio.” Relying on taxes to close the fiscal gap can create a cycle of tax increases that slow down growth, which adds pressure to expenditure growth by increasing the use of countercyclical anti‐​poverty programs, which then requires still higher taxes to avoid a debt crisis. Additional evidence outside fiscal crises also shows that new taxes are followed by increases in spending, making deficits larger, not smaller.”

If large tax increases are self‐​defeating, it leaves spending cuts as the most effective way for Congress to address the budget crisis. Spending cuts are less likely to prolong recessions and can address the root cause of long‐​term deficits, uncontrolled spending growth.

In a review of fiscal adjustments, Andrew Biggs, Kevin Hassett, and Matthew Jensen conclude, “lasting reductions in debt stem from expenditure cuts, and less so from revenue increases…our results indicate that social transfer reductions should comprise the largest share of the consolidation; there is a stark difference between the very large transfer shares in successful consolidations and very small transfer shares in unsuccessful consolidations.”

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