Different approaches to austerity

This is a really interesting chart from the IMF’s October 2012 Fiscal Monitor (HT Antonio Fatás). The red dots are the cyclically adjusted primary balance, the blue bars changes in government expenditure and the yellow bars changes in tax revenue.

It shows the extent of austerity (the red dots). Look how ludicrous is the idea that Greece is not trying hard enough – their current and planned fiscal contraction is literally off the scale! (Here are similar numbers from the OECD.) But what I want to focus on, which this chart clearly shows, is the tax and spend composition of austerity.

In many countries (Ireland, Spain and the UK) austerity is concentrated on the expenditure side. In some (e.g. US) it is more evenly balanced, while in a few (France in particular) it mainly takes the form of rising taxes rather than lower spending. Now how you regard this depends crucially on whether these measures are permanent or temporary (where by temporary, I mean lasting around ten years or less).

If they are permanent, then this is largely a political issue about the size of the state. Raising taxes protects the existing size of the state (taking on board any distortionary costs that permanently higher taxes may bring), while cutting spending aims to reduce the size of the state. In terms of short run demand impact - which is obviously important given the current state of demand deficiency in most countries - permanent tax and spending changes will have similar effects.[1]

On the other hand, if these measures are temporary, then in macroeconomic terms their impact will be rather different, because multipliers are different. A very broad generalisation is that theory suggests multipliers for spending cuts will be significantly higher than those for tax increases. The simple idea is that consumers will smooth the impact of income changes due to tax increases, whereas cuts in spending go straight into reducing demand. In addition, incentive effects on labour supply will be much less important if they are temporary and output is demand constrained.

We need to be careful, however, because this is a generalisation that applies to government spending on goods and services with a high domestically produced content. If the decline in government spending involves a temporary reduction in civil servants’ salaries, rather than building fewer hospitals or roads, then it is much more like a tax cut. As analysis later in the IMF’s report shows, cuts in wages make up a significant proportion of spending cuts in Portugal, but not much in the UK, where cuts in government investment are more important.

So are these austerity measures temporary or permanent? Normally governments do not say. An exception is a much remarked upon feature of the French austerity plans, which is the introduction for two years of a new top tax rate of 75% on incomes over €1m. We can be pretty sure that this is one group where the income effects of tax increases on consumption will be largely smoothed away (which is good), but where the incentive effects are the subject of debate which seems more ideological than evidence based. Of course whether such temporary tax measures will in fact be temporary is a moot point, as the Bush tax cuts in the US illustrate.

In the absence of reliable information from governments, people have to make their own assessments.  In the initial stages of a crisis, if either there is an unforeseen shock to government finances, or to the long run level of output, then it may make sense to regard any austerity as permanent. However as austerity proceeds, the goal is to get debt down from a high but sustainable level to a lower sustainable level. In these circumstances a rise in taxes (say) will be temporary, and will eventually be reversed as lower debt reduces debt interest payments and therefore taxes.

So it seems likely that a good part of current austerity plans involve temporary fiscal changes designed to reduce debt levels, and so the differences between the multipliers of tax and spending changes will apply. For countries like the UK, that have focused on spending cuts, the knock on effects on output will be relatively large, whereas for countries like France the impact of austerity may be more moderate (although still unwelcome).

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[1] Spending cuts may still have a larger impact on domestic demand because government spending tends to have a lower import content than private spending.