Balancing the Budget – The Sane Approach

As a follow-up to a previous post titled, “RIP – The Best Available Version of the Truth” and an introduction to the complete text of a recent article in the Wall Street Journal below, I’d like to offer the following personal observation.

A few months ago, a friend and I were discussing the topic of truth, which for the purposes of this post I’d like to define as that which is in accordance with fact or reality. My position was that the average person can’t trust much (if anything) of what is fed to the public by the media because it’s all tainted with bias in one form or another. My friend responded by suggesting that I was a nihilist, a person who rejects all moral and religious principles, often in the belief that life is meaningless.

I have to admit that although I couldn’t have provided that specific definition at the time, I rejected his assertion because it’s not a matter of believing that meaning doesn’t exist, or that truth doesn’t exist, but that I can’t trust anyone else to provide it. It’s the difference between finding out for myself by going to the source (wherever that might be and with the assumption that it’s available out there somewhere), or accepting someone else’s version.

And so it is for trying to understand two diametrically opposed approaches to dealing with America’s looming fiscal disaster, divided along the lines of Democratic versus Republican and liberal versus conservative. Which, of course, begs the issue of truth, because neither end of this political and fiscal philosophy continuum has a monopoly on fact or reality.

I’m sure that someone can find reason to label the WSJ as biased one way or the other and reject the premise and background information contained in the following article. But when I consider them, only one thought comes to mind: Why is it that our great nation can’t do anything but continue a precipitous descent into the black pit of insolvency? We have no solution, and we won’t find one unless we cease the partisan bickering and try something that has a track record of positive results.

So, without editing or inserted illustrations, here is “The Right Way to Balance the Budget: The experience of 21 countries over 37 years yields a simple truth: Cutting spending works, and raising taxes doesn’t” by Andrew G. Biggs, Kevin Hassett, and Matt Jensen.

The federal debt is at its highest level since the aftermath of World War II—and it’s projected to rise further. Simply stabilizing debt levels would require an immediate and permanent 23% increase in all federal tax revenues or equivalent cuts in government expenditures, according to Congressional Budget Office forecasts. What’s clear is that to avoid a crisis, the federal government must undergo a significant retrenchment, or fiscal consolidation. The question is whether to do so by raising taxes or reducing government spending.

Rumors have it that President Obama will propose steps to address growing deficits in his next State of the Union address. The natural impulse of a conciliator might be to split the difference: reduce the deficit with equal parts spending cuts and tax increases. But history suggests that such an approach would be a recipe for failure.

In new research that builds on the pioneering work of Harvard economists Alberto Alesina and Silvia Ardagna, we analyzed the history of fiscal consolidations in 21 countries of the Organization for Economic Cooperation and Development over 37 years. Some of those nations repaired their fiscal problems; many did not. Our goal was to establish a detailed recipe for success. If the United States were to copy past consolidations that succeeded, what would it do?

This is an important question, because failed consolidations are more the rule than the exception. To be blunt, countries in fiscal trouble generally get there by making years of concessions to their left wing, and their fiscal consolidations tend to make too many as well. As a result, successful consolidations are rare: In only around one-fifth of cases do countries reduce their debt-to-GDP ratios by the relatively modest sum of 4.5 percentage points three years following the beginning of a consolidation. Finland from 1996 to 1998 and the United Kingdom in 1997 are two examples of successful consolidations.

The data also clearly indicate that successful attempts to balance budgets rely almost entirely on reduced government expenditures, while unsuccessful ones rely heavily on tax increases. On average, the typical unsuccessful consolidation consisted of 53% tax increases and 47% spending cuts.

By contrast, the typical successful fiscal consolidation consisted, on average, of 85% spending cuts. While tax increases play little role in successful efforts to balance budgets, there are some cases where governments reduced spending by more than was needed to lower the budget deficit, and then went on to cut taxes. Finland’s consolidation in the late 1990s consisted of 108% spending cuts, accompanied by modest tax cuts.

Consistent with other studies, we found that successful consolidations focused on reducing social transfers, which in the American context means entitlements, and also on cuts to the size and pay of the government work force. A 1996 International Monetary Fund study concluded that “fiscal consolidation that concentrates on the expenditure side, and especially on transfers and government wages, is more likely to succeed in reducing the public debt ratio than tax-based consolidation.” For example, in the U.K’s 1997 consolidation, cuts to transfers made up 32% of expenditure cuts, and cuts to government wages made up 21%.

Likewise, a 1996 research paper by Columbia University economist Roberto Perotti concluded that “the more persistent adjustments are the ones that reduce the deficit mainly by cutting two specific types of outlays: social expenditure and the wage component of government consumption. Adjustments that do not last, by contrast, rely primarily on labor-tax increases and on capital-spending cuts.”

The numbers are striking. Our research shows that the typical successful consolidation allocates 38% of the spending cuts to entitlements and 25% to reductions in government salaries. The residual comes from areas such as subsidies, infrastructure and defense.

Why is reducing entitlements and government pay so important? One explanation is that lower social transfers spur people to work and save. Reducing the government work force shifts resources to the more productive private sector.

Another reason is credibility. Governments that take on entrenched, politically sensitive spending show citizens and financial markets they are serious about fiscal responsibility.

While tax hikes slow revenue growth, policies that credibly reduce government spending in the long run boost economic growth by more than their simple effects on deficits might imply. Any attempt to address the federal government’s budget shortfall that relies on less than 85% spending cuts runs too large a risk of failure. The experience of so many other countries shows that it’s crucial for the U.S. to get this right.

Mr. Biggs is a resident scholar, Mr. Hassett is the director of economic policy studies, and Mr. Jensen is a research assistant at the American Enterprise Institute.

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One Response to Balancing the Budget – The Sane Approach

  1. Ann says:

    And here we are 4.5 more years down the road of wild spending with hope and change ’cause they want it that way.

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