A couple of posts ago, I talked about the new found fondness for austerity throughout Europe. As I mentioned, it isnt 100% clear that this is a good idea. It will probably make the recession worse. But for a country as indebted as Ireland , it probably makes sense. If we donbt curb our borrowing, we might run out of people willing to lend us money at a reasonable rate.
So if we are going to cut the deficit should we increase taxes or reduce expenditure? In the last budget the government chose large reductions in expenditure and relatively small increases in taxes. The recent UK budget took a similar path. Whether this is a good or a bad idea obviously comes heavily loaded with ideological or philosophical considerations. Is there anything objective to be said?
Fortunately the answer is yes! Let me be up front and say that I believe that the evidence points to expenditure cuts being better than tax increases. There is a large body of economic literature that studies large scale fiscal crises. The main conclusions of this literature is that plans to solve these crises based on increasing taxes tend not to be successful, while those based on expenditure cuts do tend to be successful. The reason is, presumably, that tax increases need to be large to close the deficit. Large increases in tax rates reduce the incentives for people to work and pay tax and so, in fact, end up generating much less revenue than was anticipated. The net result is that even though tax rates go up, the deficit is not reduced.
Of course this isn’t an iron law of nature — it is just an observed relationship that tends to hold in practice. But it is informative. If we propose to go in the opposite direction and increase taxes for philosophical reasons, we would have to ask why would expect it to work here and now when the international is experience suggests it wont? Why is Ireland different? Ireland might be different of course, but we would need to be clear why this is the case.
In fairness, the methodology used in this lieterature has been criticsied — inluding by me with my academic hat on. Nevertheless, I dont think that these criticisms are fatal to the overall conclusion. In addition recent work by Philip Lane from TCD has shown that the effect on the economy of cutting public sector salaries is less damaging than that of cutting taxes. Both these pieces of evidence (the international experience and Lane’s work) suggest that expenditure cuts are the way to go in order to stabilize the budget. But there is a philosophical consideration. Expenditure cuts will inevitably hurt vulnerable people in society. We may decide to go with tax increases (even if they are less likely to work) for moral reasons. But we must be honest and acknowledge that we adopting a policy that is less likely to work and may only be postponing the inevitable. If that is so, then we are not doing the vulnerable (or anyone else) any favours.
