Fiscal consolidation: Non-Keynesian fiscal adjustments
By
Gordon L. Brady
Alberto Alesina and several colleagues have been an important force in the work on non-Keynesian effects of fiscal adjustments. While the recent work has been dominated by Alesina, much of the historical roots of controlling leviathan can be found in the writing of the Henry Simons, Aaron Director, and Henry Hazlitt. Regarding the effects of fiscal stimulus, their primary worry was about political economy consequences, and in particular on the credibility of fiscal tightening during the up-phase of the business cycle. This paper reviews their contributions to the question of non-Keynesian effects of fiscal adjustments and seeks to identify the relevant public choice insights useful in bringing about non-Keynesian economic growth and expansion.
Fiscal consolidation refers to a multiyear program to (1) reduce government budget deficits, and (2) stabilize government debt as a percentage of GDP. A successful fiscal consolidation should not only achieve these objectives, but also should stimulate economic growth. Theoretically, fiscal consolidation could occur through any combination of government spending reductions and revenue increases (including tax increases and government asset sales).
However, a growing body of empirical studies proves that fiscal consolidations based predominately or exclusively on government spending reductions are far more likely to be successful than fiscal consolidations in which revenue increases play a significant role. Keynesian economists and their macroeconomic models hold that fiscal consolidations are contractionary. According to the Keynesians, spending reductions decreases GDP because (1) reducing the level of government employment or the compensation of government workers decreases government consumption, (2) reducing government spending for infrastructure decreases government investment, and (3) reducing transfer payments decreases personal consumption expenditures. Tax increases also reduce GDP because both personal consumption expenditures and private investment fall.
Recent empirical studies by Alesina and others found that fiscal consolidations based predominately or exclusively on spending reductions may actually be expansionary. 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 two reasons:
1. Spending reductions lower real interest rates by decreasing the government’s current and future demand for credit.
2. 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.
While all this makes sense, there are strong institutional obstacles and powerful interest groups which seek to derail the potential improvements of these economic responses. The work of Buchanan, Tullock, Wagner, and others will be discussed with regard to the forces opposing the success (budget, deficit, and debt reduction) of the economic response to fiscal consolidation.