The Right Way to Balance the Budget

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.

Andrew G. Biggs is a resident scholar at AEI. Kevin A. Hassett is a senior fellow and director of economic policy studies at AEI. Matt Jensen is a research assistant in the economics department at AEI.

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About the Author

 

Kevin A.
Hassett
  • Kevin A. Hassett is the State Farm James Q. Wilson Chair in American Politics and Culture at the American Enterprise Institute (AEI). He is also a resident scholar and AEI's director of economic policy studies.



    Before joining AEI, Hassett was a senior economist at the Board of Governors of the Federal Reserve System and an associate professor of economics and finance at Columbia (University) Business School. He served as a policy consultant to the US Department of the Treasury during the George H. W. Bush and Bill Clinton administrations.

    Hassett has also been an economic adviser to presidential candidates since 2000, when he became the chief economic adviser to Senator John McCain during that year's presidential primaries. He served as an economic adviser to the George W. Bush 2004 presidential campaign, a senior economic adviser to the McCain 2008 presidential campaign, and an economic adviser to the Mitt Romney 2012 presidential campaign.

    Hassett is the author or editor of many books, among them "Rethinking Competitiveness" (2012), "Toward Fundamental Tax Reform" (2005), "Bubbleology: The New Science of Stock Market Winners and Losers" (2002), and "Inequality and Tax Policy" (2001). He is also a columnist for National Review and has written for Bloomberg.

    Hassett frequently appears on Bloomberg radio and TV, CNBC, CNN, Fox News Channel, NPR, and "PBS NewsHour," among others. He is also often quoted by, and his opinion pieces have been published in, the Los Angeles Times, The New York Times, The Wall Street Journal, and The Washington Post.

    Hassett has a Ph.D. in economics from the University of Pennsylvania and a B.A. in economics from Swarthmore College.

  • Phone: 202-862-7157
    Email: khassett@aei.org
  • Assistant Info

    Name: Emma Bennett
    Phone: 202-862-5862
    Email: emma.bennett@aei.org

 

Andrew G.
Biggs
  • Andrew G. Biggs is a resident scholar at the American Enterprise Institute (AEI), where he studies Social Security reform, state and local government pensions, and public sector pay and benefits.

    Before joining AEI, Biggs was the principal deputy commissioner of the Social Security Administration (SSA), where he oversaw SSA’s policy research efforts. In 2005, as an associate director of the White House National Economic Council, he worked on Social Security reform. In 2001, he joined the staff of the President's Commission to Strengthen Social Security. Biggs has been interviewed on radio and television as an expert on retirement issues and on public vs. private sector compensation. He has published widely in academic publications as well as in daily newspapers such as The New York Times, The Wall Street Journal, and The Washington Post. He has also testified before Congress on numerous occasions. In 2013, the Society of Actuaries appointed Biggs co-vice chair of a blue ribbon panel tasked with analyzing the causes of underfunding in public pension plans and how governments can securely fund plans in the future.

    Biggs holds a bachelor’s degree from Queen's University Belfast in Northern Ireland, master’s degrees from Cambridge University and the University of London, and a Ph.D. from the London School of Economics.

  • Phone: 202-862-5841
    Email: andrew.biggs@aei.org
  • Assistant Info

    Name: Kelly Funderburk
    Phone: 202-862-5920
    Email: kelly.funderburk@aei.org

 

Matthew H.
Jensen
  • Matthew Jensen is a research associate for economic policy studies. He maintains an active research agenda focused on public finance and taxation, and he coordinates the ongoing development of AEI’s International Tax Database. Jensen has written for The Wall Street Journal, US News, and Tax Notes, among others, and he frequently appears on radio and television. Before joining AEI, he worked for a hedge fund in Minneapolis.


    Follow Matthew Jensen on Twitter.

  • Email: Matt.Jensen@AEI.org

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