The effects of austerity: recent research.
Alesina, Alberto ; Giavazzi, Francesco
What are the costs in terms of output losses of so-called
"austerity" policies designed to reduce large government
deficits and mounting public debt? The debate on this issue is raging,
especially after the latest round of austerity in Europe.
The question is difficult to answer for at least three reasons. The
first is "endogeneity," the two-way interaction between fiscal
policy and output growth. Suppose you observe a reduction in the
government deficit and an economic boom. It would be highly questionable
to conclude that deficit reduction policies generate growth, since it
could be easily the other way around. Second, major episodes of
austerity are often accompanied by changes in other policies: monetary
policy, exchange rate movements, labor market reforms, regulation or
deregulation of various product markets, tax reforms, and so on. In
addition, they are sometimes adopted at times of crisis due to runaway
debts, not in periods of "business as usual." Third, virtually
all austerity programs are based upon multi-year plans announced in
advance and then revised along the way. To the extent that expectations
matter, the multi-year nature of these plans cannot be ignored.
An early literature started by Francesco Giavazzi and Marco Pagano
(1) and reviewed and summarized by Alberto Alesina and Silvia Ardagna
(2) reached two conclusions regarding austerity policies in advanced
industrial economies. First, expenditure-based adjustments, namely those
based upon cutting spending and not raising taxes, or relying less on
tax increases than on spending cuts, were found to be much less costly
in terms of output losses than tax-based approaches. Second,
expenditure-based adjustments accompanied by an appropriate set of
related policies can sometimes be expansionary, even in the short run.
This literature was well aware of the three problems discussed
above. The first was initially addressed by considering cyclically
adjusted deficit over GDP ratios as measures of fiscal policy. This
variable, in principle, should eliminate the effects on deficits of
output fluctuations. The second and third problems were addressed in a
variety of ways, including case studies. (3)
In some recent research, we and our coauthors have revisited these
questions, and tried to go deeper (4) than previous work. In order to
address the endogeneity problem, we adopt the "narrative
method" proposed by Christina Romer and David Romer. (5) This
approach attempts to solve the endogeneity problem by identifying
through direct consultation of the relevant budget documents only
changes in fiscal policy not implemented to achieve cyclical
stablization, but for other goals. Implementing this technique, Romer
and Romer identified episodes of tax changes in the U.S. (6) Using a
similar methodology, Pete Devries, Jaime Guajardo, Daniel Leigh, and
Andrea Pescatori identified "exogenous" increases in taxes and
spending cuts motivated by the explicit desire to reduce deficits for 17
OECD economies over the period 1980-2007. (7) Guajardo, Leigh, and
Pescatori (8) analyzed these data and found results broadly consistent
with those summarized by Alesina and Ardagna, (9) although with some
variation on the size of the difference between tax increases and
spending cuts, depending on monetary policy.
In the previously cited work with Carlo Favero, we address the
third problem mentioned above, namely that fiscal adjustments are
typically carried out through multi-year plans in which announcements
and revisions deeply affect the expectations of economic agents. To
begin, we checked the episodes of exogenous fiscal consolidations
identified by Devries, et al, and corrected a few inconsistencies. More
importantly, we constructed "plans." By going back to the
original sources (National Budget Reports, EU Stability Programs, IMF
documents, OECD Economic Surveys, etc.), we reconstructed actions taken
at the time an austerity plan was adopted, announcements made at the
time of adoption regarding future periods of up to three years, and
revisions of these announcements in the actual policies then carried
out.
To be more precise, a fiscal plan implemented at time t typically
contains three components:
* Unexpected shifts in fiscal variables, announced upon
implementation at time t
* Shifts implemented at time t but which had been announced in
previous years
* Shifts announced at time t, to be implemented in future years
Each year of a fiscal plan is fully characterized by these three
components, which we allow to have different effects on macroeconomic
variables.
To study the potentially heterogeneous effects of plans depending
on their nature, we distinguish between Tax-Based (TB) and
Expenditure-Based (EB) plans. A plan is labeled TB if the sum of all the
tax measures (unexpected, announced in the past and currently
implemented, and announced at t for future implementation) measured as a
fraction of year t GDP is greater than the sum of the corresponding
expenditure measures.
Consider as an example the Australian fiscal plan implemented
between 1985 and 1988. The plan was announced in 1985 and consolidation
lasted until 1988 with subsequent revisions of the original plan. In
1985 the government announced a sequence of medium-term spending cuts
aimed at reducing a large, inherited budget deficit. The initial plan
featured no change in taxation and spending cuts of 0.45 percent of GDP
in both 1985 and 1986. In 1986, the plan was revised. The new plan
called for additional spending cuts of 0.4 percent of GDP to be
implemented immediately, that is, in 1986; it also announced a further
spending cut of 0.26 percent of GDP to be implemented in 1987 and a
small reversal of -0.08 in 1988. Eventually, in 1987, this slight
spending reversal was abandoned and replaced by further cuts amounting
to 0.37 percent of GDP. Revenue increases were also introduced: an
unanticipated tax increase of 0.17 percent of GDP was implemented in
1986, while a further increase of 0.19 percent of GDP, and an almost
complete reversal of -0.27, were announced for 1987 and 1988. In each of
its four years, this plan is an "EB" plan because expenditure
cuts exceed tax increases. This example shows that overlooking
pre-announced plans and considering simply unanticipated shifts in
fiscal variables would ignore important information available both to
firms and to consumers.
When studying fiscal plans, it is important to take into account
the correlation between tax changes and spending cuts. Governments never
decide the two components in isolation, but design the plan as a whole.
For instance, a government may first decide it needs to implement an
adjustment of, say, 2 percent of GDP and also decide that 0.5 percent of
that adjustment will take place through spending cuts. Once this
decision is adopted, tax increases are endogenous: They will amount to
(2-0.5) = 1.5 percent of GDP. Similarly, one should also consider the
correlation between unexpected measures and those announced for future
implementation, because they are also jointly determined within a plan.
We categorize plans according to what we call their "style,"
which reflects the correlation between unanticipated shifts in fiscal
variables and those announced for the future. In some countries--Italy,
for example--actions such as spending cuts often are reversed after
being implemented. In other countries--Canada, for example--fiscal
actions are persistent. Country "styles" are particularly
important when we simulate the effect of an unanticipated shift in
fiscal variables, amounting, say, to 1 percent of GDP, paired with the
announcement of actions to be taken in the future. Omitting
announcements would amount to simulating a plan that is not the one
actually adopted.
In our work with Favero, we simulate the effect of the average plan
implemented over the estimation period (1981-2007). (10) In work with
Favero, Omar Barbiero, and Matteo Paradisi, (11) we simulate out of
sample the plans adopted by various countries since 2010. In the first
of these papers, we examine the effect of EB and TB plans on output,
private consumption, investment, and consumer and investor confidence
for 14 countries: Australia, Austria, Belgium, Canada, Denmark, Germany,
Spain, France, United Kingdom, Ireland, Italy, Japan, Portugal and the
United States. In our sample, 84 plans are EB and 51 are TB. Although
our model with the TB and EB dummies could be sensitive to the
categorization of plans into EB and TB, in particular if spending and
tax shares were close to 50 percent, this is not the case here. The vast
majority of plans in our estimation sample are far from a 50-50. In only
three plans is the share of spending cuts between 49 and 51 percent and
in only 15 is it between 45 and 55. The share of spending cuts in the
average EB plan (in which the average total annual adjustment is 1.36
percent of GDP) is 84 percent, while in the case of TB plans (in which
the average total annual adjustment is 0.89 percent of GDP) the share is
76 percent. In the estimated model, the effects of EB and TB adjustments
are constrained to be the same across countries. We allow styles to
differ across countries, and we allow for parameter differences between
euro area and non-euro area countries.
Our main finding is that fiscal adjustments based upon cuts in
spending are much less costly, in terms of output losses, than those
based upon tax increases. Over our estimation period (1981-2007), the
output effect of an average TB adjustment plan with an initial size of
one percent of GDP is a cumulative contraction in GDP of two to three
percent in the following three years. (12) In contrast, spending-based
adjustments generate very small recessions, with an impact on output
growth not significantly different from zero. As an example, Figure 1
shows the large differences between the effects of a one percent
reduction of deficits implemented through an EB plan (in blue) and a TB
plan (in black) in Canada. The effect on output growth of EB plans is
indistinguishable from zero for about two years and then becomes
significantly positive, while TB adjustments lead to deep recessions.
The component of aggregate demand which seems to explain these
differences in all countries, not only Canada, is investment, which is
correlated with investor confidence.
[FIGURE 1 OMITTED]
In our work with Favero, Barbiero, and Paradisi, we extend the
dataset up to 2013 for the following countries: Austria, Belgium,
Denmark, Spain, France, Germany, United Kingdom, Ireland, Italy,
Portugal, and the United States. (13) The effects of recent episodes of
austerity do not look different from previous ones. Out-of-sample
simulations of our model projecting output growth conditional only upon
exogenous fiscal adjustments do reasonably well in predicting the total
output fluctuations of the countries in our sample over the years
2010-13, particularly for those countries in which the main shock in
that period was a fiscal policy one. For example, our estimates suggest
that the tax-based adjustment implemented in Italy in 2010-13 is
sufficient by itself to explain the recession experienced by the country
over the period 2011-12, with negative GDP growth of around 2 percent in
each year. The expenditure-based adjustments implemented in countries
such as the U.K. and Denmark are associated with much milder recessions,
with GDP growth fluctuating around zero.
We cannot reject the hypothesis that recent fiscal adjustments had
the same effect on output growth as past ones, although in some cases
failure to reject is marginal. We do not find sufficient evidence to
suggest that the recent rounds of fiscal adjustments have been
especially costly for the economy, and we conclude that the fiscal
multipliers estimated using data from the pre-crisis period give
valuable information about the amount of output loss due to the
post-crisis fiscal consolidation measures. This result is at odds with
Blanchard and Leigh, (14) who find that the costs of fiscal adjustments
have been higher in recent years than previously estimated. The
difference between the two results depends on a number of factors,
including our choice not to constrain consolidations based on spending
cuts and those based on increases in government revenues to have
identical effects on output.
In current work in progress with Favero, Barbiero, and Paradisi,
(15) we take our analysis a step further by exploring the potential
heterogeneity in the output effects associated with different components
of revenues and expenditures. We disaggregate fiscal shocks into four
components: government consumption and investments, transfers, direct
taxes and indirect taxes. From a theoretical point of view, each of
these components should affect GDP growth through different channels.
For instance, in the short run, cuts in government consumption and
investment might impact GDP growth through demand-side effects; in the
medium and long run, their effect on growth might depend on the
government's efficiency in providing public goods and services.
Transfer cuts reduce the resources available to households, which in
turn may be forced to cut consumption, especially if liquidity
constrained. These measures also may have supply-side effects by
increasing labor supply. In addition, a reduction in both expenditure
components may generate expectations of lower taxes and correspondingly
reduced future economic distortions, with potentially positive wealth
effects.
[FIGURE 2 OMITTED]
The previous literature has addressed the issue of composition
primarily by looking at revenues versus spending in the aggregate.
Recent papers by Karel Mertens and Morten Ravn, (16) Romer and Romer,
(17) and Roberto Perotti (18) are exceptions. However, they focus only
on the United States. Our paper presents an international panel of
disaggregated fiscal consolidation plans and analyzes their economic
effects. Building on the methodology established in our work with
Favero, we classily fiscal plans into four categories: direct tax-based,
indirect tax-based, consumption-based, and transfers-based.
Our first finding is that plans based on different spending and
revenue components indeed have heterogeneous effects on GDP growth, as
Figure 2 shows for the case of France. Results for the other countries
are similar. While the heterogeneity in revenue components is less
pronounced, on the expenditure side transfers seem to be clearly
different from consumption and investment. The effect of a cut in
transfers is more similar to that of an increase in taxation than to
that of a cut in expenditure. Looking at other macroeconomic variables,
the similarity between tax hikes and transfers cuts is particularly
evident in the case of consumption and consumer confidence. The impact
of a cut in transfers on investment is more similar to a cut in
government consumption. The overall impact on output growth is more
negative than that from a cut in government consumption, but less
negative than a tax increase.
Overall, our findings suggest that major fiscal adjustments based
upon cuts in government consumption, excluding transfers, are much less
costly than tax-based fiscal adjustments in terms of foregone output
growth. In fact, cuts in government consumption seem to have virtually
no costs in terms of output losses on average--a result which probably
balances some recessionary and some expansionary cases. Tax-based fiscal
adjustments are very costly in terms of output losses. Cuts in
government transfers seem to lie somewhere in between the extremes of
government consumption and tax increases, though they are closer to tax
hikes. Perhaps the smaller effect of transfers cuts relative to tax
increases may have to do with a supply-side response, but more research
is needed on this point. Regarding which tax increases are more costly,
direct and indirect taxes seem to have overall similar effects, though
this is also an issue to be explored further.
We also find that the differences in tax-based and
expenditure-based fiscal adjustments cannot be explained by different
responses of monetary policy, although the evidence points to a slightly
more expansionary response of monetary policy in the case of
expenditure-based adjustments, perhaps because tax-based adjustments
tend to raise prices, while expenditure-based adjustments tend to lower
them, or because central banks believe that expenditure-based
adjustments are more long lasting and credible.
Our findings seem to hold for fiscal adjustments both before and
after the financial crisis. We cannot reject the hypothesis that the
effects of the fiscal adjustments, especially in Europe in 2009-13, were
indistinguishable from previous ones. They certainly show the same
relative patterns between tax-based and expenditure-based adjustment.
This does not mean, however, that expenditure-based and tax-based plans
have identical effects during periods of economic expansion and
contraction. This question, in the context of disaggregated fiscal
plans, remains hard to answer.
(1) F. Giavazzi and M. Pagano, "Can Severe Fiscal Contractions
Be Expansionary? Tales of Two Small European Countries," in O. J.
Blanchard and S. Fischer, eds., NBER Macroeconomics Annual, 5, 1990,
Cambridge, MA: MIT Press, 1990, pp. 75-122.
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(2) A. Alesina and S. Ardagna, "Large Changes in Fiscal
Policy: Taxes versus Spending," in J.R. Brown, ed., Tax Policy and
the Economy, 24, Chicago, Illinois: The University of Chicago Press,
2010, pp. 35-68.
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(3) See in particular the following: F. Giavazzi and M. Pagano,
"Can Severe Fiscal Contractions Be Expansionary? Tales of Two Small
European Countries," in Olivier J. Blanchard and Stanley Fischer,
eds., NBER Macroeconomics Annual, 5, 1990, Cambridge, MA: MIT Press,
1990, pp. 75-122; F. Giavazzi andM. Pagano, "Non-Keynesian Effects
of Fiscal Policy Changes: International Evidence and the Swedish
Experience", NBER Working Paper No. 5332, November 1995, and
Swedish Economic Policy Review, 3, 1996, pp. 67-103; F. Giavazzi, T.
Jappelli, and M. Pagano, "Searching for Non-Linear Effects of
Fiscal Policy: Evidence from Industrial and Developing Countries,"
NBER Working Paper No. 7460, January 2000, and European Economic Review,
44, 2000, pp. 1259-90; A. Alesina and S. Ardagna, "Tales of Fiscal
Adjustments," Economic Policy, 13(27), '1998, pp. 487-545; and
A. ' Alesina and S. Ardagna, "The Design of Fiscal
Adjustments," in J.R. Brown, ed., Tax Policy and the Economy, 27,
Chicago, Illinois: The University of
Chicago Press, 2013, pp. 35-68.
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(4) See A. Alesina, C. Favero, and F. Giavazzi, "The Output
Effect of Fiscal Consolidation Plans," NBER Working Paper No.
18336, August 2012, and Journal of International Economics, 2015,
forthcoming; A. Alesina, O. Barbiero, C. Favero, F. Giavazzi, and M.
Paradisi, "Austerity in 2009-13," NBER Working Paper No.
20827, January 2015, and Economic Policy, 2015, forthcoming; and A.
Alesina, O. Barbiero, C. Favero, F. Giavazzi, and M. Paradisi, "The
Output Effect of Fiscal Adjustment Plans: Disaggregating Taxes and
Spending," 2015, mimeo, http://www.bde.es/f/
webbde/INF/MenuHorizontal/ SobreElBanco/Conferencias/2015/
Archivos/26_114OA_GIAVAZZI_ PAPER.pdf.
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(5) C.D. Romer and D.H. Romer, "The Macroeconomic Effects of
Tax Changes: Estimates Based on a New Measure of Fiscal Shocks,"
American Economic Review, 100(3), 2010, pp. 763-801.
Return to text
(6) C.D. Romer and D.H. Romer, "The Macroeconomic Effects of
Tax Changes: Estimates Based on a New Measure of Fiscal Shocks,"
American Economic Review, 100(3), 2010, pp. 763-801.
Return to text
(7) P Devries, J. Guajardo, D. Leigh, and A. Pescatori, "A New
Action-based Dataset of Fiscal Consolidations," IMF Working Paper
No. 11/128, 2011.
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(8) J. Guajardo, D. Leigh, and A. Pescatori, "Expansionary
Austerity? International Evidence," Journal of the European
Economic Association, 12(4), 2014, pp. 949-68.
Return to text
(9) A. Alesina and S. Ardagna, "Large Changes in Fiscal
Policy: Taxes versus Spending," in J.R. Brown, ed., Tax Policy and
the Economy, vol. 24, 2010, pp. 35-68.
Return to text
(10) A. Alesina, C. Favero, and F. Giavazzi, "The Output
Effect of Fiscal Consolidation Plans," NBER Working Paper No.
18336, August 2012, and Journal of International Economics, forthcoming.
Return to text
(11) A. Alesina, O. Barbiero, C. Favero, F. Giavazzi, and M.
Paradisi, "Austerity in 2009-13,"NBER Working Paper No. 20827,
January 2015, and Economic Policy Journal, 2015, forthcoming.
Return to text
(12) This is comparable to the estimates in Romer and Romer,
"The Macroeconomic Effects of Tax Changes: Estimates Based on a New
Measure of Fiscal Shocks," American Economic Review, 100(3), 2010,
pp. 763-801.
Return to text
(13) A. Alesina, O. Barbiero, C. Favero, F. Giavazzi, and M.
Paradisi, Austerity in 2009-13," NBER Working Paper No. 20827,
January 2015, and Economic Policy Journal, forthcoming.
Return to text
(14) O. Blanchard and D. Leigh, "Growth Forecast Errors and
Fiscal Multipliers," IMF Working Paper No. 13/1, 2013.
Return to text
(15) A. Alesina, O. Barbiero, C. Favero, F. Giavazzi, and M.
Paradisi, "The Output Effect of Fiscal Adjustment Plans:
Disaggregating Taxes and Spending," 2015, mimeo. http://www.
bde.es/f/webbde/INF/MenuHorizontal/ SobreElBanco/Conferencias/2015/
Archivos/26_1140AGIAVAZZI_ PAPER.pdf
Return to text
(16) K. Mertens and M.O. Ravn, "The Dynamic Effects of
Personal and Corporate Income Tax Changes in the United States,"
American Economic Review, 103(4), 2013, pp. 1212-47.
Return to text
(17) C. D. Romer and D. H. Romer, "Transfer Payments and the
Macroeconomy: The Effects of Social Security Benefit Changes," NBER
Working Paper 20087, May 2014.
Return to text
(18) R. Perotti, "It's the Composition: Defense
Government Spending is Contractionary, Civilian Government Spending is
Expansionary," NBER Working Paper 20179, May 2014.
Return to text
Alberto Alesina is the Nathaniel Ropes Professor of Political
Economy at Harvard University and director of the Political Economy
Program at the National Bureau of Economic Research. He is a member of
the Center for Economic Policy Research, the Econometric Society, and
the American Academy of Arts and Sciences.
Alesina has published five books, including The Future of Europe:
Reform or Decline, with Francesco Giavazzi, and Fighting Poverty in the
US and Europe: A World of Difference, with Edward Glaser. He has been a
co-editor of the Quarterly Journal of Economics for eight years and has
published widely in all the major academic journals in economics.
He has written columns for leading newspapers around the world, and
has visited at institutions including MIT, Tel Aviv University,
Stockholm University, the World Bank, and the IMF. He holds a visiting
position at IGIER, Bocconi University.
Born in Italy in 1957, Alesina obtained his Ph.D. from Harvard in
1986 and served as chairman of the department of economics there from
2003-06.
Francesco Giavazzi is professor of economics at Bocconi University
in Milan, where he also has served as deputy rector for research. He
previously taught at the University of Essex, the University of Venice,
and the University of Bologna. He was a visiting professor at MIT from
2003 to 2014.
Giavazzi is a research fellow of the Center for Economic and Policy
Research and a research associate of the National Bureau of Economic
Research. Jointly with these organizations and Bocconi University, he
contributed to creation of IGIER, the Innocenzo Gasparini Institute for
Economic Research.
Giavazzi has served as director general at the Italian Treasury, as
a member of the strategic committee of Agence France Tresor, and as an
adviser to the President of the European Commission. He chairs the
scientific committee of the Centre d'Etudes Prospectives et
d'Informations Internationales and is a member of the Bellagio
Group. In 2003, he was the Houblon-Norman Fellow at the Bank of England.
He visited the Federal Reserve Bank of New York in 2013 and 2015. He
published Limiting Exchange Rate Flexibity with Alberto Giovannini in
1989 and The Future of Europe: Reform or Decline with Alberto Alesina in
2006.
Giavazzi obtained a degree in electrical engineering from the
Politecnico di Milano in 1972 and a Ph.D. in economics from MIT in 1978.
STABILIZATION PLAN IN AUSTRALIA--1985
Year Tax hikes
Unexpected Previously Announced for
announced implementation at
t+1 t+2 t+3
1985 0 0 0 0 0
1986 0.17 0 0.19 -0.27 0
1987 0 0.19 -0.27 0 0
1988 0 -0.27 0 0 0
Year Spending cuts
Unexpected Previously Announced for
announced implementation at
t+1 t+2 t+3
1985 0.45 0 0.45 0 0
1986 0.4 0.45 0.26 -0.08 0
1987 0.45 0.26 0.37 0 0
1988 0 0.37 0 0 0
