Members of both parties agree that Washington’s present fiscal course is dangerously unsustainable. We’re now borrowing 40 cents for every dollar we spend. This profligacy continues to weaken the dollar, threatening its status as the global reserve currency and fostering anxiety in the bond markets. Last month, Standard & Poor’s delivered a sobering wake-up call when it revised its outlook on the U.S. long-term credit rating from “stable” to “negative.”
No question, our accounts must be brought into balance — but not at the expense of economic growth. Those who advocate gigantic tax increases are short-sighted. Amid a sluggish recovery, abrupt tax hikes could drive the economy back into recession. (That’s what happened in Japan during the late 1990s.) Moreover, it will be impossible to generate sufficient revenue without robust growth. A rapidly expanding economy creates new jobs and income for investment in wealth-creating enterprises. Some of that wealth flows back to the government and can be used to reduce the debt.
The policy tools we use to restore fiscal stability will go a long way toward shaping the future of American prosperity and promoting the economic expansion we need. Will we impose tax hikes that discourage investment and punish job creation? Or will we make the tax system more efficient and conducive to growth?
As these and other questions are debated, policymakers should consult the evidence from other industrialized countries, which overwhelmingly suggests that spending cuts, not tax hikes, are the best way to close massive budget gaps and help produce economic growth. Indeed, after studying large-scale fiscal adjustments by wealthy, developed countries between 1970 and 2007, Harvard economists Alberto Alesina and Silvia Ardagna determined that “spending cuts are much more effective than tax increases in stabilizing the debt and avoiding economic downturns.” Moreover, they found “several episodes in which spending cuts adopted to reduce deficits have been associated with economic expansions rather than recessions.”
Goldman Sachs economists Ben Broadbent and Kevin Daly recently undertook a similar study that reviewed every major fiscal correction in wealthy nations since 1975. They found that “decisive budgetary adjustments that have focused on reducing government expenditures have (i) been successful in correcting fiscal imbalances; (ii) typically boosted growth; and (iii) resulted in significant bond and equity market outperformance. Tax-driven fiscal adjustments, by contrast, typically fail to correct fiscal imbalances and are damaging for growth.”
Broadbent and Daly pointed to successful fiscal adjustments in Ireland (1987–89), Sweden (1994–98), and Canada (1994–97). In each case, the adjustment was driven primarily by cuts in public spending. Sweden in particular is famous for the generosity of its welfare state. Yet, when faced with a crisis, Swedish officials were able to trim the size of government substantially. If Stockholm could do it back in the mid-1990s, Washington can do it today.
Reducing the short-term deficit and stabilizing the long-term debt are critically important to American prosperity and living standards. But studies show that if fiscal consolidation relies heavily on tax increases, it will stifle economic growth and prove counterproductive.
This is the lesson we must apply as we try to forge a genuine bipartisan compromise to deal with our debt crisis.