Cutting public spending fuels economy

Armchair economists, in Canada and around the world, tend to use the term “austerity” to refer to a mix of budgetary and tax measures aiming to balance the budget, without differentiating between these measures and their varied effects. These distinctions are crucial, however, since spending cuts and tax hikes have effects on economic growth that are diametrically opposed.

Whereas many armchair economists still cling to the bygone notion that public spending stimulates the economy, cutting edge economic research shows instead that reducing public spending to balance the budget is likely to stimulate the economy. The reason for this is that when the government reduces spending, it competes less with the private sector in attracting workers and capital. While there may be some short-term pain during an immediate adjustment period, the negative effects of these cuts disappear within a year. Over the longer term, the positive effects become overwhelming, leading to an acceleration of economic growth.

These are authoritative results obtained by economists that the profession widely considers Nobel-worthy, published in the most prestigious peer-reviewed journals. And despite the claims of various government agencies and lobbies, academic research tells us that it is rather tax hikes that are more likely to create recessions.

Practically any major economic textbook will tell you that taxes cause a deadweight loss to the economy. This is not just a theoretical result; it is backed up by mountains of research showing that industrialized economies have reached a point where each extra dollar of income for the government can cost society up to $5 of economic welfare.

Instead of equating these very different measures, it is imperative that we are strict in differentiating between public spending cuts on the one hand and tax increases on the other.

And indeed, among OECD countries, those that reduced both spending and taxes achieved the highest economic growth. Those that did so between 2009 and 2013—Canada among them—achieved an enviable average annual growth rate of 2.4%.

Certain countries adopted one good and one bad measure, which is to say that they reduced spending but increased taxes. These countries achieved much more modest levels of economic growth over this period, averaging 0.8% annually.

Finally, a third group of countries decided to increase both their spending and their tax burdens. This group of countries experienced even slower average annual growth of just 0.4%—and by including the extreme case of Greece, we actually observe an economic contraction averaging 0.3% annually.

The perils of trying to balance the budget by raising taxes are clear. This policy choice can even create a vicious circle whereby the combination of tax hikes and spending sprees slows economic growth to the point of threatening the achievement of fiscal balance.

Although much ink (and snake oil) has been spilled in the debate over the merits of austerity in Canada, public spending at all levels of government relative to GDP fell by 3 percentage points over the 2009-2013 period, reaching 40.7%, while revenues fell by 1.2 percentage points, to reach 38% of GDP. Canada as a whole chose the most effective deficit reduction measures, reducing both spending and revenues, and the Canadian economy quickly achieved an enviable annual growth rate of 1.8%.

The economics of austerity are counterintuitive, but although it is an inconvenient truth that might not please everyone, a better understanding of the effects of measures used to balance budgets would favour the adoption of economic policies that are more effective and more conducive to the prosperity of all.

Mathieu Bédard is Economist at the Montreal Economic Institute and author of the recently published study entitled “Cutting Public Spending Promotes Economic Growth.” The views reflected in this op-ed are his own.