Alberto Alesina, Carlo Favero and Francesco Giavazzi on Austerity

AusterityFiscal austerity is hugely controversial. Opponents argue that it can trigger downward growth spirals and become self-defeating. Supporters argue that budget deficits have to be tackled aggressively at all times and at all costs. In this masterful book, three of today’s leading policy experts cut through the political noise to demonstrate that there is not one type of austerity but many. Bringing needed clarity to one of today’s most challenging subjects, Austerity charts a sensible approach based on data analysis rather than ideology.

What is controversial about fiscal austerity?

The term austerity indicates a policy geared toward the sizeable reduction of government deficits and stabilization of government debt achieved by means of spending cuts or tax increases. Discussions about the relative benefits and costs of austerity policies have been toxic, often taking a very ideological, harsh tone. The anti-austerity front argues that austerity is counterproductive: it results in increases—rather than reductions—in the debt-over-GDP ratio since it generates reductions in the denominator of this ratio which more than offset the gains in the numerator. The pro-austerity front emphasizes the impact of expectations and confidence on government debt. Imagine a situation in which an economy is on an unsustainable path with an exploding public debt. Sooner or later a fiscal stabilization has to occur. The longer this is postponed, the higher the taxes that will need to be raised or the spending to be cut in the future. When the stabilization occurs it removes the uncertainty about further delays which would increase the costs of stabilization.

Why did you write this book?

The contentious discussion on the effects of austerity has distracted commentators and policymakers from meaningful discussion on the enormous difference, on average, between expenditure-based and tax-based austerity plans. This book discusses the theory and the evidence needed to better assess the consequences of the different types of austerity. 

What are the differences in the impact of tax-based measures versus expenditure-based measures?

Spending-based austerity plans are remarkably less costly than tax-based plans. Spending-based plans have, on average, a close to zero effect on output and lead to a reduction of the debt over GDP ratio. Tax-based plans have the opposite effect: they cause large and long lasting recessions and do not lead to the stabilization of the debt to GDP ratio. Two recent examples are the consolidations carried out by Ireland and Spain in response to the Eurozone crisis. The Spanish correction, which featured a larger share of tax hikes, markedly slowed the real GDP growth and did not result in a decline in the debt ratio. Contrast that with Ireland, where the spending-based correction had little output costs and led to a sharp decline in debt.

How should we change our thinking about austerity in order to assess its effectiveness properly?

The empirical analysis of the macroeconomic effect of different types of austerity is crucial. To this end one should start from the data. The book documents in detail close to 200 austerity plans carried out in 16 OECD economies from the late 1970s to 2014. To reconstruct these plans we have consulted original documents (some produced by national authorities, and some produced by organizations such as the OECD, the IMF or the European Commission) concerning about 3,500 individual fiscal measures. The second step is the proper modelling of fiscal actions. When legislatures decide to launch a fiscal consolidation program, this rarely consists of isolated shifts in this or that tax, or in this or that spending item; instead, what is adopted is typically a multi-year plan with the objective of reducing the budget deficit by a certain amount every year. To the extent that expectations matter for the planning of consumers and investors, the multi-year nature of a fiscal adjustment, and the announcements that come with it, impact their economic effects. Third, the effect of different plans on the economy should be assessed. We document a sharp difference between adjustment plans based mostly on tax increases and plans based mostly on expenditure reductions. This finding suggests that there is no “austerity” as such: the effects of austerity policies are sharply different depending on the way they are implemented.

In assessing the empirical evidence we needed to overcome three major obstacles.

The first is the so-called “endogeneity” problem, or the 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 policies that reduced deficits have generated growth, as it could easily be the other way around. We address the endogeneity problem by considering only policy changes not motivated by the state of the business cycle but rather by a desire to reduce deficits.  

Second, once exogenous fiscal adjustments episodes have been identified, then the calculation of their impact on the economy requires the specification of an empirical model. An important tradeoff emerges here: the simpler the model the easier to calculate the multipliers, but the more likely that important relations among variables are missed. We adopt several models in this book to assess the robustness of our empirical results. 

Third, major episodes of austerity often are 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, austerity is sometimes adopted at times of crisis due to runaway debts, not in periods of business as usual. We assess explicitly the role of accompanying policies in the determination of the impact of austerity to conclude that the heterogenous effects of tax-based and expenditure-based plans does not depend on different accompanying policies.

In cases where austerity has “gone wrong,” what accounted for that? What should have been done differently?

During 2010-11 the collapse of confidence in sovereign European debt and the explosion of interest rates on government bonds in some countries (Italy, Spain, Greece, Portugal) led to a situation that was close to a debt-induced financial crisis. Could the governments of these countries have waited, postponing austerity to when the recession was over? Hard to say. We do not know what would have happened without austerity. What we can say, however, is that even in these cases, namely when austerity policies are implemented during a recession, the differences between the two types of austerity is very relevant: tax-based austerity plans have been much more costly than spending-based plans.

Can you give an example of a government that had the right idea about austerity?

In the 1990s Canada implemented a successful package of large government cuts which, coupled with accommodating monetary policy and structural reforms, was expansionary. In the book we document how since the 1993 elections almost all the contending parties accepted the need for such a reduction in government debt and deficit. In 2010, the Coalition government led by David Cameron in the UK responded to unsustainable and growing deficits with a program of large budget cuts. After this correction, the UK economy grew at respectable rates compared to the other major economies and proved the IMF predictions of a major recession wrong. Finally, and maybe most interestingly, the Irish government in its December 2009 Stability Programme Update was clear in acknowledging the unsuccessful effects of tax-based austerity. This in turn justified the adoption of a package of significant expenditure cuts.

What do you hope readers will take away from this book?

Talking about “austerity” without defining how austerity is implemented does not make any sense. The composition of austerity plans is crucial to understanding their effects on growth and fiscal sustainability. The data on 16 OECD countries over the period 1978-2014 show that a spending reduction plan and tax-based plans of the same dimension have different effects on growth. Tax-based plans lead to deep and prolonged recessions, lasting several years. Expenditure-based plans on average exhaust their very mild recessionary effect within two years after a plan is introduced. The component of aggregate demand which mostly drives the heterogeneity between tax-based and expenditure-based austerity is private investment. The effects of fiscal plans on the debt to GDP ratio depend on the initial level of the debt. In the high-debt high-cost of debt scenario, an expenditure-based plan has a stabilizing effect on the debt dynamics while a tax-based plan has a destabilizing effect; in a low-debt low-cost scenario the expenditure-based adjustment remains stabilizing, while the effect of a tax-based plan becomes neutral. The main goal of our work is to explain the evidence and the theory which underlies these results. To this end we discuss the theory; we construct a new data set; we propose to analyze fiscal plans to take the empirical modelling of fiscal policy closer to the real-life process of its implementation; and we consider case-studies and econometric evidence. We also study the role of accompanying policies: devaluations, monetary policy and structural reforms in the goods and labor markets. We devote special attention to the recent round of austerity plans implemented after the financial and Eurozone crises. Finally, we ask the political economy question of whether austerity is the kiss of death for the governments that implement it, concluding that the answer is much less obvious than the popular debate would seem to suggest.

Alberto Alesina is the Nathaniel Ropes Professor of Political Economy at Harvard University. He is the author, with Francesco Giavazzi, of The Future of Europe: Reform or DeclineCarlo Favero is the Deutsche Bank Chair in Quantitative Finance and Asset Pricing at Bocconi University in Italy. He is the author of Applied MacroeconometricsFrancesco Giavazzi is professor of economics at Bocconi University.

Kenneth Rogoff: James S. Henry’s early approach to the big bills problem

Presenting the next post in a series by Kenneth Rogoff, author of The Curse of Cash. You can read the other posts in the series here, here, here, and here.

RogoffMy new book, The Curse of Cash, calls for moving to a “less cash” society by very gradually phasing out big notes. I must mention, however, a closely-related idea by James S. Henry. In a prescient 1980 Washington Monthly article, Henry put forth a plan for rapidly swapping out $100s and $50s. While The Curse of Cash highlights his emphasis on the use of cash in crime, it should have noted his snap exchange plan early on (as it will in future printings).

Rather than gradually eliminate big bills as I suggest in the book and in my earlier 1998 article, Henry argues for having the government declare that large denomination bills are to expire and must be exchanged for new bills at short notice:

A surprise currency recall, similar to those that had been conducted by governments in post-World War II Europe, and Latin America, and by our own military in Vietnam. On any given Sunday, the Federal Reserve would announce that existing “big bills”—$50s and $100s—would no longer be accepted as legal tender, and would have to be exchanged at banks for new bills within a short period. When the tax cheats, Mafiosi, and other pillars of the criminal community rushed to their banks to exchange their precious notes, the IRS would be there to ask those with the most peculiar bundles some embarrassing questions. (Henry, “The Cash Connection: How to Make the Mob Miserable,” The Washington Monthly issue 4, p. 54).

This is certainly an interesting idea and, indeed, the U.S. is something of an outlier in allowing old bills to be valid forever, albeit most countries rotate from old to new bills very slowly, not at short notice.

Henry’s swap plan absolutely merits serious discussion, but there might be significant problems even if the government only handed out small bills for the old big bills. First, there are formidable logistical problems to doing anything quickly, since at least 40% of U.S. currency is held overseas. Moreover, there is a fine line between a snap currency exchange and a debt default, especially for a highly developed economy in peacetime. Foreign dollar holders especially would feel this way. Finally, any exchange at short notice would be extremely unfair to people who acquired their big bills completely legally but might not keep tabs on the news.

In general, a slow gradual currency swap would be far less disruptive in an advanced economy, and would leave room for dealing with unanticipated and unintended consequences. One idea, detailed in The Curse of Cash, is to allow people to exchange their expiring large bills relatively conveniently for the first few years (still subject to standard anti-money-laundering reporting requirements), then over time make it more inconvenient by accepting the big notes at ever fewer locations and with ever stronger reporting requirements. True, a more prolonged period would give criminals and tax evaders lots of time to launder their mass holdings of big bills into smaller ones or into other assets, and at relatively minimal cost. This appears to have been the case, for example, with exchange of legacy European currency (such as German deutschemarks and French francs) for new euro currency. Of course, in most past exchanges (such as the birth of the euro), governments were concerned with maintaining future demand for their “product.” If, instead, governments recognize that meeting massive cash demand by the underground economy is penny wise and pound foolish, they would be prepared to be more aggressive in seeking documentation in the exchange.

Lastly, just to reiterate a recurrent theme from earlier blogs, the aim should be a less-cash society—not a cashless one. There will likely always be a need for some physical currency, even a century from now.

RogoffKenneth S. Rogoff, the Thomas D. Cabot Professor of Public Policy at Harvard University and former chief economist of the International Monetary Fund, is the coauthor of the New York Times bestseller This Time Is Different: Eight Centuries of Financial Folly (Princeton). He appears frequently in the national media and writes a monthly newspaper column that is syndicated in more than fifty countries. He lives in Cambridge, Massachusetts. His latest book is The Curse of Cash.

Taxing the Rich

Taxing the RichIf you didn’t file your taxes on April 15th, you can breathe a sigh of relief. Thanks to the Emancipation Day holiday in the District of Columbia, the tax deadline was switched to April 18 this year. Already ahead of the game? While the final hours tick down, we have just the history of fiscal fairness for you.

In Taxing the Rich, Kenneth Scheve and David Stasavage analyze the history of taxes and take a look at when and why countries tax their wealthiest citizens. The authors argue that governments don’t tax the rich simply because of striking inequality—they do it when its citizens believe that such taxes compensate for the state unfairly privileging the wealthy. What matters most is society’s views on how the inequality is being generated in the first place.

The Atlantic recently wrote about the book, including quotes from Scheve and Stasavage:

Relative to the past 200 years of U.S. history, how heavily are the rich being taxed today? Kenneth Scheve and David Stasavage, professors of political science at Stanford University and New York University respectively, looked into when countries have taxed their wealthiest citizens most heavily, and what societal conditions might have produced those tax rates. In a project that took five years, the two constructed databases of tax rates and policies in 20 countries over the last two centuries in order to answer those questions. They recently published this research in a book, Taxing the Rich: A History of Fiscal Fairness in the United States and Europe.

One of their motivations for starting the project was a disconnect they noticed between rising inequality and static tax rates. “With inequality rising over the last three or four decades, why have there not been public policies that seem to address that in an important and substantive way?” says Scheve. But while it would seem intuitive that taxes would increase at the times when inequality is highest, Scheve and Stasavage found that this relationship hasn’t held true over the course of history.

You can read the full piece in The Atlantic here, and an exclusive interview with Scheve and Stasavage here.

Q&A with Kenneth Scheve and David Stasavage on Taxing the Rich

Taxing the RichWho to tax, how much to tax, and what the taxes should pay for are questions sure to elicit an array of responses in today’s politically charged climate. Kenneth Scheve and David Stasavage combine forces on this comprehensive history and reflection on how the rich have (or haven’t) been taxed. Taxing the Rich: A History of Fiscal Fairness in the United State and Europe tackles what is sure to be a hot election topic using an approach that manages to showcase both sides of the often contentious issue. Recently the authors took the time to answer some questions on their book.

Why did you write this book?

KS & DS: Taxing the rich is a subject of considerable political conflict today. There has been a great deal of debate about what government should do in this area, but we know far less about the reasons why some governments actually do tax the rich and others do not. We think answering this question requires a long run historical perspective, and one that doesn’t just look at developments in the United States. Our book considers income, inheritance, and other taxes from 1800 to the present in a set of twenty countries.

What’s your main argument?

KS & DS: Countries tax the rich when the public thinks the state has failed to treat citizens as equals and in so doing has privileged the rich. [a more colloquial version: Countries tax the rich when people think the deck is stacked in favor of the wealthy and the government has done the stacking.]

Debates about taxation revolve around self-interest (no one likes paying taxes), economic efficiency, and fairness. We argue that fairness considerations center on what it means for the state to treat citizens as equals in income tax policy. Historically, there are three main fairness arguments that have been used for or against taxing the rich. Equal Treatment arguments claim that everyone should be taxed at the same rate just like everyone has one vote. Ability to Pay arguments contend that states should tax the rich at higher rates because they can better afford to pay when compared with everyone else. Compensatory Arguments suggest that it is fair to tax the rich at higher rates when it compensates for unequal treatment by the state in some other policy area. We argue that over the last two centuries compensatory arguments have been the most powerful arguments in favor of taxing the rich.

What are examples of compensatory arguments in history?

KS & DS: Compensatory arguments were important in the early development of income tax systems in the 19th century when it was argued that income taxes on the rich were necessary to compensate for heavy indirect taxes that fell disproportionately on the poor and middle class. But the most significant compensatory arguments over the last two centuries have been arguments to raise taxes on the rich to preserve equal sacrifice in wars of mass mobilization. These conflicts, particularly World War I and World War II, led states to raise large armies, often through conscription, and citizens and politicians alike adopted compensatory fairness arguments to justify higher taxes on income and wealth. Mass war mobilization led governments of both left and right to tax the rich.

When have countries taxed the rich?

KS & DS: Well, one thing our book shows is that governments haven’t taxed the rich just because inequality is high, nor have they done this simply because the poor and middle class outnumber the rich when it comes to voting. The main occasion when governments have moved to tax the rich is during times of mass mobilization for war, especially in democracies in which the norm of treating citizens as equals is held more strongly. The real watershed for taxing the rich for many countries came in 1914. The era of the two world wars and their aftermath was one in which governments taxed the rich at rates that would have previously seemed unimaginable.

How do we know that the effect of wars was due to changes in fairness considerations?

KS & DS: We show in the book that when countries shift from peace to war, or the reverse, there has also been a big shift in the type of fairness arguments made in favor of taxing the rich. During times of peace debates about whether it is fair to tax the rich center on competing equal treatment and ability to pay arguments. During times of war supporters of taxing the rich have also been able to make Compensatory arguments. If the poor and middle class are doing the fighting, then the rich should be asked to pay more for the war effort. If some with wealth benefit from war profits, then this creates another compensatory argument for taxing the rich. These compensatory arguments had the biggest impact in democracies that are founded on the idea that citizens should be treated as equals. The fact that war had a much bigger impact on taxes on the rich in democracies than in autocracies also suggests that the rich weren’t being taxed out of simple necessity. It was because war determined what types of fairness arguments could be made.

What are the implications for future tax policies in the United States?

KS & DS: Don’t expect high and rising inequality to necessarily lead to a return to the high top tax rates of the post-war era. What really matters is what people believe about how inequality is generated in the first place. If it is clear that inequality has risen because the government failed to treat citizens as equals in the first place, then there is room for convincing compensatory arguments. Today, in an era where military technology favors more limited forms of warfare — drones rather than boots on the ground — the wartime compensatory arguments of old are no longer available. Absent new compensatory arguments, we expect some to argue for taxing the rich based on ability to pay, but this probably won’t suffice to produce radically higher tax rates. More politically plausible reforms include those that involve increasing taxes on the rich by appealing to the logic of equal treatment to remove deductions, exemptions, and cases of special treatment.

Kenneth Scheve is professor of political science and senior fellow at the Freeman Spogli Institute for International Studies at Stanford University. He is the coauthor of Globalization and the Perceptions of American Workers. David Stasavage is Julius Silver Professor in the Wilf Family Department of Politics at New York University. He is the author of States of Credit: Size, Power, and the Development of European Polities (Princeton). Together they wrote Taxing the Rich: A History of Fiscal Fairness in the United States and Europe.