'Why cutting spending is preferable to raising taxes'

Over the last few days we have been featuring ideas for spending cuts from the TaxPayers' Alliance and Institute of Directors. Today in another extract from their joint report on reducing the size of the state by £50bn we republish their argument for cutting spending rather than increasing taxes.  For a PDF of the full report (including footnotes for claims made below) click here.

"The key element for debate is over the nature of the fiscal tightening.  This section sets out why we believe it should be comprised of spending cuts rather than tax rises, although taxes have already increased this month.

There is a wealth of academic evidence on the effects of taxes and spending on economic growth and deficit reduction, which points to three conclusions:

1.     Higher taxes reduce economic growth:

• Surveying OECD countries over the 1980-2000 period, the OECD concluded that a 1 percentage point increase in the tax/GDP ratio reduces output per capita by 0.3 per cent, or 0.6-0.7 per cent if the effect on investment is taken into account.
• A study of EU15 and OECD countries from 1970 to 2004 by the European Central Bank found that a 1 percentage point increase in the tax/GDP ratio reduces output by 0.12 percentage points for the OECD countries and 0.13 percentage points for the EU countries.

2.     Lower government spending, especially government consumption spending, increases economic growth:

• The 2008 European Central Bank study mentioned above also found that a 1 percentage point increase in the spending/GDP ratio reduces output by 0.12 percentage points for the OECD countries and 0.13 percentage points for the EU countries.
• Writing in Fiscal Studies in 2007, Mo found that a 1 percentage point increase in the share of government consumption in GDP reduces the equilibrium GDP growth rate by 0.216 percentage points, while the same increase in government investment raises the growth rate by 0.167 percentage points.

3.     Fiscal consolidations that are largely comprised of lower spending are more durable than those largely comprised of higher taxes:

• The IMF, in its latest Staff Report on the UK economy, stated that “evidence from OECD countries shows that although changes in revenue and expenditure contribute to closing the fiscal gap, expenditure restraint brings about longer lasting and larger adjustment episodes, which are more successful in achieving a debt stabilizing fiscal position.  Expenditure reduction demonstrates a firmer commitment to feasible and substantial consolidation, and may trigger lower interest rates and boost private demand.”
• The EU Commission has also confirmed this view, stating in a 2008 paper that “as regards the composition of successful fiscal consolidation, the EU experience confirms that cuts in current primary expenditure are more likely to produce a lasting effect than higher revenues or large cuts in government investment.”  The EU paper also points out that other factors such as fiscal governance and structural reforms are also key to the success of fiscal consolidation efforts.

It is not surprising that this latter conclusion is drawn.  Increasing taxes reduces GDP growth, which makes deficit reduction harder, while reducing government consumption increases economic growth, making deficit reduction easier.  While the reality is somewhat more complicated, with successful economic recoveries and fiscal consolidations depending on many more factors than discussed in this section, the broad trends are clear.  It is better to reduce borrowing by cutting spending than by increasing taxes.

Using a dynamic model of the UK economy first developed for the TaxPayers’ Alliance in Spring 2007, the Centre for Economics and Business Research found that a broadly-based set of income and corporation tax rises would so damage the supply-side of the economy that the package would be revenue-negative after seven years.  Increasing the basic rate of income tax to 25 per cent, the higher rate to 50 per cent and the corporation tax rate to 41 per cent would initially raise £15 billion, but by 2020-21 the package would lead to a 6.1 per cent reduction in GDP and a £33 billion increase in the deficit.

International leaders have also rejected the idea of responding to deficits with tax rises.  Angela Merkel, the German Chancellor, has attacked a proposed VAT rise, saying: “An increase in the reduced rate would be unfair and would damage growth.  Germany needs a swift exit out of the crisis.  People need relief, not additional burdens.”  President Barack Obama recently told NBC: “The last thing we want to do is to raise taxes in the middle of a recession, because that would just suck up, take more demand, out of the economy and put businesses in a further hole."

What makes the argument for spending cuts even more compelling in the UK’s case is the recent record of public spending.  Between 2000 and 2007, in other words before the current economic crisis began, public spending increased by 7.5 percentage points of GDP, which was by far the fastest increase in the OECD.  Comparing projections of public spending in 2010 with the actual numbers for 2000 puts the UK in an even worse light – next year, UK public spending is projected to be 17.5 percentage points of GDP higher than in 2000, an increase that only Ireland is expected to exceed."