Thought of the Week - How to reform government finances
Let’s face it, we have too much debt and need to reform our government finances to put our national debt onto a more sustainable basis. This sentence is correct for practically every developed country (with the only exceptions being the Netherlands, Ireland, Switzerland, Sweden, and Norway as well as a few tiny countries like Luxembourg and Hong Kong). But how can developed countries reduce their government debt in a world where ageing societies imply a lower trend growth rate than what we used to have?
A group of researchers from the IMF has written a wonderful paper that summarises all we know about fiscal consolidation, when it works and when it doesn’t. My personal summary of it would be “the left’s view of tax increases and the right’s view of government spending are both correct”.
But let’s take it one step at a time. First, we need to be aware that the success rate of fiscal consolidations in the past is pretty low. Only about 20-60% of all historical episodes have been successful in permanently reducing debt levels. And the lower a government’s borrowing costs (i.e. the lower the level of interest rates) the less likely it becomes that fiscal consolidation works. The reason is that fiscal consolidation reduces growth, at least in the short term. And where there is less growth, there are fewer tax revenues with which to pay back debt.
If a government’s borrowing costs are low, then paying back debt will reduce the government deficit much less than in a high-interest-rate world because government spending on interest will be low and the cost reduction from a smaller deficit is lower. That’s a problem because I agree with the IMF when it says that in the next five to ten years, interest rates will decline to lower levels. I doubt we will go back to the near-zero levels we saw before the pandemic, but short-term interest rates between 1.5% and 2.5% in the US and Europe seem reasonable to me. And in such a low-interest-rate environment, fiscal consolidation is more likely to fail than in an environment of interest rates of 5% or more.
But when it comes to making fiscal consolidation a success, we have to keep the following things in mind:
- Fiscal consolidation, if successful, increases long-term growth in a country, but it isn’t pain-free. In the short term, growth will decline, and inequality may rise (but doesn’t necessarily have to).
- The short-term impact on growth is worse for countries that are more closed or already in recession. Free trade is a great buffer to the short-term costs of fiscal consolidation because the weaker home currency allows exporters to gain market share and generate jobs and growth.
- Reducing government spending leads to a bigger increase in inequality than increasing taxes. However, by implementing labour market reforms and targeting social assistance for affected workers the impact on income inequality can be reduced.
Most important for our current situation is that large fiscal consolidations like the ones we need to undertake to reduce our current debt load need both a reduction in government spending and an increase in taxes:
- To reduce government spending try to avoid cutting government investments since these are the driver of long-term growth. The same goes for spending on health and education.
- Spending cuts should focus on reducing public sector wage bills (i.e. cutting the fat and reducing the number of civil servants) and subsidies for state-owned enterprises. Furthermore, reduce government spending on transfer payments (e.g. pension benefits).
- To increase tax revenue focus on raising taxes that are less distortionary and cannot be gamed. Examples are increases in property taxes, excise duties on tobacco, alcohol, etc. or fuel taxes. Leave income and business taxes alone if possible. Also, focus less on the actual tax rate and more on broadening the tax base and closing tax loopholes (i.e. removing legal tax deductions).
It is not going to be easy, and the list above shows that both the left and the right have arguments in their favour. But we should not forget that if we want to reduce our public debt, we all have to pay the bill. If a government focuses too much on spending cuts or too much on raising taxes, the political imbalance will lead to a backlash and the fiscal consolidation will fail.
And that is the most common problem with fiscal consolidations. One party is in power and puts the country on a path of its choosing in line with its political ideology. Then the backlash occurs, and the opposition parties get into power where they reverse many of the measures taken by the previous government and move in the opposite direction. The result is that the country is whipsawed left and right, and, in the end, we are all worse off because the national debt is never really reduced and growth never really accelerates.
So, what we really need is a unity government with a long-term plan that is followed for several years, by governments from different parties over several election cycles. How hard can it be?
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