Austerity, Not Just Tax Hikes, Destroys Growth

Ronald Janssen

Ronald Janssen

Over the last weekend, European Commissioner Olli Rehn warned France that any new taxes would destroy growth and handicap the creation of jobs. New measures to reduce the public deficit, in his opinion, are to come from public spending cuts and not from tax hikes.

Of course, commissioner Rehn knows all about destroying growth. It is under his guidance that European member states back in May 2010 embarked on their experiment of joint and excessive fiscal austerity, thereby transforming the tentative recovery into a double dip recession lasting six consecutive quarters.

Moreover, the lessons from this tragic experiment are still not being fully understood. Indeed, as is testified by Mr Rehn’s remarks, the Commission is now trying to sway the French government into a deal in which France is given two years extra time to reach the 3% deficit, provided its fiscal consolidation policy is completely based on cuts in expenditure. In doing so, the Commission is ignoring the results from recent studies on austerity. These studies do not only find that fiscal multipliers are much higher when the economy is in recession. They also find that when the economy is in recession and an expenditure based consolidation instead of a tax based consolidation is being pursued, the costs in terms of growth are enormous.

Even the IMF, which otherwise enjoys the doubtful reputation of being obsessed with orthodox fiscal consolidation policy, is now publishing one research paper after the other pointing to the fact that expenditure multipliers are significantly larger than tax multipliers, especially in times of  recession.

Below is an extract from a table from an IMF paper, showing that cutting public expenditures when the economy is suffering from recession can drag down overall GDP activity seven times more compared to tax based consolidations. If fiscal policy is squeezed by 1% of GDP, economic activity after two years is down by 2.49%. The effects of this downfall in economic activity on government revenue and social expenditure make austerity not just self – defeating but totally counterproductive.

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The Commission’s offer to France of cutting the deficit less by cutting public expenditure more is a poisoned gift. If France accepts this ‘gift’, it will jeopardise the prospects for its economy to recover and to return to some more decent pace of growth. The right thing to do for France and other member states is to end the policy of excessive austerity as such and not engage in this doubtful trade off which the Commission is proposing between the pace of fiscal adjustment on the one hand and a consolidation fully based on expenditure cuts on the other hand.

Also visit our Hot Topic page on Austerity