As national and state government debt levels have risen, governments are facing the fact that they must soon either default on their obligations, cut their spending, increase their revenue or some combination thereof.
Default is an intriguing option, but it rarely occurs on government debt, even when the alternatives are painful. That is because default sharply increases the cost of future borrowing, and possibly because creditors enjoy a lot of political influence.
That leaves tax increases and government spending cuts, or “fiscal austerity” as it is often called. Austerity seems to be the opposite of fiscal stimulus policies, the tax cuts and spending increases that governments sometimes carry out for the stated purpose of trying to expand the economy.
But economic theory and experience show that the growth effects of both austerity and stimulus depend on the form they take.
For brevity and simplicity, I focus on the employment effects of fiscal policies and partition the public in two groups: high earners and low earners. In this view, a total of four policy options (plus their combinations) might qualify as austerity, depending on whether taxes or spending are adjusted and whether those changes are experienced by the high earners or the low earners.
Both raising taxes on high earners and cutting subsidies — food stamps, for example — for low earners would qualify as austerity, but they have different employment effects.
The typical reason that people work is to have earnings – income from their jobs that they can use to support themselves and their families. This monetary reward is the difference between the resources a person has available if she works and what she has available if she doesn’t work. The better the government treats low earners, the less incentive people have to keep their earnings high.
Thus, both raising taxes on high earners and cutting subsidies for low earners would reduce the government deficit, but the former would reduce employment and the latter increase it. For the same reasons, raising subsidies and cutting taxes for low earners, as the 2009 American Recovery and Reinvestment Act did, would both add to deficit and reduce employment.
From this perspective it might appear that the best way for a government to put austerity into effect is by cutting subsidies and raising taxes for low earners, and the best way to carry out stimulus is by cutting taxes for high earners. But, of course, there is no free lunch. The same policies that increase the incentives to work also redistribute from those with low earnings to those with high earnings.
Thus, while the American Recovery and Reinvestment Act probably reduced employment, it deserves credit for giving resources to those in poverty.
The interplay of the social good of helping the poor and providing them incentives creates tough policy choices for governments looking to reduce their deficits. The more resources available to those living below the poverty line, the less incentive they have to raise their income above that line.
More research is needed to quantify work incentives in various countries, but I suspect that Western European nations have been pursuing exactly such redistributive austerity and will continue to do so, which means that they can expect austerity to depress their economies.