The Facts about Spending Cuts, the Debt and Gross Domestic Product

August 18, 2011

Free Market Foundation

Veronique de Rugy, a senior research fellow at the Mercatus Centre at George Mason University, discusses the facts and myths surrounding spending cuts, the debt and gross domestic product (GDP).

Myth 1: You cannot reduce the deficit to an appropriate level without also raising taxes.

Fact 1: Spending cuts are the most effective way to reduce the debt-to-GDP ratio.

Harvard’s Alberto Alesina and Silvia Ardagna examined 107 efforts to reduce the debt in 21 Organization for Economic Cooperation and Development nations between 1970 and 2007; their findings suggest that tax cuts are more expansionary than spending increases in the cases of a fiscal stimulus.

Also, they found that spending cuts are a more effective way to reduce the debt-to-GDP ratio.

Myth 2: Lawmakers facing economic catastrophe forget about politics and adopt measures that address genuine fiscal issues.

Fact 2: Politicians rarely put politics aside.

A recent paper by Andrew Biggs, Kevin Hassett and Matthew Jensen of the American Enterprise Institute shows that even in a time of crisis (or especially in a time of crisis), lawmakers tend to adopt policies for the sake of politics.

Countries in fiscal trouble generally got there through years of catering to interest groups and pro-spending constituencies (on both sides of the political aisle), and their fiscal adjustments tend to make too many of the same mistakes

Myth 3: The US has had higher debt-to-GDP ratios before so we shouldn’t worry now.

Fact 3: We should worry the debt-to-GDP ratio actually underestimates the size of the government’s real liabilities.

History appears to be reassuring, since several advanced countries have had debt-to-GDP ratios much higher than the one we have now without defaulting, so why should we worry?

Two main reasons: First, while the US debt is big now, it’s only going to get bigger in the coming years. Second, the debt-to-GDP ratio actually underestimates the scale of the US debt problem because of intra-governmental debt, unaccounted liabilities and unfunded liabilities.

Source: Veronique de Rugy, The Facts about Spending Cuts, the Debt and the GDP, Reason Magazine, July 29, 2011.

For text: http://reason.com/archives/2011/07/29/the-facts-about-spending-cuts

For more on Tax and Spending Issues: http://www.ncpa.org/sub/dpd/index.php?Article_Category=25

First published by the National Center for Policy Analysis, United States

FMF Policy Bulletin/ 09 August 2011