As Kevin Hassett and Andrew Biggs of the American Enterprise Institute have shown, a staggering eight of every 10 attempts by countries to reduce their debt-to-GDP ratios are failures. This means that even in a time of crisis (or especially in a time of crisis), lawmakers prefer politics over solid, pro-growth policy. Countries experiencing fiscal trouble generally get there through years of catering to interest groups and constituencies that favor spending (on both sides of the political aisle), and their fiscal adjustments tend to make too many of these same mistakes. The United States seems poised to do the same.
What is the impact of spending cuts or tax increases on the economy? First, agreement among economists on the impact of budget cuts on growth is far from being settled. However, a few lessons have emerged. Fiscal adjustments achieved through spending cuts rather than tax increases are less recessionary than those achieved through tax increases. Alesina and Ardagna’s research also reveals that private investment tends to react more positively to spending-based adjustments. Thus, they argue that spending cuts are more sustainable and effective in reducing debt and raising economic growth; thus expansionary fiscal policy becomes possible again.
Second, tax cuts are more expansionary than spending increases in the case of a fiscal stimulus. The work of former Obama Council of Economic Advisers Chairwoman Christina Romer and her economist husband, David Romer, shows, for instance, that increasing taxes by 1 percent of GDP for deficit-reduction purposes leads to a 3 percent reduction in GDP. Third, research from the International Monetary Fund in particular finds that fiscal adjustment based mostly on tax increases will hurt the economy the most.
The bottom line is that Obama’s "balanced approach" more closely resembles the historic failures — the fiscal adjustments that don’t successfully reduce a nation’s debt-to-GDP ratio. What’s more, history reveals that the balanced approach generally results in tax increases but rarely delivers on the spending cuts. That’s unfortunate, considering that if the government could actually collect $1.6 trillion over 10 years from tax increases, this amount still wouldn’t be enough to fill in the projected $6 trillion cumulative deficit over the period.