Friday, May 25, 2007

OECD Makes Correct Observation-But Wrong Interpretation

I see here that the OECD observes that deficit reduction based on reduced spending is "deeper and longer-lasting than those founded on increased revenues." So far, so good, but the OECD messes up its interpretation of why that is. The OECD thinks this is because spending cuts somehow lower interest rates more or makes politicians more reluctant to waste the surplus.

But there is no real reason to expect spending cuts to affect interest rates differently than most tax increases (the exception being capital income taxes). Nor is there more reason to expect politicians to not spend surplus/ deficit reductions created by spending cuts than tax increases. If anything, the pressure should be greater in the former case since people are more likely to demand a return to what they are used to enjoying rather than something they never had.

No, the real reason why spending cuts provide more sustainable deficit reduction is this: higher revenues is either due to a cyclical upswing or tax rate increases. In the former case, the revenue windfall is almost by definition unsustainable, in the latter case the tax increases weaken long term growth and undermines the tax base (although the benefits of the deficit reduction will greatly limit this effect in most cases). By contrast, spending cuts will not only not weaken incentives, but will in some cases improve them (such as reductions in unemployment benefits), thus reinforcing rather than limiting the positive effects from the deficit reduction.


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