15 March 2023 Fiscal Policy

Budget 2023 to Avoid Causing Economic Slump?

Summary

A new Economic Modelling paper runs through the economic consequences of government cutbacks in advanced economies, such as the UK and US.
The authors find that government cutbacks are rarely positive for growth but are even worse for more indebted countries in which growth is weak, such as the UK.
Central bank policies also matter. If government cutbacks coincide with rising interest rates, as is the case in most advanced economies, the GDP effects are even worse.
In the current UK economic climate, meaningful tax raises and spending cuts could significantly hurt growth.

Introduction

Unprecedented fiscal expansions in most countries during the pandemic have rapidly expanded public debt. These burdens are becoming increasingly expensive to service as interest rates creep higher.

In the UK, the government is expected to pay over £100bn in interest payments to finance its debt this year. This is double the previous year and 10% of its entire spending budget. Post-WWII, the cost of debt has never been higher.

It is not unrealistic to assume, therefore, that governments will (if they have not already) introduce substantial fiscal consolidations in 2023. An Economic Modelling paper reviews the impacts of such cutbacks on key macroeconomic variables and how these are influenced by prevailing economic headwinds.

Data and Methodology

The authors use annual data from 24 OECD countries from 1990 to 2019. To identify ‘fiscal consolidations’ (i.e. reductions in borrowing through spending decreases or tax increases). They look at changes in a country’s cyclically adjusted primary balance (CAPB) as a percentage of their potential GDP.

It may surprise you to know that the UK government has very little control over roughly half of its annual spending outlay. It’s because many policies, like unemployment benefits, are linked to the state of the economy. So they automatically change depending on the economic climate.

The CAPB removes this automatic component and deals more with changes to policies that governments do have more control over, and ones which are typically covered in budget reports, such as healthcare, public sector pay or education spending.

The macroeconomic variables collected in the paper are real GDP, unemployment rate, inflation, consumption, investment, exports, imports, and the debt-to-GDP ratio. The aim is to understand how fiscal consolidations affect each of these unconditionally, but it is also conditional on four other prevailing conditions:

Whether the economy is in recession or growing above average.
Whether public debt is high (90% of GDP), intermediate (60–90%), or low (<60%).
Whether monetary policy conditions are loose or tight.
Whether a country has a high or low degree of trade openness.

Fiscal Consolidations Reduce Public Debt but Harm GDP

The first set of results from the paper show that fiscal consolidations typically harm real GDP growth (Chart 1a). The impact is felt most in year two, falling 0.62%, but recuperates after four years. As real GDP declines, the unemployment rate rises slightly (Chart 1b). Inflation also increases slightly as the home currency appreciates in response to a credible debt reduction strategy (Charts 1c and 1d).

What if Growth is Weak and Debt is High, Such as in the UK…?

Next, the authors check the responses under different macroeconomic contexts, starting with fiscal consolidations undertaken in recessions. Typically, the decline in real GDP is much more pronounced (Chart 2a), falling twice as much as in the unconditional scenario. Consequently, the unemployment rate increases but inflation declines. The negative economic impact reduces government revenues and increases benefits, meaning the public debt ratio does not fall as much (Chart 2b).

In expansions, the responses are the opposite. After four years, real GDP may be higher than pre-consolidation (Chart 2a), and the unemployment rate does not change throughout. The public debt ratio also declines by more than in recessions (Chart 2b), making fiscal consolidations far more attractive in better economic conditions.

If the starting debt level in an economy pre-consolidation is above 90%, like in the US, Canada, UK, Spain, Italy, Greece, and Japan, the impacts of fiscal consolidations are usually more severe. GDP falls by twice the average (Chart 2c), and the public debt ratio may therefore increase in the short-term (Chart 2d).

Less indebted countries, however, will see a rise in GDP levels after fiscal consolidations (Chart 2c). This allows the unemployment rate to fall, with the additional benefit that inflation remains unchanged. Moreover, the public debt ratio drops by twice the average level (Chart 2d).

Tax Rises or Spending Cuts?

Next, the authors examine revenue- versus spending-based fiscal consolidations. I will only summarise the impacts in scenarios I believe are relevant to the current economic climate.

Regarding the average impact, both types of consolidations have a similar impact on growth for the first two years (Chart 3a). Thereafter, expenditure-based policies are less harmful, and even beneficial, for growth. These policies also have a larger deflationary impact than revenue-based ones, but they have similar effects on the unemployment rate and debt-to-GDP ratios.

However, expenditure-based fiscal consolidations are worse when growth is weak. Typically, they have a larger negative impact on growth relative to revenue-based policies (Chart 3b). Revenue-based policies also appear less harmful for growth under tight monetary conditions (Chart 3c). Meanwhile, the impacts of both types of policies in more indebted countries are similar (Chart 3d).

Bottom Line

While the paper is straightforward, it offers a great high-level overview of the impacts of fiscal consolidations on key macroeconomic variables. The results suggest a challenging period ahead for some countries.

For instance, the UK is a highly indebted country with weak growth and a hiking central bank. Jeremy Hunt has a tough task. He needs to reduce borrowing, which is not forecast to decline meaningfully over the medium term. To do so, he will need to be delicate in his mix of tax rises and spending cuts if he does not want to harm growth. If he gets it wrong, the costs of these cutbacks will further weaken growth and, perversely, will push the debt-to-GDP level even higher.