Fiscal pressures are back. What have policymakers learned?
As the bill comes due for post-pandemic spending, national lawmakers are unlikely to make the difficult fiscal cuts that may be called for.
In a nutshell
- Fiscal warning signs are flashing for a number of major economies
- Economic stimulus and social and military spending have eroded fiscal health
- Spending cuts may be in order but governments are reluctant
In the post-pandemic era, governments around the world are again struggling with high debt loads and persistent annual deficits in a kind of twisted homage to the post-2008 fiscal crises. As history stumbles toward repeating itself, the period following the global financial crisis can be instructive for policymakers grappling with new budgetary realities.
Responding to renewed fiscal pressures, the European Commission’s new economic governance framework entered into force at the end of April 2024, replacing old fiscal rules that have been suspended since the pandemic. The Commission’s follow-on report identified eight member states with high debt and excessive deficits over the 3 percent target: Belgium, France, Italy, Hungary, Malta, Poland, Romania and Slovakia. In the coming months, the Commission will detail recommendations for each country to address its fiscal imbalance.
The Commission’s report raises questions about the sustainability of public finances in Europe and worldwide. Following the twin health and economic crises of Covid-19, government spending has remained elevated, contributing to rising debt loads and sustained budget deficits. The dilemma now facing many developed countries is how to close the yawning gap between revenue and spending. Using history as a guide, governments are more likely to reach for tax increases than spending cuts. As in the past, such tax-based fiscal adjustments will make meeting sustainable fiscal goals harder, if not impossible. Ultimately, spending reforms will be needed in countries struggling with sustained budget deficits.
The fiscal landscape after Covid-19
The EU Commission’s report paints a grim picture of fiscal health across member states, a reality shared by the United States, the United Kingdom and others.
Before the pandemic, average developed country deficits were relatively small, with a few notable outliers, such as the U.S. In 2019, the average EU member deficit was less than 0.5 percent of gross domestic product (GDP). Overall government debt levels remained high – above 75 percent of GDP – but had been steadily declining in the preceding years.
The last decade of fiscal progress was wiped away in 2020 and has been slow to recover. Spending has remained elevated since then following economic stimulus measures, expanded social safety nets and increased military spending. Across the EU, 2023 government expenditures as a share of GDP grew from pre-pandemic levels, rising from 43 percent in 2019 to 45 percent in 2023. Revenues have not kept up, remaining relatively flat since 2020, leading to structural deficits and mounting debts.
According to IMF data on deficits, shown below, some of the most prominent economies face persistent annual deficits of between 3 percent and 5 percent of GDP. The data projections for 2024 and 2025 are likely rosier than what will actually transpire, as they do not include yet-to-be-legislated spending or tax cuts that are likely in many countries.
Given current trajectories, advanced economies will eventually need to make tough choices: cut spending or increase taxes. The Commission report makes this clear for the eight identified EU members. Still, adjustments on a smaller scale will be necessary for most EU members and non-member countries across the developed world. Recent forecasts from congressional scorekeepers in the U.S. similarly make clear that significant fiscal adjustments will be necessary to rationalize a rapid growth in spending given slower-growing revenues.
The immediate post-pandemic period offered some leeway due to low interest rates and accommodative monetary policies, but this window is closed or closing for most countries. Persistent deficits and mounting debt levels are leading to higher borrowing costs and reduced fiscal space for more pressing needs and future crises. Countries now face a choice: to cut spending, increase taxes, or both. Each option has significant economic and political implications.
Austerity is coming
Budget reforms in the EU will eventually occur, whether through the Commission’s fiscal target recommendations or market-enforced discipline by higher interest rates. Politicians often turn to tax increases first in times of crisis, but spending-based fiscal adjustments are more effective in terms of economics, budgets and politics.
In their 2019 book “Austerity: When It Works and When It Doesn’t,” Alberto Alesina, Carlo Favero and Francesco Giavazzi summarize more than a decade of research on how countries have reduced budget deficits across 184 distinct austerity plans, primarily in the euro area. They conclude that tax‐heavy fiscal adjustments fail to address the underlying drivers of deficits and cause more economic damage than expenditure-based reforms, prolonging recessions. The authors show that, “tax-based plans lead to deep and prolonged recessions, lasting several years. Expenditure‐based plans on average exhaust their very mild recessionary effect within two years after a plan is introduced.”
Read more on fiscal policy by Adam Michel
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Because nothing is black and white, successful expenditure-based fiscal adjustment plans are made up of as much as 20 percent tax increases, on average. Thus, plans that cut spending may not even be recessionary at all, contrary to the traditional Keynesian economic models used to justify government stimulus. Cutting government spending can restore consumer confidence and reassure investors that taxes will not have to increase in future years to cover current expenditures. By signaling a credible, long-term solution, expenditure-based budget reforms can boost private economic activity in a way that more than offsets the government cuts.
On the other hand, tax increases can be self-defeating. In a review of post-financial crisis empirical research, Valerie Ramey finds that in a majority of estimates, tax increases reduce GDP by two or three times the amount of revenue they raise. By slowing growth, tax hikes can drive spending by pushing more people into countercyclical income support programs, making expenditure reforms even harder. If tax increases are self-defeating, spending cuts are left as the most effective way to address prolonged fiscal imbalances. Such cuts are less likely to prolong recessions and are the most realistic way to address the root causes of deficits caused by expenditure growth.
Dr. Alesina and his coauthors have one more hopeful conclusion for politicians facing tough choices in addressing their fiscal imbalances. In a review of electoral outcomes following large fiscal adjustments, they find “no evidence that governments which reduce budget deficits even decisively are systematically voted out of office.” Well-designed spending cuts can be the best way to protect essential government services and ensure long-running economic prosperity for future generations.
Scenarios
More likely: Policymakers favor tax hikes
Despite the economic and political advantages of spending cuts, the reality is that many EU governments will likely resort to raising taxes. Historical patterns suggest that policymakers often prefer tax hikes due to the immediate revenue gains and the (incorrect) perception that they spread the costs more evenly across society.
If political campaigns in the UK, France and the U.S. are any indication, history is likely to repeat itself. In the UK, the recently elected Labour Party is likely to rely on new revenue raises to cover fiscal deficits, and in the U.S., whether through proposed tariffs or taxes on investment returns, both presidential candidates have promised new revenue sources. Even more dramatic dynamics exist in France, where the focus seems to be on increasing spending – with some proposals to increase taxes and others to cut them, making the fiscal situation even worse.
Beyond the electorate, the European intellectual class has also bought into increasing the role of state actors through more spending, higher taxes and new tariffs. As this author has noted in the past, the U.S. and the EU have recently shifted toward a subsidy-driven model of industrial policy that is being institutionalized through the Organisation for Economic Co-operation and Development’s global minimum tax rules. A similar sentiment is being put forward by former Italian Prime Minister Mario Draghi, whose influential work argues for a robust EU industrial policy with larger state subsidies, more protectionist tariffs and more centralized economic power in Brussels. Paired with existing budget deficits, these trends are well summed up in the headline of a 2023 Wall Street Journal article: “The Era of Big Taxes is Upon Us.”
Less likely: A pivot to spending cuts
Some countries might defy expectations, learn from past episodes and opt for significant spending cuts instead of raising taxes. This approach could put their governments on a more sustainable fiscal path, promote improved investor confidence and boost economic growth.
By reducing expenditures, these countries could avoid the negative impacts of tax hikes on economic activity and productivity. If successful, this strategy might lead to a virtuous cycle of growth, with lower deficits and shrinking debt levels – ultimately providing more fiscal space to reduce longer-term burdens on taxpayers.
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