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"Spending Cuts Will Hit the Vulnerable Hardest – So Find Another Way!" by Andrew Watt

A banner unfurled on the Leaning Tower of Pisa reads No alla riforma (of education). Portugal virtually comes to a halt as a result of a general strike that has united the bitterly divided union movement against austerity measures. British students trash the headquarters of the ruling Conservative Party in protest at budget cuts. In Dublin trade unionists protest against the EU/IMF cash-for-austerity deal with the Irish government. Four examples of the spectre that is going around Europe – austerity – and of the fears of citizens about and the nascent protest movements against it.

Major cuts in public services and the welfare state have already been implemented in many countries, and more is in the pipeline. Against this background, the normative question of whether cuts in the welfare state, in ‘social Europe’, are justified within the framework of austerity packages is one of the most pressing political issues. It is helpful to see that it can be broken down logically into three specific questions. These questions need to be addressed for each EU country individually, in the light of its specific situation, and at the level of the EU (or EMU) as a whole, given the spillovers between countries and the scope for supra-national policymaking. The three questions are:

  1. Are austerity measures – by which I mean discretionary policy changes to reduce government spending or raise revenue with the aim of reducing government borrowing and debt – necessary?
  2. If so, what should be the balance between increases on the revenue side and cuts on the spending side?
  3. Given the size of cuts on the spending side, to what extent should they be focussed on ‘welfare’ as opposed to other spending categories?

Merely setting out the issue in this way makes one thing immediately clear: there is no automatic link between ‘government debt is high’ and ‘welfare benefits must be cut’. Rather, a series of political choices have to be made. And these need, of course, to be informed by sound economic and political analysis and, no less, by normative-ethical value judgements. Let us briefly consider the questions in turn.

Are austerity measures necessary?

The macroeconomic arguments for and against fiscal austerity have been exchanged with gusto in recent months, also on the pages of the SEJ. In a nutshell, the fiscal hawks argue that government finances are unsustainable and that discretionary fiscal contraction is necessary to ensure sustainability and will be effective by increasing consumers’ and investors’ confidence in the future. Sceptics counter that finances are sustainable without austerity and/or that contractionary measures, because of their knock-on effect on output, will ultimately be self-defeating: fiscal consolidation must wait until private sector demand is expanding robustly. This latter position received an important boost with the publication of a detailed IMF analysis which showed that fiscal contraction almost always reduces output substantially. Moreover, the output losses can be expected to be particularly severe in conditions such as those currently prevailing, namely when interest rates cannot be reduced further, when export demand is weak (because almost all countries are seeking to consolidate at the same time) and – relevant for the euro area countries in particular – where currency depreciation is not an option.

Given the very close trade interlinkages within Europe, and the constraints on monetary policy, it is surely obvious that any fiscal contraction in high-debt EU countries needing also to improve their price competitiveness must be offset by continued expansionary policies at the EU level (quantitative easing, support packages) and by those countries with relatively sound government finances and export surpluses (especially Germany). This would enable the consolidation to remain credible while being spread out over a longer period, reducing the contractionary effects and, not least, easing the burden on welfare programmes.

Raise revenue or cut spending?

This is a pre-eminently political issue. If public spending is cut, or even if its rate of growth is held below that of the economy as a whole, the weight of the public sphere in the economy declines. Your view on whether, in the abstract, that is a good thing or not is a pretty good litmus test of where you stand in the political spectrum. One thing is clear: both the taxation/contribution and the spending side of the government account tend to be progressive, i.e. the rich pay more and receive less as a proportion of their market income than the poor. That means that, other things being equal, focusing on spending cuts increases social inequalities, concentrating on raising revenues reduces them. (Clearly this is not necessarily true of all measures on either side of the ledger – see below). Let’s look at some European numbers to get some perspective on these issues (all data from the AMECO database; calculations are mine).

Government – I have used the average of spending and revenue – accounted for somewhat under half (46%) of GDP in both the EU27 and the Euro area (EA) in 2008, the year the crisis hit. Is that a lot? Well, it was down by 1½ pp of GDP in the EA compared with ten years earlier; in the wider EU the fall was much smaller at about ½ pp. So there is evidence neither for liberal prejudices of an out-of-control ballooning of the state in Europe, nor, on the other hand, for the widely held perception on the Left of massive state retrenchment in the ten years running up to the crisis.

Turning to country differences (Fig. 1), we see quite a range across Europe, from Slovakia, with 34%, to Sweden, where the state accounts for 54% of GDP. Broadly speaking, the size of the state increases as you sweep westwards and northwards across the EU. Certainly there is nothing in these numbers to suggest that, beyond a certain minimum, the ‘dead hand of the state’ weighs down on economic outcomes. The countries with the largest public sector are amongst those with the highest living standards (not to mention more equal income distributions). One argument might be that spending cuts would be appropriate in those countries where the size of government had risen fastest before the crisis: that would be, in order of the pp increase, Cyprus, UK, Malta, Portugal, Ireland and Romania. (Greece is noticeable by its absence from this list: its fiscal problems are almost exclusively on the revenue side.) However, every single one of these countries had a smaller state share than the EU average at the end of the period: the increases can thus be seen as a catch-up process. More generally, the ten years have seen a convergence in the relative size of government across the EU, with catch-up in ‘small-state’ economies and retrenchment in some ‘large-state’ countries such as Sweden.

An argument frequently made in favour of spending cuts over revenue increases is that taxes are distortionary and thus tend to reduce output (‘if tax rates are high people choose to work less’). Well, as we have seen, the country distribution does not confirm this. Either the distortionary effect is small and/or it is (more than) offset by the positive effects of public spending (for instance on health and education) on output. A further point is that, if market prices are themselves distorted, then ‘distortionary taxation’, to the extent that it corrects such aberrations, enhances efficiency. An obvious example would be a carbon tax. Energy pries are too low because the full costs of burning fossil fuels are not included in the price. A carbon tax is ‘distorting’ only in the sense that it affects specific prices – but it brings us closer to an ‘optimal’ outcome. A similar argument can be made for a financial transactions tax.

It is also sometimes argued that spending cuts are less contractionary than tax hikes. However, this appears (see the IMF study cited above) primarily to reflect the fact that monetary policy is less offsetting in the latter case (This may reflect the personal prejudices of central bankers or the fact that tax hikes tend to push up prices). In any case, with monetary policy at the lower bound (unable to cut interest rates further), this argument has no traction in the current context.

It can be concluded from this that policymakers can honestly argue for a general focus on spending cuts over revenue increases only if they accept that it will, in all likelihood, raise inequality: choosing spending over revenue implies a clear normative choice in favour of a smaller state influence in the economy. It is mendacious to claim that this choice follows some immutable economic law. It is certainly not the ‘large-state’ economies that are confronting especially severe problems in Europe – if anything, the opposite is true. The spending-revenue choice is a normative-political one.

If spending cuts, where should they fall?

Now, imagine you have decided – for good or bad reasons – that a certain volume of the fiscal contraction deemed – rightly or wrongly – to be necessary in your country is to take the form of government spending cuts. Where should the axe fall? Again, let’s start with some numbers. If we break down the average government spending figures for the EU27 (2008), we see where the real money is: social transfers (including those ‘in kind’, i.e. public services) represent just under 30% of GDP. The public sector wage bill is around 10%. Everything else is a lot smaller (investment and interest payments 2.7% each, and subsidies 1.2%). What these numbers tell is simple: any major cuts in public spending are almost inevitably going to hit welfare payments (financial transfers and in-kind service provisions) and public sector wages. In other words, benefits and service cuts, public sector jobs and pay. It is simple mathematics that the lion’s share of any meaningful cuts on the spending side will have to come from these sources, simply because of their size. The other categories are simply too small (and interest payments are in any case set to increase).

Capital spending is a partial exception – but that is a mixed blessing. It is true that it is politically easier for governments to cut planned but not yet implemented capital spending projects – and this has been done in past consolidation exercises, for instance by countries seeking Euro area entry in the late 1990s. However, the longer-run returns of (most) public investment are high. Shielding welfare by cutting the capital budget is not a sensible policy in anything but the short run. It is because of the short-run orientation of our political systems that this happens in practice – but this is not something that the centre-left should welcome, much less champion.

The EU data also enable us to break down national governments’ spending – the EU27 average – by policy area (Fig. 2).

Social protection is almost 40% of government spending. Health, ‘general public services’ and education each account for between 10 and 15%. Everything else, apart from ‘economic affairs’, is close to being peanuts in terms of the share of spending. You could, in theory, scrap the entire armed services of all EU countries overnight and public spending would be reduced by just a little over 3%. So here too, the message is really that meaningful cuts in public spending are almost inevitably going to imply that ‘soft targets’ – social and welfare services in a broad sense – will be hit hard. These are EU averages and, of course, there are some national differences. To stick with the defence category, it is noticeable for example that defence spending in Greece is the second highest in the entire EU as a share of GDP, in glaring contradiction to the country’s low taxation capacity. Spending on the British armed forces is ten times higher as a share of GDP than in Luxembourg. Still the basic point remains: realistically, meaningful cuts have to come from spending categories of a meaningful size.

Moreover, it should not be forgotten that those working in the armed forces are also employees with employment rights. Withdrawing even harmful subsidies overnight can cause economic dislocation. In other words, any cutbacks in any given area will need to be spread out over time. This re-emphasises the basic point that cuts over, say, a five-year horizon will have to come from big-ticket items.

Conclusion

This analysis shows two important things. First, there are alternatives to spending cuts. They are: postponing discretionary consolidation until demand is stronger, using EU-level tools to protect countries from bond markets and promote economic growth, and raising additional and alternative domestic sources of revenue. And there are strong economic arguments in favour of such alternatives, depending on the specific situation in different member states. Second, when expenditure-side cuts are made, the structure of government spending is such that it is virtually impossible to make cuts that are meaningful in quantitative terms but do not impact disproportionately severely on vulnerable groups in society. Beware of politicians who claim otherwise! Often, some cutbacks are trumpeted as hitting the rich, with the suggestion that in consequence the overall programme of cuts is ‘fair’. Always look at the quantitative importance of such measures! In most cases they are essentially political window-dressing rather than a substantive contribution to fiscal consolidation.

For the centre-left this dual conclusion constitutes a strong argument to focus the debate – and where they are in power, the policy initiatives – on the alternatives to expenditure cuts: some combination of external support, EU solidarity, postponing consolidation and raising revenue (also from new sources). The scope to use these different measures clearly varies from country to country. Equally clearly, EU-level solutions are urgently needed that do not penalise well-meaning governments, and their taxpayers, with onerous requirements. Ireland is a – negative – case in point. Where spending has to be cut, ‘progressive’ choices can of course be made. There are some wasteful subsidies and tax breaks; some benefits to the well-off can be culled. Public sector pay-cuts can be targeted at those on high salaries. But one should be under no illusions about the extremely limited room for manoeuvre in choosing ‘progressive spending cuts’. Making the socially vulnerable pay for the crisis is manifestly unfair. Much better to find another way.

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