What is the effect of spending and taxes on GDP? – 04/04/2023 – Bernardo Guimarães

When we talk about fiscal issues, we often make an analogy between government accounts and a family’s budget. The analogy always generates outraged comments on social media.

As a family, the government must go into debt when it spends more than it earns. Higher debt tends to lead to higher interest rates and greater risk. It is therefore prudent not to let the debt grow to that point.

While useful, the analogy is in fact incomplete.

A crucial difference between a government budget and a household’s is that spending and taxes affect how much is produced in the economy. More taxation discourages production. Spending cuts reduce demand for goods and services, which can negatively affect production.

An extensive literature in economics seeks to estimate the effect size of changes in taxes and government spending.

It is not easy to estimate these effects. Fiscal consolidations in emerging countries tend to happen in times of crisis, just as surgery tends to happen when the patient has problems. Evaluating the surgery requires comparing its outcome with what would happen if the patient had not been operated on. The same goes for fiscal consolidations, but in general in economics it is difficult to know what would have happened if other measures had been taken.

The various estimates of the effect of fiscal policy on the economy use a variety of statistical techniques to get around this problem.

As you would expect, not all studies reach similar results. Still, the literature holds some important lessons.

For developed countries like the United States, increases in spending or reductions in taxes tend to boost GDP (Gross Domestic Product). Lower spending and higher taxes do the opposite. The effect appears substantial. However, the effect of fiscal consolidations depends on many factors.

One particularly influential study uses quarterly data from 44 countries. One conclusion is that changes in fiscal policy have a large impact on GDP in developed countries, but much less effect in emerging countries (and less effect when the exchange rate regime is flexible).

This work also concludes that, when public debt is high, cutting spending or raising taxes does not have negative effects on output.

In fact, in moments of distrust about the debt’s direction, fiscal consolidations seem particularly important. This logic worked in 2003, when the Lula government promised —and fulfilled— to increase the primary surplus to 4.25% of GDP.

How the adjustment is made seems to affect its effect on the product.

Several studies conclude that cutting public investment has a substantial negative effect on output.

Using data from Latin American countries, there is evidence that fiscal consolidations through tax increases negatively affect GDP more than adjustments based on spending cuts.

This evidence is not definitive, but it is what we have at the moment to guide macroeconomic policy decisions. According to this literature, a fiscal adjustment today would not have the short-term negative effect on GDP, common in other cases.

Many of the comments on fiscal plans seem to assume that a strong consolidation would have a recessive effect. As far as we know, these ideas do not correspond to the facts.

In Brazil today, the analogy between government accounts and a family’s budget works very well.

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