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Pro-Growth Austerity

Tightening the government’s belt doesn’t have to squeeze the economy.

Jul 2, 2012, Vol. 17, No. 40 • By CHARLES WOLF JR.
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Think back for a moment to the bygone days of the GATT (General Agreement on Tariffs and Trade). Suppose the United States were to propose something that might be called a “Most Tax-Favored Nation Treatment”(MTFN). The result of our lowering corporate tax rates to the lowest rates prevailing abroad would likely be to reduce the $329 billion outflow, as well as to attract additional foreign capital to invest in the United States. Economic growth here would be spurred. Tax revenues might fall or rise (rates would be lower, but the amount of taxable earnings from foreign investment in the United States would rise), but no additional government spending need ensue. 

Again, we would achieve austerity in debt-financed government spending, while giving an added push to economic growth: Think of it as a “trade-on,” rather than “trade-off.” 

Finally, focus again on the disaggregated components of demand, rather than on the aggregate, which is the root of the mistaken view that austerity and growth are antonyms. The component parts suggest another opportunity for reinforcing the positive relation between austerity and growth.

Debt-financed government spending often has perverse effects on private consumption and private investment. Consumers may respond to additional government outlays by a precautionary rise in savings as a cushion for anticipated higher taxes required to service the added debt in the future. Investors may also worry lest the increase in government spending adversely affect their business planning (for example, the added government spending might help competing producers, or subsidize competing products, or be accompanied by additional regulation that would further inhibit business planning). 

As a result, potential investors may respond by deferring or diminishing their otherwise intended investment. In the Keynesian vernacular, the “multiplier” may in fact turn out to be negative: The consequence of relaxing government austerity would thus be reduced economic growth.

The takeaway point from all the above is that government austerity and economic growth are not antonyms: Austerity in debt-financed government spending complements economic growth, rather than conflicting with it.

Charles Wolf Jr. holds the distinguished corporate chair in international economics at the RAND Corporation and is a senior fellow at the Hoover Institution.

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