Public spending cuts foster economic growth

Montreal, October 8, 2015 – Seven years after the financial crisis, budgetary rigour remains at the heart of economic debates in Canada and in most Western countries. It is important, though, to properly distinguish various “austerity” measures—and their effects—in evaluating a country’s economic policies, states an Economic Note published today by the MEI.

“The term ‘austerity’ is misunderstood in Canada. Too often, certain commentators lump together tax increases and spending cuts, whereas the two measures have effects on economic growth that are diametrically opposed,” says Mathieu Bédard, Economist at the MEI and the author of the publication.

For example, some say that reducing public spending necessarily leads to slower economic growth. This notion is contrary to the results of independent academic studies published in the most prestigious academic journals. That research shows instead that lowering public spending is less likely to provoke a recession than raising taxes, and that it ends up having a positive impact on growth.

On the other hand, raising taxes in order to balance the budget can hurt the economy. Above a certain level, tax increases entail a loss of economic well-being that is larger than the growth of well-being funded by the government’s additional revenues.

“These results are at the cutting edge of economic research, and are confirmed as much by economists who are more in favour of government intervention as by others who advocate greater reliance on market mechanisms,” adds Mr. Bédard.

International experience also confirms this thesis. OECD countries whose governments concentrated 75% of their efforts on balancing the budget with spending cuts experienced average annual growth of 1.3%. Those that concentrated 75% of their efforts on increasing revenues instead experienced average economic contractions of 0.4% per year.

Canada as a whole (including all levels of government) reduced both spending and revenues between 2009 and 2013 (the former more than the latter). The combination of two measures with positive effects allowed the country to register an enviable average annual growth rate of 1.8%, more than twice the OECD average.

“Participants in the public debate on ‘austerity’ have an obligation to distinguish between spending cuts and tax hikes,” says Michel Kelly-Gagnon, President and CEO of the MEI. “The most up-to-date economic literature, as well as the experiences of other countries, not only show that these two policies have different effects, but also run counter to the explanations put forth by those who propose increasing the tax burden in order to balance the budget.”

The Economic Note entitled “Cutting Public Spending Promotes Economic Growth” was prepared by Mathieu Bédard, Economist at the MEI, in collaboration with Vincent Geloso and Youcef Msaid, Associate Researchers at the MEI. This publication is available on our website.

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The Montreal Economic Institute is an independent, non-partisan, not-for-profit research and educational organization. Through its studies and its conferences, the MEI stimulates debate on public policies in Quebec and across Canada by proposing wealth-creating reforms based on market mechanisms.

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