At the beginning of the current recession a common narrative was that spending cuts were always better than tax increases and that fiscal austerity could actually cause the economy to grow. These claims were based more upon anecdotes and strongly held opinions than rigorous analysis. Five years on, much firmer evidence has emerged.
Using the HERMIN model, the effects of a consolidation of €1bn were simulated for eight fiscal measures. These are are 1) an increase in direct tax (such as income tax), 2) an increase in indirect tax (such as VAT), 3) an increase in capital tax (such as capital acquisitions tax), 4) an increase in corporation tax 5) a cut to non-wage public consumption, 6) a cut to public sector wages, 7) a cut to social transfers, and 8) a cut to public investment. Consistent with other analyses, there is no evidence to support either that fiscal austerity can expand the economy, or that spending cuts are more effective at closing the deficit than tax increases.
The analysis suggests that the most effective methods of closing the deficit are through increases in capital taxes, the effective rate of corporation tax, and indirect tax. The least effective methods are cuts to public investment and to public sector wages.