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April 30, 1997

Two Types of Reforms (Serious and Not)

A recent study divided fiscal reforms in a number of countries into two types. Type-one reforms were successful. They tended to cut spending. Type-two reforms were failures. They tended to raise taxes. Will President Clinton choose type one or type two? By Hoover fellow Robert J. Barro.

Since the 1980s, the key question about the U.S. budget deficit has been not whether it would be reduced but whether this would be accomplished by spending reductions or tax increases. Similarly, today the question about entitlements is not whether Medicare or Social Security will be fixed but whether these repairs will involve reduced benefits and enhanced efficiency or will instead entail more taxes. In general, the success and permanence of fiscal adjustments depend on their form, especially on whether governments restrain the growth of outlays.

The idea that the form of a fiscal adjustment matters more than the amount is the theme of a recent International Monetary Fund study by Alberto Alesina and Roberto Perotti, "Fiscal Adjustment in OECD Countries: Composition and Macroeconomic Effects." The authors examined the experience with budget deficit reduction in twenty major developed countries in the Organization of Economic Cooperation and Development (OECD) from 1960 to 1994.

In 62 of the 378 annual observations the study considered, the government was conducting a fiscal adjustment, defined as a reduction in the cyclically adjusted budget deficit by at least 1.5 percent of gross domestic product. However, only about one-quarter of these adjustments were successful three years later-successful meaning that the fall in the fiscal deficit was sustained or that the cumulated reduction in the ratio of the public debt to gross domestic product was at least 5 percentage points. Examples of successes were Ireland and Sweden in the late 1980s and Denmark in the mid-1980s. The United States made the success list only for 1976.

The interesting finding in the Alesina-Perotti study is that a plan's success or failure depends on the composition of the reform. For one thing, the successful cases concentrated much more on spending reductions than on revenue increases. In the successes, 73 percent of the deficit reduction involved spending less, whereas for the failures, only 44 percent took this form.

The composition of the spending cuts also differed markedly. In the successes, 51 percent of the spending decreases were in transfers and government wages, while 20 percent was in public investment. For the failures, only 17 percent of the reduced spending was on transfers and government wages, whereas a striking 63 percent was in public investment. Referring to the successful reform model as type one, the authors write, "The reason why type 1 adjustments were successful is that they tackle the two items of the budget, government wages and welfare programs, which have the strongest tendency to automatically increase." In contrast, in the typical unsuccessful effort, described as type two, the focus on cuts in public investment reveals a short-term outlook with no lasting commitment to fiscal discipline.

On the revenue side, successful fiscal adjustments raised 62 percent from higher business taxes, whereas only 10 percent was on household taxes and social security contributions. In the unsuccessful cases, 48 percent of the extra revenue came from household taxes and social security contributions, while only 21 percent derived from business taxes. Thus, a concentration on household levies is another sign of a type-two uncommitted reform.

Successful fiscal adjustments are valuable not only because they last but also because they are more favorable for the economy. Economic growth was more rapid under type-one successful reforms, and this growth was accompanied by more robust investment and exports. The authors attribute much of the better economic performance to the enhanced credibility of governments willing to undertake sustained reforms: "Governments which are willing to tackle the politically more delicate components of the budget- public employment, social security, welfare programs-may signal that they are really 'serious' about the fiscal adjustment."

Professors Alesina and Perotti then go on to describe Italy as a prototypical nonserious country because of its continuing type-two fiscal policy. (Italian economists seem prone to criticize the Italian government; the upside is that the United States benefits from the presence of many brilliant Italian economists.) Some reductions of fiscal deficits have occurred in Italy; but the focus has been on more revenue rather than less spending, and the spending cuts have emphasized public investment.

A central issue for the second Clinton administration is whether fiscal adjustments in the entitlement area will be of type one or type two. An example of a type-two approach is the 1980s "fix" of Social Security (in which Bob Dole took pride during the presidential campaign). In fact, this fix focused on increases in payroll taxes and only very little on spending restraint, primarily as agonizingly slow and modest increases in the retirement age. An example of the type-one approach is the highly successful social security privatization pioneered by Chile.

We cannot yet be sure which way Clinton will go. But two reasons to be pessimistic are his unwillingness to go along with previous Republican plans to restrain Medicare spending and his recent proposal for revisiting the cutbacks in welfare benefits. Mr. Clinton, in other words, shows telltale signs of "type twoness."

Robert J. Barro is a senior fellow at the Hoover Institution and the Paul M. Warburg Professor of Economics at Harvard University.

Barro's expertise is in the areas of macroeconomics, economic growth, and monetary theory. He is currently researching the interplay between religion and political economy.

Reprinted with permission of the Wall Street Journal, from an article titled "Serious and Nonserious Fiscal Reforms," January 14, 1997. © 1997 Dow Jones & Company, Inc. All rights reserved. This article is part of the Hoover Institution's Viewpoints series, distributed by the Office of Public Affairs, 650-723-0603. Getting It Right: Markets and Choices in a Free Society, by Robert J. Barro, is published by the MIT Press; to order a copy, call 617-253-5249.