The positives and negatives of fiscal policy’s tightening

LAHORE: New Pakistani Prime Minister Imran Khan's austerity drive is certainly a laudable step, aimed chiefly at cutting down exorbitant government expenses and to curb the misuse of state resources by those at the helm of affairs, but tightening of fiscal policy during a time of economic weakness may also lead to higher unemployment and lower economic growth, hence resulting in a fall in cyclical tax revenues.

Research conducted by the "Jang Group and Geo Television Network" shows that economists all over the world hold contrary views on this subject though. For example, in 2012, the International Monetary Fund (IMF) had released a report stating that the Eurozone's austerity measures might have slowed economic growth and worsened the debt crisis, but the European Union Commission had also produced a parallel report, arguing that austerity measures were working to reduce budget deficits.

Jose Manuel Barroso, the European Union Commission President, had said: "I can say the medicine is beginning to work." He had pointed out to falling deficits in countries such as Estonia, Finland, Luxembourg and Sweden due to austere steps. Hungary had also improved its fiscal position.

The June 2, 2012 report of the "Economist" had stated: "Super-fit Germany has made the adjustment earlier than planned and been released from the excessive deficit procedure. Bulgaria was similarly freed, proving that discipline is not just for the strong. They will join Estonia, Finland, Luxembourg and Sweden in the club complying with deficit targets. Hungary, which had incurred disapproval all round, now gets a nod for tackling its deficit: the commission recommended lifting a threat to withhold a chunk of aid."

Research further shows that during the last decade, a good number of countries on the planet have introduced austerity measures. Some got the desired results and some failed to reap dividends.

Here follow a few examples in this context: In 1993-96, Canada had cut its fiscal deficit, but maintained strong economic growth. Canada’s deficit reduction was successful because it could loosen monetary policy, devalue exchange rate and benefit from strong export demand to United States and rest of world. Many European economists felt that Eurozone economies could not do this because neither could they devalue their currency, nor could they pursue expansionary monetary policy as they could not rely on exports to recover – because the whole Eurozone was weak.

Supporters of austerity in Latvia and Estonia had argued that the rebound in economic growth in these countries had showed that nations who pursue fiscal austerity can overcome their problems. The June 8, 2012 edition of "The Guardian" had maintained: "Not every European country is gasping under the straitjacket of austerity. Estonia and Latvia are both powering ahead after a period of excruciating belt-tightening. The example of Latvia is particularly stark. The small Baltic state suffered the worst recession in Europe with a 24% drop in GDP between 2007 and 2009. Two years later its economy was the fastest growing in the EU, putting Latvia in a position possibly to join the euro. Estonia, meanwhile, grew by 7.6% last year, five times the Eurozone average. In Estonia, civil servants took a 10% pay cut and ministers saw 20% shaved from their salaries. The government raised the pension age, cut job protection and made it harder to claim health benefits. Latvia's government sacked 30% of public sector staff and slashed salaries by 40%. Both introduced new taxes and raised existing ones."

In October 2010, the United Kingdom had eliminated 490,000 government jobs, cut budgets by 49 percent, and increased the retirement age from 65 to 66 by 2020. It had slashed the income tax allowance for pensioners, reduced child benefits, and raised tobacco taxes.

The "New York Times" had written: "The British government has unveiled the country’s steepest public spending cuts in more than 60 years, reducing costs in government departments by an average of 19 percent, sharply curtailing welfare benefits, raising the retirement age to 66 by 2020 and eliminating hundreds of thousands of public sector jobs in an effort to bring down the bloated budget deficit," an increase in the official retirement age to 66 from 65 would start in 2020 — four years sooner than planned — saving $8 billion a year. Britain has already said it will stop paying child benefit payments to people earning more than around $70,000 a year."

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The French government had closed tax loopholes. It withdrew economic stimulus measures. It increased taxes on corporations and the wealthy. The German government had cut down on subsides dished out to parents previously. It eliminated 10,000 government jobs and raised taxes on nuclear power.

The May 21, 2012 edition of the "BBC News" had asserted: "Europe is in the grip of tough austerity measures - some of the deepest public sector cuts for a generation. France's new Socialist President, Francois Hollande, has made it clear he aims to shift the EU's emphasis away from austerity and towards growth. Controversially he says he wants to renegotiate the EU's fiscal pact - already agreed by 25 nations - to include measures to stimulate growth. He wants to raise the minimum wage, hire 60,000 more teachers and lower the retirement age from 62 to 60 for some workers."

The British media house had added: "Germany's economy is doing better than most in Europe. It grew by 3% in 2011 and its growth of 0.5% in the first three months of 2012 was stronger than expected. The German performance - largely a result of strong exports - meant the Eurozone as a whole narrowly avoided returning to recession. The government plans to cut budget deficit by a record 80billion euros by 2014. The plans include a cut in subsidies to parents, 10,000 government job cuts over four years, and higher taxes on nuclear power."

In Portugal, the coalition government had passed the austerity measures necessary in 2012 under the bailout conditions. The previous government was voted out of office after failing to get opposition backing for a new austerity package. In Spain, the government had planned to cut 27 billion euros from the state budget this year - one of the toughest austerity drives in modern Spain's history. In 2011, the United States had initiated austerity reforms to reduce the country's ever-surging national debt. A stalemate over these austerity measures had then led to the American debt crisis as spending cuts and tax increases became an issue. Consequently, the US Congress had refused to approve the Fiscal 2011 Budget in April 2011, almost shutting down the government. In 2011, Italian Prime Minister Silvio Berlusconi had increased health care fees. He also cut subsidies to regional governments, family tax benefits, and the pensions for the wealthy. Italians voted him out of office.

His successors raised taxes on the wealthy, raised eligibility ages for pensions, and went after tax evaders. However, Italy's budget-cutting had calmed worried investors, who then accepted a lower return for their risk. Italy's bond yields dropped. The country found it easier to roll over short-term debt. In 2011, the government of Ireland had cut its employees' pay by five percent. It reduced welfare and child benefits and closed police stations.

Few years ago, the government of Portugal had cut wages by five percent for top government workers. It raised Value Added Tax (VAT) by one percent and had resorted to increase taxes on the wealthy. It had cut military and infrastructure spending, besides expediting privatization. Spain had frozen government workers' salaries and reduced budgets by 16.9 percent. It raised taxes on the wealthy. It also increased tobacco taxes by 28 percent.

Arguments against austerity: Some Western economists have opined that in a recession and liquidity trap, there is a rise in private sector saving and, therefore, triggering strong demand for government bonds. They have contended that despite the rise in UK and US deficits, bond yields have continued to fall – suggesting that there is no immediate need to cut spending in a recession. The fear of rising bond yields in UK and US is misplaced.

In September 2011, the "Guardian" had carried a warning by the United Nations, which had feared that mass austerity programmes sweeping across the developing world could affect children and other vulnerable groups. The Guardian had stated: "A study by the UN children's fund, UNICEF, said there would be "irreversible impacts" of wage cuts, tax increases, benefit reductions and reductions in subsidies that bore most heavily on the most vulnerable in low-income nations.

It found that between 2010 and 2012 a quarter of developing nations were engaged in what it called excessive belt-tightening, reducing spending to below the levels before the financial crisis began in 2007." Commenting on an IMF report that had highlighted and analysed spending projections for 128 countries, the UNICEF had viewed: "While most governments introduced fiscal stimuli to buffer their populations from the impacts of the crisis during 2008-09, premature expenditure contraction became widespread beginning in 2010 despite vulnerable populations' urgent and significant need of public assistance."

The UN children's fund had commented: "The analysis showed that the scope of austerity was severe and widening quickly. Of the 128 countries, 70 reduced spending by nearly three percentage points of GDP during 2010 and 91 planned cuts in 2012. A comparison of the 2010-12 period with the three years before the financial crisis began showed that nearly a quarter of developing countries were undergoing "excessive contraction", defined as slashing spending to below pre-crisis levels." The IMF study had found that governments had relied on five main ways of saving money: cutting or capping wages (56 countries); phasing out or removing subsidies, primarily fuel but also on electricity and food (56 countries); rationalizing or means-testing social programmes (34 countries); reforming pensions (28 countries) and increasing consumption taxes on basic goods (53 countries).

If there is a fall in output, firms will employ less workers leading to higher unemployment. Also, government spending cuts may involve making public sector workers redundant. In addition, media coverage of 'austerity measures' tend to reduce consumer and business confidence. Fears over job losses and expectations of lower growth will encourage consumers to save rather than spend. Research further shows that in some cases, austerity to reduce a budget deficit can be self-defeating, with sharp falls in real GDP, causing debt to GDP ratios to soar.

Arguments for austerity and Pakistan's case:

In Pakistan's case, 'fiscal austerity' has the potential to reduce budget deficits, besides helping to improve public finances in the long term. Research shows that countries use austerity measures to avoid a sovereign debt crisis, and Pakistan is undoubtedly not very far from this eventuality. But one really hopes that government of Pakistan does not decide to raise corporate taxes at any stage in near future because businesses are struggling, and any such move will only cause more layoffs. Raising income taxes will take money out of consumers' pockets, giving them less to spend.

Austerity measures normally come into play when creditors become concerned that the country will default on its debt, and Pakistan has had such warnings in recent past. Austerity drives are launched when the debt-to-GDP ratio touches alarming levels and Imran Khan has been better advised here because the debt is almost as much as what the country's economy produces in a year. Creditors then start demanding higher interest rates to compensate them for the higher risk. And higher interest rates mean it costs the country more to refinance its debt. At some point, it realizes it can't afford to keep rolling over debt. Countries then turn to other countries or the IMF for new loans. In return for bailouts, these new lenders require austerity measures. They just don't want to bankroll continued spending and unsustainable debt. Pakistan is in a similar position right now.

Austerity measures restore confidence in the borrowing country's budget management. The proposed reforms create more efficiency and support a stronger private sector.

Targeting tax evaders brings in more revenues. Privatizing state-owned industries can bring in foreign expertise. There is no doubt that spending cuts can lead to lower inflation as the fall in aggregate demand can help lower the inflationary pressures in the economy.