Can a spending freeze solve the problem of the Italian enormous government debt?

Question

In view of the upcoming Italian general election, I've been reading the program of a party (please let me know in the comments whether I can/should mention its name), and in a section of it they propose a freeze of the public spending for the next 5 years in order to face the gigantic public debt. Not having a solid understanding of Economics, I thought of asking about it here.

Here's the translation of the relevant passage:

The Italian government debt, stabilised over the last few years around 132% of GDP, has become an unsustainable weight for the country's economy. Interest expenditure, equal to 66 billion euros (around 8% of the total expenditure), is a huge weight on the national budget that determines a displacement of resources in the economy. Besides, the high stock of debt is a threat to the stability of the whole euro area and one of the major obstacles to the process of integrating budgetary policies at European level.

To face the problem we propose a freeze of the public expenditure in nominal terms for the duration of the next parliamentary term, as well as a redesign of taxation with cuts to the tax rates on income of people and companies, and a reduction of fiscal expenditure: thus there would be a redistribution of resources from the public to the private, from income to productive economy.

To freeze nominal expenditure means to establish an insurmountable limit for five years, which entails a reduction of public spending as a share of GDP if inflation and economic growth are positive. It is therefore necessary to reduce current outlay and tax benefits in order to compensate for the inertial increase of pension costs, by acting on current expenditure on the basis of the guidelines set by the former commissioners for the spending review.

I have seen critics to this strategy: according to Dr Domenico Moro, a lecturer in Economics at Birmingham Business School, debt growth does not depend on public primary expenditure. Indeed he states that in Italy it was below the European average in 2016, whereas the problem is interest expenditure (4% in Italy vs 1.8% in the EMU). He also points at wrong choices made by the Treasury Department over the last few years.

But in fact he adds that reducing public spending wouldn't be only useless, but even counterproductive: in a context of weak recovery and most of the new workers having a temporary contract and being underemployed, it would result in a drop of aggregate demand. This notoriously has a downward effect on GDP growth, and in turn an upward effect on public debt - since it is calculated as a percentage of GDP.

He then concludes the other proposal, i.e. the reduction of the company tax rate accompanied by the VAT increase, would make it worse: prices would rise and workers' income would drop proportionally; this would yield a further decrease of aggregate demand, especially of consumer goods rather than luxury ones, and consequently a decrease of GDP.

Question: is Moro's analysis completely sound? Did he really demolish the economic agenda of this political party?

Answer 1

This question is somewhat political, and runs into the area of “opinion-based,” which this site has to avoid. I am only going to attempt to discuss part of it. There’s some long-running economic debates involved, so I will try to describe the debates. I obviously have my own opinions.

One side issue: it is unclear in what sense is an “enormous” debt a “problem”, other than the technical issue of the European treaties? But since those treaties exist, I will put that aside.

As background information, we normally think about the size of the government as a percentage of GDP. So if nominal GDP is growing in steady state, so would government spending. Therefore, a “freeze” in euro terms, although that might be interpreted as unchanged, would be thought of as shrinking government spending relative to trend. In commonly used terms, it would be viewed by many as a mild austerity policy.

This leads us to the debate about expansionary austerity. Alberto Alesina is the economist most associated with the revival of this policy. I am not familiar with the more recent literature, but this paper by the IMF was critical of idea of expansionary austerity - IMF paper link. I would summarise the conclusions that there was a mild depressing effect on growth (“contractionary” versus “expansionary”), but one may note that this is just reducing the growth rate of an already growing economy.

I am not going to claim to give the “correct” answer, but the debate is this: will the cut in spending reduce growth, so that the effect on the denominator of the debt/GDP ratio of reduced spending is cancelled out? Realistically, it probably depends on the state of the cycle. Cutting spending right after a crisis when confidence is low may have a more dampending effect than when the economy is starting to grow more rapidly. In Italy’s case, one would need to do a detailed forecasting exercise to see how large the margin of safety is.

However, freezing spending would only reduce the deficit if the tax take rises along with nominal GDP. The suggested policy is to cut tax rates. That enters into another bitter debate in economics, the supply side effect of tax cuts.

(As an immdiate disclaimer, it is possible to redesign the tax system so that a lower tax rate will imply a higher tax take; for example, eliminate a popular deduction. It does not sound like that is the case here.)

The original supply side debate was very strong in the era of Ronald Reagan, the “Laffer Curve” (an idea of economist Art Laffer) was that very high tax rates were counter-productive. Cutting taxes would raise incomes through growth, and so revenues would increase. In 2018, I do not know of anyone who would argue that this would happen right now in the short term (one or two years, say). I believe the consensus is that the improved growth will appear on a longer horizon. In the United States, there is a debate about “dynamic scoring” that discusses this. There are plenty of resources for dynamic scoring on the internet, this is a recent presentation by the CBO - link to CBO presentation.

So one could expect that such a policy might result in a higher deficit in the short term (1-2 years), but will the tax cut lead stimulate enouh new activity on a longer horizon - that leads to a falling debt-to-GDP ratio? That question would either require analysis by experts on the Italian economy, or it would be largely opinion-based.