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With America threatening to run off the "fiscal cliff" of tax increases and spending cuts on Jan. 1, it risks repeating the mistakes of Europe. The folly of "austerity" composed mainly of tax hikes with less in the way of spending reductions has driven the economies of the Old World into the ground. We're next unless Congress keeps Uncle Sam out of Americans' wallets and takes a chainsaw to Washington's budget.
Beginning next year, $136 billion of spending cuts are scheduled to take place according to the Congressional Budget Office (CBO). These include the mandatory sequestration of defense and discretionary spending resulting from the failure of last year's bipartisan "supercomittee" to agree on a 10-year plan to cut the federal budget by $1.5 trillion. They also include the end of unemployment benefit extensions and reductions in Medicare reimbursement rates. Keep in mind these aren't real cuts in overall government spending, but merely reductions in its rate of growth.
They are also trivial compared to the $532 billion of scheduled tax increases that CBO also reports. Most of this comes from income tax rates reverting back to pre-2001 levels and the alternative minimum tax expanding deeply into middle-class households. That's roughly four dollars of tax increases for every one dollar of so-called spending cuts.
How is this likely to pan out? To get an idea, we can look at Europe, which has followed a similar strategy and has had little success in reviving growth.
Spending cuts have been weak. Today, not a single Euro Zone government is spending less as a percentage of GDP than it did in 2007, according to Eurostat data.
Tax increases, on the other hand, have been rampant. The average cyclically adjusted total tax burden among Euro Zone countries increased by about 5% from 2007 to 2010, according to European Commission data . European politicians continue to reach deeper into their citizens' pockets. Most recently, the French parliament approved Socialist President Francois Hollande's proposal for sky-high 75% marginal tax rates on incomes greater than €1 million.
This misguided focus on raising taxes instead of cutting a morass of unaffordable spending has led to prolonged recession. The International Monetary Fund projects that total Euro Zone output in 2013 will remain below potential by 2.7% — worsening from 2.4% this year. Unemployment will rise accordingly.
Grim as they are, these trends aren't surprising. A 2012 study by Professor Alberto Alesina of Harvard University found that economies undergoing fiscal consolidation centered on spending cuts recovered to pre-austerity output within roughly one year, while economies faced with rising taxes didn't recover for more than three years. Cutting government largesse also had an immediate boost on business confidence, while asking taxpayers to pony up for more spending caused confidence to plummet.
Several Baltic countries have broken the European straitjacket of growth-strangling tax "austerity," and have enjoyed success relative to their peers as a result. Take Estonia, for example. The Estonian government implemented an austerity program in 2009 composed two-thirds of spending cuts and one-third of tax increases. These were real cuts, too—cutting into public employee wages by 40% and slashing total government spending by a whopping 16% by 2011. Estonia's economy contracted severely in 2009, but bounced right back with 2 percent growth the following year and has since continued to prosper. For the past two years, Estonian industry has expanded more than twice as fast as that of Germany.
Rolling back government's burden on the economy brings growth. European leaders are finally beginning to realize this as they renege on their weak and ineffective austerity programs. After driving French taxes to stratospheric heights, President Hollande announced last week a €20 billion three-year payroll tax break. Also last week, Greek parliament, which had been punting on real cuts since June, passed a €18 billion four-year plan composed of public sector wage and benefit cuts as well as layoffs. The savings will total 10% of Greek GDP, with over €6.5 billion taking place next year.
Tax increases don't bring about prosperity. Shrinking government to live within its means does. America's Founders settled our republic on the principle of learning from Europe's mistakes. Let's hope President Obama and Congress heed their wisdom.