A good deal of economists, analysts, and investors appear to believe that strong deficit reduction – either through increased taxes or budget savings through entitlement reform and federal workforce reduction – would correlate with prolonged below trend economic growth.

A recently released report by the Congressional Budget Office (CBO) came to the exact opposite conclusion.

report by CBO

Source: Congressional Budget Office

In it, the CBO projects that a $2 trillion increase in primary deficits – i.e. stimulus spending – initially increases overall economic growth.  The effect, though, quickly fades into a fiscal drag on the economy.

In contrast, the CBO looked at two alternative scenarios involving $2 trillion and $4 trillion in deficit reduction.  The conclusion indicates that these two scenarios initially have a fiscal drag of around a half to a quarter of a percent of total economic growth.  After the initial downside effect, the authors find that economic growth becomes stronger, with the effect of say a $4 trillion deficit reduction package increasing overall economic growth by about one and a half percent ten years after enactment.

The CBO’s view, contrasting strongly with the view that fiscal drags induce substantial long-term downward pressure on the economy, stems from behavioral assumptions regarding saving, investment, and consumer/business confidence (some of this is implicitly assumed rather than directly stated).

In addition to behavioral factors, the CBO analysis accounts for the real effect of the additional debt burden.  Essentially, the straw (additional debt) doesn’t break the camel’s back (federal government operating capacity), but the additional straw does make the camel move slower after a while; in the CBO analysis, that time period is five years.

There are, of course, at least three important caveats the CBO’s analysis.

The first is that the report is general, meaning that it doesn’t address the differential impact of tax increases versus spending reductions (cost savings).  A deeper look would address the downward pressure tax increases have over the real long-term outlook in comparison to the short-term bump from further government spending (cost increases) and long-term drag from additional debt burden.  The analysis would also need to address the incentive effects or benefits of reducing government costs over the long-term.

The second issue is that the report assumes a phasing in.  If deficit reduction happens quicker, then the effects could be quite different.

The third issue left out of the analysis is the productivity effect of deficit reduction.  Presuming the federal government reduces costs by eliminating unneeded statisticians, auditors, administrative professionals, and many others, in conjunction with entitlement reform, aggregate productivity should increase.

How could aggregate productivity increase?  Simple.  As individuals shift from the generally less productive sector of the economy – government employment – towards more productive sectors, such as being business owners, creating useful market products, and so forth.

Overall, the view that deficit reduction is bad – either through tax increases or government savings (spending reductions) – is challenged by the recently released CBO report on the macroeconomic effects of alternative budgets.  Essentially, as long as deficit reduction is phased in and accomplished through government cost savings (spending reductions), deficit reduction will likely turn out to be a very good move for the economy as a whole.