The United States is heading in this wrong direction. Even if the $110 billion in annual sequestration cuts are allowed to take place, the Congressional Budget Office projects that annual federal spending will increase by $2.4 trillion to $5.9 trillion in a decade. The higher debt implied by this spending will eventually crowd out investment, as holdings of government debt replace capital in private portfolios. Lower tangible capital formation means lower real wages in the future.
Since World War II, OECD countries that stabilized their budgets without recession averaged $5-$6 of actual spending cuts per dollar of tax hikes. Examples include the Netherlands in the mid-1990s and Sweden in the mid-2000s. In a paper last year for the Stanford Institute for Economic Policy Research, Stanford’s John Cogan and John Taylor, with Volker Wieland and Maik Wolters of Frankfurt, Germany’s Goethe University, show that a reduction in federal spending over several years amounting to 3% of GDP—bringing noninterest spending down to pre-financial-crisis levels—will increase short-term GDP.
Why? Because expectations of lower future taxes and debt, and therefore higher incomes, increase private spending. The U.S. reduced spending as a share of GDP by 5% from the mid-1980s to mid-1990s. Canada reduced its spending as share of GDP by 8% in the mid-’90s and 2000s. In both cases, the reductions reinforced a period of strong growth.