A recently published study by the German Institute for Economic Research (DIW Berlin) analyses the effectiveness of fiscal measures within the Eurozone. The investigation concludes that government expenditure, particularly in the form of public investments and government consumption, stabilises the economy of a member state significantly more effectively in the short term than tax cuts. These effects are amplified by the common monetary policy in the Eurozone, which underscores the need for a precise balancing of short-term stabilisation benefits and the long-term impacts on public finances and growth.
For their study, authors Gökhan Ider and Malte Rieth from the Macroeconomics Department at DIW Berlin combined a specific model of a typical Eurozone economy with empirical analyses based on Eurostat data. Their analysis proves that every additional euro of government expenditure increases the gross domestic product by up to 1.30 EUR in the first year. In contrast, tax cuts only generate an effect of up to 40 cents per euro invested, representing a significant difference in immediate economic stimulus.
Influence of monetary policy on fiscal impulses
Mr Ider explains that the common monetary policy fundamentally alters the framework conditions for fiscal policy in the Eurozone. The European Central Bank generally does not react to fiscal measures of individual member states, meaning national spending programmes are not slowed down by interest rate increases. Mr Rieth adds that in a currency union like the Eurozone, fiscal policy spending measures have far stronger effects than in countries with their own monetary policy, such as the USA. At the same time, tax cuts, which tend towards deflation, do not benefit from potential monetary policy loosening that could further amplify their effect.
While public investments and government consumption both boost economic output more than tax cuts, they operate through different channels. Public investments primarily stimulate private investments and expand the public capital stock, for example through infrastructure measures. This not only increases demand in the short term but also strengthens the productive capacities of the overall economy. Increased government consumption, however, primarily stimulates private consumption. Tax reliefs boost overall private demand considerably less, and their effect is shorter-lived. After four years, their effect almost dissipates, while the fiscal multiplier for government expenditure remains at around one.
Weighing opportunities and risks
Mr Ider stresses that well-designed spending measures represent a more effective instrument for short-term economic stabilisation. Nevertheless, it is crucial for governments to consider the long-term consequences for public finances and overall economic growth. Higher government expenditure or reduced tax revenues can impair the sustainability of public finances and diminish long-term economic growth. The authors also point out that the study results primarily apply to fiscal policy measures of individual member states. A simultaneous expansion of expenditure by several Eurozone countries could provoke a reaction from the European Central Bank and weaken the effectiveness of these measures.
