Fiscal austerity is when the government of a country decides to raise taxes or cut government spending in order to reduce a government budget deficit.
It has advantages as well as disadvantages, one being that it reduces the welfare of citizens both in the short-run and in the long-run. For example, a rise in taxes means that consumers have less disposable income. Government spending includes transfer payments which is welfare benefits, so a cut in government spending effects those gaining benefits who are likely to be those on low-incomes. This leads to income inequalities.
Cutting spending on infrastructure and education will reduce the supply of physical and human capital in the future, this will then lead to lower economic growth. Austerity will lead to a fall in GDP, in the short-run – the more severe the rise in taxes are or the more severe the cut in government spending is, the more negative the impact on GDP is. If the economy is in a recession, austerity will only cause the recession to worsen. If the economy is in the recovery phase of the trade cycle, it will slow down the rate of recovery. However, Canada pursued austerity in 1993-1996 and maintained strong economic growth; their exchange rate depreciated as a result of this.
Unemployment will rise when there are cuts in government spending, this is because cuts in public spending or rises in taxes reduces aggregate demand which means there will be more spare capacity in the economy. This leads to welfare benefits for those unemployed or on low incomes rising while tax revenues will fall.
The main advantage of austerity is that it reduces the budget deficit, which overtime reduces the national debt. Austerity can cause interest rates to decrease, because there is low domestic demand,
and can cause the current account of the balance of payments to improve. This is because interest rates decrease which means that exports are cheaper so they increase and imports decrease as they are more expensive, the exchange rate depreciates which helps to restore a country’s competitiveness.
Spending cuts will lead to lower inflation, this is due to the fall in aggregate demand and if the government decreases public sector wages, public sectors workers will have less disposable income so consumption decreases, lowering aggregate demand which leads to a fall in inflation.
Some economists say that austerity is self-defeating – government spending cuts and higher taxes fail to reduce budget deficits. They come to this conclusion due to the large negative impact on real GDP. As explained above, government spending cuts lead to lower aggregate demand which leads to lower real GDP. The fall in GDP causes tax revenues to fall and spending on transfer payments (i.e. benefits) to increase. Although the original aim is to reduce budget deficit, there is no real improvement in the deficit as the spending cuts are outweighed by the increase in government spending that follows.