Cato's Center for Global Liberty and Prosperity/
By Juan Ramón Rallo, Ángel Martín Oro and Adrià Pérez Martí*
Last year's election of Spain's conservative People's Party opened up
an opportunity to implement much needed fiscal and structural reforms.
However, merely a week following the December 21, 2011, inauguration of
Prime Minister Mariano Rajoy, the government announced a significant tax
hike that will have pernicious effects on the Spanish economy.
The main reason for the tax hikes, according to Spain's new leadership,
was that the government would miss its budget deficit target for 2011.
While the previous Socialist Party government had promised the figure
would be 6 percent of GDP, the revised data showed a budget deficit of 8
percent, a difference of approximately 20 billion euros ($26.3
billion).
1 That change makes it more challenging for the government to fulfill its deficit pledge of 4.4 percent by the end of 2012.
While the government claimed that missing the target for 2011 was
unexpected, few if any independent analysts believed the previous
administration's official estimates. Nonetheless, the Rajoy
administration seized the opportunity to announce one of the largest tax
increases in recent Spanish history — which aims to raise 6 billion
euros ($7.9 billion) — along with a spending cut of nearly 9 billion
euros ($11.8 billion). The measure mainly consists of a so-called
solidarity surtax to come on top of tax rates on income and capital
gains; it also includes an increase in real estate taxes. The government
announced the tax hike as "temporary" and "inevitable." In fact, the
measure demonstrates nothing more than a lack of political will to cut
excessive and unsustainable public spending.
Spanish Income Taxes among the Highest in Europe
Following the tax increase, Spanish individuals will be paying one of the highest personal income tax rates in Europe.
2
For instance, from 2012 onwards, only Sweden and Belgium, with 56.4
percent and 53.7 percent, respectively, will have a higher top marginal
income tax rate than Spain, which stands at 52 percent.
3
However, if one takes into account local surcharges imposed by some
Spanish regional governments, the top marginal rates rise further. In
Catalonia, for example, the top tax rate is 56 percent.
It is important to also consider the structure of personal income tax
brackets and compare Spain with other major European countries, such as
France, Germany, Italy and the United Kingdom. As we can see in Figure
1, personal income tax rates in Spain will be among the highest for any
income bracket in the countries considered.
As for the tax on capital gains, the rates will no longer remain low
and competitive, relative to other European countries. Before the tax
increase, capital gains were taxed at a progressive rate of 19 percent
for the first 6,000 euros and 21 percent for gains above that amount.
Now, there will be three different rates: 21 percent for the first 6,000
euros, 25 percent from 6,000 to 24,000 euros, and 27 percent for
capital gains above 24,000 euros. Thus, the rates will now be as high as
in Germany and considerably higher than those of Italy, and the top
rate will almost match those of Finland and Norway.
All of those countries enjoy a considerably higher income per capita
than Spain and thus can more easily withstand higher taxes than a poorer
country.
4
With Rajoy's tax hike, Spain suffers from the worst of both worlds:
very high taxes combined with decreasing income and employment levels.
At 23 percent, Spain has the highest unemployment rate in the European
Union.
The tax increase is especially harmful given the 1.5 percent economic
contraction expected for 2012. The new measures are going to further
hinder the economic recovery in two ways. First, the higher income taxes
will take away a portion of the disposable income that many
over-indebted families need to repay their debts. Second, the tax hike
on capital gains will reduce the incentive for Spanish individuals to
save. Similarly, the tax increase will diminish the appeal for
foreigners to invest in Spain. By decreasing the availability of capital
— which is essential to finance the restructuring of the productive and
banking sectors — higher taxes on capital gains will only worsen the
country's economic prospects.
The Problem Is Too Much Spending
The Rajoy administration claims that the tax increase represents an
essential and inevitable policy change to reduce the deficit and fulfill
the budget target for 2012. However, given the anti-growth bias of
these tax hikes, the taxes can hardly be expected to generate
substantial revenues to significantly reduce the deficit. The real
problem behind Spain's dire public finances is not an insufficient level
of government revenues; rather, it is a problem of excessive spending.
This becomes evident by looking at the evolution of both government
spending and revenue from 2001 to 2007 in absolute (nominal) terms in a
set of European countries. The data show that while government revenues
increased substantially in Ireland and Spain due to a period of
unsustainable credit-induced growth, government spending also increased
the most in Ireland, followed by Spain and Greece (see Figure 2).
The picture is somewhat different if one pays attention to the ratio of
government spending to GDP from 2001 to 2007. This figure increased
slightly from 38.6 percent to 39.2 percent in Spain. But the data should
be interpreted with caution, given that GDP was growing at an
artificially high rate. (It is notable that the Spanish trend contrasts
with that of Germany where spending fell from 47.8 percent of GDP in
2001 to 43.6 percent in 2007.
5)
Instead of looking at the recorded budget balance — which shows a
surplus of around 2 percent in 2006 and 2007 — consider the structural
budget balance, that is, the budget balance adjusted for cyclical
factors,
6
which shows that there was not a single surplus year from 2001 to 2007.
This lack of surplus is caused by the government financing a large
volume of long-term spending, such as social benefits or public sector
wages, with short-term and temporary revenues — mainly produced by the
housing bubble. It should come as no surprise that the deficit soared
when the bubble burst.
In other policy areas, the Rajoy administration has been somewhat more
sensible. For instance, the recently approved labor reform is a step in
the right direction. It addresses an important cause of rigidity in the
labor market by establishing the primacy of individual agreements —
between firms and workers — over collective agreements in which labor
unions have much weight. The effect of this reform on job growth,
however, is uncertain because such growth also depends on other factors —
such as the rate of credit expansion or the international context —
that are independent of the labor market. The financial reform, on the
other hand, postpones the day of reckoning without addressing the root
of the problem, because not all bank losses have been recognized and the
financial sector will continue to be far from well-capitalized. Thus,
the reform leaves the door open for a further injection of public funds
into the banking sector. In addition, very little is known about
forthcoming reforms to remove obstacles to entrepreneurial activity that
make starting a business extremely burdensome.
7
The Case for Cutting Spending Is Clear
It appears that Spain's new conservative government considers raising
taxes to near Scandinavian levels its most urgent policy action.
8
Rajoy's priorities should instead be to implement measures to increase
productivity, employment, and entrepreneurship, and put public finances
in order.
Raising taxes will only put an additional drag on private sector
recovery by reducing workers' disposable income — and consequently,
their ability to consume, save, or repay their large amounts of
outstanding debt — and by decreasing foreign investment. Moreover, high
taxes and high public spending are negatively correlated with economic
growth and entrepreneurship.
9
To reduce the deficit, cutting government spending substantially would
be a better alternative than raising taxes. (The Spanish government
could even fulfill its deficit pledge of 3 percent in 2013 and keep
basic social services through a deficit reduction policy that relies
solely on spending cuts.)
10
That public spending should adjust downward to more reasonable levels —
as is the case in the private sector — is supported by recent empirical
work that shows that the impact of tax hikes on short-term growth is
worse than that of spending cuts.
11
*Juan Ramón Rallo is associate professor of applied economics at
King Juan Carlos University, Ángel Martín Oro is director of the
Observatorio de Coyuntura Económica at the Instituto Juan de Mariana,
and Adrià Pérez Martí is tax consultant at JPB Asesores, all based in
Spain.
Notes:
1 Dollar calculations are based on the exchange rate of February 3,
2012, of $1.31 per euro. On February 27 the government announced that
the official budget deficit for 2011 was 8.5 percent.
2 This is one of the main conclusions of a report by the Observatorio de
Coyuntura Económica of the Instituto Juan de Mariana, "España: en la
cola del paro y a la cabeza de impuestos," January 23, 2012, available
in Spanish at
http://www.juandemariana.org/estudio/5340/espana/cola/paro/cabeza/impuestos/.
3 European Commission, "Taxation Trends in the European Union 2011," July 1, 2011,
http://ec.europa.eu/taxation_customs/taxation/gen_info/economic_analysis/tax_structures/index_en.htm.
4 For instance, at the end of 2010, French and German GDP per capita was
more than 30 percent higher than Spanish income. In the case of Italy,
GDP per capita is more than 10 percent higher than that of Spain. See
International Monetary Fund, World Economic Outlook Database.
5 International Monetary Fund, World Economic Outlook Database.
6 The structural budget balance is defined, according to the IMF, as
"the government's actual fiscal position purged of the estimated
budgetary consequences of the business cycle (for example, the amount of
windfall tax revenue during boom times), and is designed in part to
provide an indication of the medium-term orientation of fiscal policy."
International Monetary Fund, "The Structural Budget Balance: The IMF
Methodology," IMF Working Paper, 1999, p. 1,
http://www.imf.org/external/pubs/ft/wp/1999/wp9995.pdf.
7 According to the latest
Doing Business report by the World
Bank, Spain is ranked 133 out of 183 countries in the category of
"Starting a Business", which measures how hard it is for entrepreneurs
to start up and formally operate an industrial or commercial business
due to all sorts of regulations and administrative burdens. See, World
Bank,
Doing Business 2012: Doing Business in a More Transparent World (Washington: World Bank, 2011).
8 Contrary to what many people believe, the Scandinavian experience does
not vindicate a belief in big government. See, Graeme Leach, "Economic
Lessons from Scandinavia," October 2011, Legatum Institute,
http://www.li.com/attachments/Economics_Scandinavia_2011_WEB.pdf.
9 On the negative impact of big government on growth, see Andreas Bergh
and Martin Karlsson, "Government Size and Growth: Accounting for
Economic Freedom and Globalization," 2010,
Public Choice 142, pp. 195–213. Available as a working paper at
http://www.ratio.se/pdf/wp/ab_mk_governmentsize.pdf.
On the negative correlation between the size of government and
entrepreneurship, see C. Bjørnskov and N. Foss, "Economic Freedom and
Entrepreneurial Activity: Some Cross-Country Evidence," 2008,
Public Choice 134, pp. 307–28.
10 See Juan R. Rallo, "El recorte que debería haber aprobado Rajoy," January 2, 2012,
Libre Mercado, available in Spanish at
http://www.libremercado.com/2012-01-02/juan-ramon-rallo-el-recorte-que-deberia-haber-aprobado-rajoy-62621/.
11 See Alberto Alesina and Silvia Ardagna, "Large Changes in Fiscal
Policy: Taxes versus Spending," January 2010, National Bureau of
Economic Research Working Paper no. 15438.
