Spain Trying to Tax Its Way Out of Recession

Spain sacrifices long term economic progress to short term deficit reduction.

Despite €100 billion in European support for its banks and European Central Bank financing of its debt, Spain is struggling to climb out of recession. Little economic growth is expected this year and next while millions of Spaniards are out of work.

Although Spain voted conservatives into government late last year, there appears to be little patience with the few austerity measures that have yet been tried. Public opposition to spending cuts is mounting but austerity in Spain has largely consisted of tax hikes.

The previous socialist government increased personal income taxes in 2010 and introduced two new brackets of 44 and 45 percent for higher incomes. Tax credits for self employed workers were revoked. The sales tax rate was increased from 16 to 18 percent as were excise duties on tobacco and gasoline.

The sales tax could be further raised if Spain follows the recommendations of the European Commission which has allowed the country an extra year to reduce its government shortfall to under 3 percent of gross domestic product in compliance with European fiscal rules.

The Commission also suggests that Spain eliminate tax breaks on housing and speeds up a planned increase in the retirement age to 67.

Spain’s deficit target of 5.3 percent of GDP will probably prove impossible to reach this year. Last year, after Prime Minister Mariano Rajoy’s conservatives ousted the socialists, the deficit ended at 8.9 percent. Government spending was cut that year by 3.6 percent after 1 percent in cuts in 2010.

Spending had increased by a yearly average of 7.6 percent since the start of the decade, from some €250 billion in 2000 to nearly €500 billion in 2009. As a share of GDP, government spending remained stable at around 40 percent during that period but growth was fueled by a bubble in real estate, necessitating the economic contraction that Spain is now suffering.

After the housing market collapsed in 2008, government spending as a share of GDP reached a record high of 46.3 percent. The ruling socialists attempted a Keynesian stimulus policy that did little to shift employment from construction or create jobs in it. One out of five Spanish workers is currently unemployed. Among the young, the jobless rate stands at over 50 percent.

What the socialists’ policy did achieve was that Spain lost the confidence of credit markets, evidenced by the high interest rates it pays on its bonds, which prompted the European Central Bank to directly finance Spanish borrowing by several hundreds of billions of euros.

The conservatives are wary of deficit spending with the aim of boosting growth but are equally hesitant to implement the sort of supply-side economic reforms that will improve Spanish competitiveness in the long term. Airports and utilities have yet to be privatized. The energy sector should be liberalized. Jobless benefits, among the most generous in Europe, can be overhauled to encourage job seeking.

Instead, the government is focused on short-term deficit reduction at the expense of growth. Further tax increases will discourage entrepreneurship and investment which are needed to create jobs.

The conservatives are also reluctant to cut waste in lower governments.

In Spain’s highly decentralized system of government, the provinces account for more than half of total public spending. The country has more than 8,000s municipalities, 60 percent of which have a population of less than 1,000.

Even in regions where Rajoy’s conservative party is in government and has been for years, the financial difficulties are pressing.

Spanish regions have committed to find over €18 billion of savings by the end of this year, almost half of the nation’s planned deficit reduction, but given their past record, the regions are unlikely to deliver which would force the central government to borrow more to foot their bills — leading to further tax hikes if the ruling party continues to take the easy way out.