Greece, then Ireland, and more recently Portugal have applied for EU and IMF financial aid. A troika of European Commission, ECB, and IMF officials have negotiated accords for ambitious adjustment programmes with either two or three main components, as mandated by the Eurogroup and the Ecofin Ministers (2010a; 2010b; 2011):
- Fiscal adjustment (tax increases, tax deductions, and expenditure cuts)
- Competitiveness enhancement, including ambitious privatisation programme
- Financial sector support measures
In this column I argue that, because these countries have high net external debt, these programmes are not likely to succeed in achieving a sustainable fall in (public sector) net borrowing requirements.
External debt is paid out of export revenues
Table 1. Public plus private net external debt and net international investment position: EU countries, Switzerland
Keynes (1920) argued that budgetary policy could not be used to obtain funds to pay Germany’s external debt. This debt arose from the very large reparations imposed by the allies at Versailles in the aftermath of World War I, equivalent to 200% of Net Social Product in 1921/22 (Webb 1988).
The “peripheral” countries of the EU (Greece, Ireland, Portugal, Spain) and several Eastern European countries face a challenge similar to that of 1920s Germany precisely because they have high net external debt (see Table 1). In fact, the Eurozone sovereign debt crisis is really a balance of payments and external debt crisis.
The EU policy response has, to date, mainly been based on ambitious budgetary adjustment programmes. This approach is not adequate. Governments use taxation to appropriate a share of the real economic output of, foremost, domestic economic activity. The currency in which taxes are expressed is simply the unit of account. In the long run, tax revenues can only be used to pay external debt to the extent that they accrue directly or indirectly from export revenues, or if the foreign creditor is willing to use those payments to acquire domestic goods and services or domestic assets. If this is not the case, then there is an inconsistency between physical flows and monetary flows. This inconsistency may ultimately have to be resolved through, for example, domestic sector bankruptcies and forced reallocation of resources to the export sector with potential loss of efficiency, as argued by Keynes (1920).
Impact of the EU/IMF programmes on net borrowing requirements
As can be seen in Table 2, with the exception of Ireland1, the “peripheral” countries have high overall net borrowing requirements. Despite this, the current EU/IMF fiscal adjustment programmes do not directly and meaningfully target improvements in the trade balance. It is also not clear that competitiveness enhancement component of the programmes will translate in trade balance improvements. For example, Felipe and Kumar (2011) argue that the competitiveness enhancement programmes focused on reducing unit labour costs in the peripheral countries are misguided, and likely to do more damage due to demand compression.
Table 2. Net borrowing requirements and current account balance components in 2009
Moreover, the programmes are likely to have a detrimental effect on these countries income balance deficits. In particular, as existing sovereign debt is refinanced through loans by the European Financial Stability Facility and the IMF, and as the ECB raises its official interest rates (Whittaker 2011) average interest rates on the stock of external debt of Greece, Ireland, and Portugal are likely to rise. In addition, interest compounding on the existing stock of external debt is likely to result in growing income balance deficits. Furthermore, the net borrowing requirements’ share of GDP may rise if the adjustment programmes cause nominal GDP to fall.
In fact, other than through higher economic growth rates, the EU “peripheral” countries have, in practice, limited ability to reduce their respective income balance deficits (Table 2). They may seek to increase their use of Eurosystem liquidity facilities as Ireland has (Whittaker 2011)2; they may, like Greece, seek to renegotiate the interest rates on EU/IMF aid; or they may seek to substantially restructure their (external) debt (Cabral 2010).
Finally, if assets are sold to non-residents, the proceeds of the “ambitious privatisation” component of the EU/IMF adjustment programmes might be used to pay down some of the existing stock of external debt. However, in the current context, these asset sales may be accomplished at distressed prices. Moreover, the privatisation of assets to non-residents is likely to result in dividend and interest outflows that will aggravate future income balance deficits and thus future net borrowing requirements.
In summary, because the current EU/IMF adjustment programmes do not directly and meaningfully target the trade and the income balance deficits, they may not succeed in substantially reducing Greece, Ireland, and Portugal’s overall net borrowing requirements in the long term. If indeed so, it is hard to see how public sector net borrowing requirements can be reduced in a sustainable way.
A solution: Tax rebalancing to replicate the effect of currency devaluation
It is now widely argued that the “peripheral” countries face an insolvency crisis and that a key element of a solution involves the restructuring of their sovereign and/or banking-sector debt (Wyplosz 2011, Portes 2011, Haufler et al. 2011, Eichengreen 2010a, 2010b, Strauss-Kahn 2010, Cabral 2010). If debt restructuring is sufficiently large, and results in a substantial reduction of net external debt, these countries income balance deficits would likely fall, contributing to a reduction in these economies’ net borrowing requirements.
Nonetheless, this still leaves the question of how to improve these countries external competitiveness within the euro (Felipe and Kumar 2011, Dadush and Stancil 2011, Jones 2010).
One of the most interesting proposals on how to improve a country’s external competitiveness is Cavallo and Cottani’s (2010) proposal to reduce Greece’s employers’ social security contributions while increasing VAT rates.
The solution suggested in this column is based on and extends the tax-rebalancing approach identified by Cavallo and Cottani (2010).
Balance of payments (and external debt) crises in fixed exchange-rate regimes typically result in abrupt currency devaluations. This response of financial markets impacts exchange rates in a way that reduces the imbalances that caused the balance of payments crisis in the first place. Currency devaluation acts on both demand and supply. On the demand side, it changes relative prices of imports and domestic production, which results in a switch of demand away from imported goods and services towards domestic ones. On the supply side, it lowers the costs in foreign currency terms of the tradable goods and services sector (hereafter simply tradable sector). A by-product of the devaluation is that it reduces the income (in foreign currency terms) of the non-tradable sector of the economy that is protected from international competition. Similarly, residents see their personal income fall in foreign currency terms.
While countries in the Eurozone cannot use exchange-rate policy to improve their external competitiveness, they can rebalance their tax structure to seek to replicate the effects of currency devaluation.
As can be seen in Table 3, total receipts from taxes and social contributions represented, on average, 40.1% of the 2009 Eurozone GDP. Thus, taxes and social contributions are likely to be, on average, the largest component of the value added by each and every economic activity. By rebalancing the tax and social contributions structure, while keeping their overall level approximately stable, it may be possible to substantially reduce the costs of tradable-sector firms and thus improve their international competitiveness (Cavallo and Cottani 2010).
Table 3. Tax and social contribution receipts in 2009
Which taxes should be changed and how
One approach to increase the relative price of imports and thus contribute to a reduction in the trade deficit would be to increase existing excise tax rates on goods and services with large weight on the “peripheral” countries imports. Tax exemptions on imports should be eliminated. Such adjustments would need to respect EU single-market rules and be carried out in consultation with EU partners.
On the supply side, the average taxation of firms in sectors subject to international competition should be reduced while the average taxation of firms in sectors protected from international competition should be increased, in order to seek to replicate the effect of currency devaluation.
Firms in the tradable sectors are more likely to face (perfectly) competitive international markets. As a result it is likely that tradable-sector firms have lower levels of profitability. Firms in non-tradable sectors often face oligopolistic industry structures, particularly in smaller economies, and as a result are more likely to have significant market power and high profitability. Therefore, to lower the costs and improve the competitiveness of firms in the tradable sector, social security taxes and VAT rates should be substantially reduced3. To reduce the after-tax income of non-tradable sector firms, corporate income tax rates should be increased, and corporate income tax exemptions reduced. In combination, this tax rebalancing would likely promote a reduction in the trade deficit and the reallocation of resources away from the protected sectors of the economy towards sectors that face international competition (see example for Portugal in Table 4)4.
Table 4. Tax rebalancing simulation for Portugal5
The current EU/IMF adjustment programmes have several merits. A modicum of fiscal adjustment is warranted and justified for these countries. However, the adjustment programmes should be modified to reflect the fact that these countries face a balance of payments and external debt crisis.
One possible approach would be as follows. These countries’ public and private debt should be restructured. This would result in lower external debt levels and lower income balance deficits. In addition, the “peripheral” countries’ tax structure should be rebalanced to replicate the effect of currency devaluation and so improve these countries’ external competitiveness within the Eurozone. These measures would directly address these countries external imbalances and result in lower net borrowing requirements.
1 Ireland’s net borrowing requirements are relatively low in part due to the size of the regular plus emergency liquidity provided by the Eurosystem and the Irish National Central Bank (see Endnote 2).
2 At the end of 2010, Irish banks had €183bn of regular plus emergency liquidity (ELA) from the Eurosystem and the Irish National Central Bank (NCB). As a result, according to Whittaker (2011), the Irish NCB had €146bn of intra-Eurosystem liabilities at the end of 2010, or 94.9% of GDP. The interest rate applicable to intra-ECSB liabilities is the ECB main refinancing rate (1% until April 12, 2011, 1.25% since). This intra-Eurosystem borrowing by the Irish NCB grew rapidly during 2010. If Ireland were to fund these €146bn at the EFSF loan reference interest rate of 5.8% on a yearly basis, and assuming an average ECB main refinancing rate of 1.25%, it would imply a deterioration in Ireland’s net borrowing requirements of 4.3% of GDP, ceteris paribus. While also significant, Greece, Portugal, and Spain’s reliance on Eurosystem liquidity was proportionally much smaller (Whittaker 2011).
3 The Eurostat considers that, since VAT is deductible, it is fully borne by the end purchaser. In contrast, the view taken in this column is that VAT is a widget tax that is paid by purchaser and supplier, to an extent that depends on the price elasticities of demand and supply. Therefore, it is not a pure consumption tax. By reducing VAT rates it is possible to reduce a part of the costs borne by suppliers. Moreover, VAT as well as the employers’ social security contributions have detrimental effects on firm cash flow because they must be promptly paid to the government. Because of the cash flow impact, VAT and social security contributions are also likely to cause higher firm financing costs. Thus, lower VAT and social security contribution rates are likely to result in lower firm costs.
4 To compensate for the fall in the part of VAT tax receipts borne by consumers, personal income tax deductions could be reduced and personal income tax rates increased.
The recently reached accord between the EC/ECB/IMF troika and the Portuguese government foresees the rebalancing of VAT and employers’ social security contribution following Cavallo and Cottani’s (2010) proposal. It also foresees an increase in car sales excise tax, as suggested here.
5 The aim of the excise tax hikes would be to increase the relative prices of a significant part (22.2%) of Portugal’s total imports and thus to contribute to a trade deficit reduction. Road vehicles and oil, gas, and coal imports represented 7.3% of Portugal’s 2010 GDP, according to the Eurostat. Given that the increase in tax rates would be accompanied by a reduction in the regular VAT rate and that these goods are subject to both excise taxes and VAT, the price to end purchasers would likely rise by 25%, assuming constant import prices and linear effects. By raising these import prices by 25% it might be possible to reduce the trade deficit by a few percentage points of GDP, all other things equal. Evidently these tax increases might also result in higher costs to tradable sector firms, but Table 4 suggests that the effect should be much smaller than the benefit those firms would derive from lower social security contributions and lower VAT rates.