Public-debt crises and bad equilibria: Lessons from the GIIPS Countries

Maurizio Bovi 02 December 2011

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All the GIIPS countries (Greece, Italy, Ireland, Portugal and Spain) have been hit by the current government debt crisis (see eg Manasse and Trigilia 2011). Yet not all these countries have comparably sized shadow economies or levels of institutional inefficiency (widespread corruption, intrusive bureaucracy, excessive regulations, etc). My focus here is in the empirical cross-country connections linking tax evasion (here roughly equalised to the shadow economy) and bureaucratic proficiency across the OECD countries.1 My main aim is to underline how these variables interact in order to offer a tentative explanation of some of the recent economic and political developments in the GIIPS countries.

Admittedly, analysing data concerning the shadow economy, rule of law, and regulation sometimes requires near-heroic assumptions. But let us suppose that it is at least possible to have a rough (but sufficiently reliable) idea of the OECD ranking referring to the mentioned items. Then, one may organise the available evidence in a logical way to highlight a number of stylised facts (see Figure 1).

Figure 1. Institutions and the shadow economy

Note: Institutional Setting = labour market regulation index + legal environment index, both running from 0 to 10 (lower numbers mean worse bureaucracy). Source: Fraser Institute. Shadow economy as percent of declared GDP. Source: our computations (Bovi and Dell’Anno, 2010) on Schneider’s estimate. Data are 1990–2003 averages.

Figure 1 clearly shows that the better the institutional setting, the lower the level of tax evasion. In particular, it seems that the GIIPS countries are characterised by weak bureaucracy and big shadow economies. Accordingly, they lie in the lower-right corner of Figure 1. Italy and Greece show the worst situation. Among the GIIPS economies, a remarkable and evident exception is Ireland. Turning back to the large shadow economy–bad institutions angle, one may note the borderline presence of Belgium (more on that later on).

Traditionally, the presence of tax evasion has been associated with tax rates. But recently some authors (Johnson et al 1997 and Friedman et al 2000) have suggested that the shadow economy, taxation, and the institutional setting should be considered all together because they may be related in a very peculiar way. By inserting the institutional framework into the traditional analysis, they emphasise that the integrity and efficiency of the public sector is connected with the shadow economy because a more honest and proficient bureaucracy increases the probability of catching tax dodgers.  Other things being equal, this lowers the optimal size of the shadow economy. Furthermore, bad governments offer few and low-quality public services, a fact that may make people less willing to pay for public services and/or may give rise to alternative, irregular service networks. Finally, intrusive regulations are costly and another extra-taxation factor potentially stimulating firms to choose the ‘quit option’ (ie the decision to go underground). In sum, the presence of inept bureaucracy may be strongly associated with the shadow economy. The evidence collected in Figure 1 supports this view.

Tax evasion equilibria

This recent strand of research argues that the shadow economy may be even more strongly connected to bad governance than to taxation. As mentioned, in fact, the foregoing variables are strictly inter-related so that only some combinations of their values are self-consistent. In particular, the recent literature suggests that economic systems can be locked into two very different equilibria, one good and one bad.

  • In the good equilibrium, a wide tax base and large public revenues are ruled by efficient and incorrupt governments. This increases the costs to firms of being underground (the expected penalty, the exclusion from appreciated public services, etc). Public institutions are honest and well-functioning because they are sufficiently supported by large flows of public receipts.
  • In the bad equilibrium, the spiral works in the opposite direction, unavoidably leading to bad institutions operating side-by-side with a large irregular sector. Consequently, and in stark contrast with the traditional view, the institutional standpoint suggests that higher tax rates could be associated with a smaller shadow economy – only efficient institutions have sufficient power to tax.

Elsewhere (see endnote 1) I have studied the possibility of other kinds of equilibria, but here the focus is on the bad equilibrium. Figure 2 plots the 1990–2003 averages of tax-to-GDP ratios across OECD countries against the size of their shadow economies.

Figure 2.Tax-to-GDP ratio and shadow economies

Note: Tax Burden = total tax revenues as percentage of declared GDP. Source: our computations (Bovi and Dell’Anno, 2010) on OECD data. See also Figure 1.

Inspection of Figure 2 suggests that, though the GIIPS economies show the largest shadow economies, they don’t have the greatest tax burdens.2 Once again Ireland turns out to be very different from the other GIIPS economies, lying much closer to the average OECD country, while Belgium shows some worrying signs. All in all it seems that, with the important exception of Ireland, the GIIPS countries are locked in a bad equilibrium of poor institutions and tax evasion (possibly because of the olive-oil belt!).

Given their bad-equilibrium status, it is not surprising that the olive-oil-belt cluster may suffer from public-debt sustainability problems amid international turmoil. In fact, some (see, eg, Boeri 2011 on this site) have recently underlined that Italy’s poor institutions may also affect growth and confidence. Inserting the mentioned two-equilibria backdrop into a discussion about the current government debt crisis may help to underline some intriguing notes.

Unlike the other GIIPS countries, Ireland seems to have found a safe exit strategy from the public-debt crisis. Possibly, this skill in finding the way out is linked to an institutional setting as good as that of Scandinavian countries.

A way out for bad-equilibrium countries

Clearly, the economic situation of the bad-equilibrium countries may deteriorate amid international financial crises. One can also add that when a country lies in a bad equilibrium only their (honest) citizens are affected and incentives to enact reforms may be, as data indicate, not strong enough. During international turmoil, on the other hand, an outstanding change may sometimes be necessary to restore the trust of the international financial markets. Thus, the question naturally arises: Can bad politicians implement the required significant shift in a short period of time? (See for example Papiaonnou and Vayanos’s (2011) suggestions for institutional reform in Greece.)

Though it is thorny question, recent events seem to suggest (or, better, to impose) a possible exit strategy in the form of the intervention of a deus ex machina. In fact, with the resignation of Mr. Berlusconi, every olive-oil-belt country has now changed its government this year due to the external pressures of both financial market and international institutions. Internationally well-known and appreciated economists have been put in office to rule governments of national health or new elections have been called to implement the drastic rearrangement needed to regain the trust of foreign operators/institutions. Is it sufficient? As for the fiscal consolidation, maybe. What is surer is that the latest developments suggest that it was a necessary step. As for the effectiveness of a deus ex machina to find a way out from the bad equilibrium, the evidence here collected suggests the need for a bit more scepticism. For instance, Italy has already been ruled by technocrats in the early 1990s (therefore at the beginning of the sample period here under scrutiny). Though they were effective in solving the economic emergencies they were put in office to address (inflation, pension reforms), data show that Italy is still locked into a bad equilibrium. Perhaps these extraordinary attempts were, almost by definition, too short-lived. A sort of resident deus ex machina (a European fiscal policymaker?) could be necessary, but it sounds like an oxymoron.

References

Boeri, T (2011) “Italy's confidence crisis: Bad policies from bad politicians”, VoxEU.org, 17 August.

Bovi M. & R. Cerqueti, (2009). “Why is the Tax Evasion so Persistent?,” ISAE Working Papers 111, ISAE - Institute for Studies and Economic Analyses - (Rome, Italy).

Bovi M. & R. Dell’Anno (2010): “The changing nature of the OECD shadow economy,” Journal of Evolutionary Economics, Springer, vol. 20(1), pages 19-48.

Friedman, E., S., Johnson, D. Kaufmann, and P. Zoido-Lobaton (2000). Dodging the Grabbing Hand: The Determinants of Unofficial Activity in 69 Countries, Journal of Public Economics. 76: 459-494.

Johnson, S., D. Kaufmann, and A. Schleifer (1997). The Unofficial Economy in Transition, Brooking Papers on Economic Activity. 2: 159-239.

Manasse, Paolo and Giulio Trigilia (2011), “Welcome to Eurotaly”, VoxEU.org, 21 November.

Papaioannou, E and D Vayanos (2011) “An institutional bailout plan for Greece”, VoxEU.org, 13 August.


 

1 A deeper empirical analysis can be found in Bovi and Dell’Anno (2010). A deeper theoretical analysis can be found in Bovi and Cerqueti (2009).  

 

2 Bovi and Dell’Anno (2010) use a battery of different tax rates. Results remain substantially unaffected. 

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Topics:  Institutions and economics

Tags:  institutions, tax evasion, public debt

Research Manager, Italian National Institute of Statistics