Making fiscal consolidation work in Greece, Portugal, And Spain: Some lessons from Argentina

Domingo Cavallo, Joaquín Cottani 07 May 2010



The Greek crisis has created fears of contagion in other countries of Europe, notably in Portugal and Spain. Unless it is resolved quickly and effectively, the spread will be more severe for it could affect other countries inside and outside of Europe. A growing consensus among international observers is that, despite a massive (€110bn) bailout package from the EU and the IMF in exchange for fiscal austerity measures, public debt restructuring in Greece will not be avoided.

We agree with this view. Back in 2001, when Argentina faced similar problems as Greece faces today, one of us had the misfortune to be at the helm of the finance ministry trying to do what, in retrospect, was an impossible task: to balance the fiscal accounts in the middle of a deep recession without restructuring an onerous public debt. Like Greece, Argentina had no easy resort to devaluation as a way to improve competitiveness since most of its liabilities, public and private, were denominated in hard currencies.

Our first response came in the form of a series of measures designed to build up confidence and regain competitiveness, but they were not enough. Our second response came in the form of a fiscal consolidation plan that included a reduction in public wages and pensions. But, all this did was to deepen the recession and exacerbate social tensions. Only then it became clear that there was no alternative for us, but to restructure the public debt. If only we had acted earlier.

Ironically, as soon as an orderly and well-crafted restructuring plan was put in place, the IMF decided to suspend disbursements under the stand-by program, triggering a panic run on commercial banks and the peso, which resulted in financial collapse. The consequences are well known: more than 20 people died in street riots in December 2001, the president resigned, and a new interim government declared a default on the public debt and produced a massive devaluation, which resulted in stagflation: real GDP fell by 11% and inflation increased from virtually zero to 41% a year in 2002. And, while it is true that the economy recovered strongly after that year, the reason was not the default or the devaluation, but the increase in commodity prices and the easing in credit conditions that accompanied the 2003-2007 global economic boom.

Three Lessons

The main lessons for Greece stemming from Argentina are, in our opinion, as follows. First, devaluation (exiting the eurozone) is not the answer, particularly since the post-crisis world outlook is unlikely to be as benign with Greece as it was with Argentina. Re-adopting the drachma and letting it fall in value relative to the euro would cause a sharp deterioration in the balance sheets of both the government and the private sector. On the other hand, a forcible conversion of euro-denominated financial assets and liabilities into drachmas (a replication of what Argentina did in 2002) would, in all likelihood, set in motion a perverse devaluation-inflation spiral, as people would want to substitute away from drachmas into euros to avoid losing purchasing power if they stay in drachmas.

Second, any sovereign debt restructuring must be planned and executed in an orderly manner, with bilateral discussions between creditors and debtors, and with an active support from the international financial organizations, both in Europe and Washington DC (i.e., the IMF). These organizations can get more bang for their bucks if instead of trying to bailout Greece’s creditors over the next two years, they use their limited financial resources to enhance, a la Brady plan, new bonds that are swapped for the old ones in exchange for haircuts in principal, interest or both. A default followed by unilateral and incomplete debt restructuring several years later, as done by Argentina in the previous decade, would be the wrong model to follow.

Third, there must be fiscal consolidation. But, this cannot be limited to cutting spending and raising taxes. It must also include fiscal measures designed to improve external competitiveness so as to ease the fiscal adjustment.

Last but not least, the three ingredients of the recovery plan (fiscal consolidation, debt restructuring, and the enhancement of competitiveness) must take place simultaneously.

Improving External Competitiveness through Tax Reform

In a previous article1, we suggested that Greece could achieve the same effect on competitiveness that could be achieved under a 20% real exchange rate devaluation by raising the collection of the value added tax (VAT) while simultaneously reducing payroll taxes. We think that this is an idea that merits consideration not only in Greece, but also in Portugal and Spain. Given the importance we give to this subject, we devote the rest of this note to explain our proposal in more detail.

One characteristic of taxation in many countries—typically in Continental Europe, but also in Latin America and other regions—is that payroll taxes, which finance social security, are extremely high (see Table 1). Of course, this is due to the fact that social transfers are also very high. However, there is no reason why these transfers have to be financed by payroll taxes, especially if there is room to increase other, more neutral, taxes.

Take the VAT, for example. Unlike payroll taxes, which are levied on labour income, the VAT is levied on final consumption. This has two main advantages: it promotes formal job creation and it stimulates private saving. In countries like Greece, Portugal and Spain, this can kill three birds with one stone by helping to reduce unemployment, informality in the labour market, and the current account deficit. Furthermore, the fact that the VAT is levied on final consumption and not on investment or exports (capital goods purchases are deductible as VAT “credits” and exports are tax exempt) makes the substitution of VAT for payroll taxes a competitiveness-enhancing tool. As such, it is like devaluing the local currency, but without the inflationary pass-through to domestic prices or the disrupting balance sheet effects.

Another characteristic of taxation in the countries mentioned before is the disparity of VAT rates, including exemptions, across goods and services and regions of the same country. This can also be appreciated in Table 1. Such discrepancies are the cause of tax arbitrage and other inefficiencies in tax collection, which result in lower revenues for the government. While the objective of special rates and exemptions is to benefit or promote certain activities and areas of the country, including tourism, the same results could be obtained if a single rate was applied uniformly and the promoted activities and regions were subsidized directly from the budget.

To show how much revenue the governments of Greece, Portugal, and Spain lose as a result of not having a uniform VAT rate, consider the following table.

The first and second columns show, respectively, the actual collection of VAT and the level of final consumption in the economy as shares of GDP. Together they determine the effective tax rates (Column 3). As shown, these are significantly lower than the general tax rates that apply to activities and regions not specifically promoted or exempted. Multiplying the general rate by the final consumption tax base yields the maximum revenue that each country could raise if all rates were unified at the same level. Obviously, this is an upper limit that can only be reached in steady state and in the complete absence of tax evasion. But, the comparison between Columns 5 and 1 is illustrative of how much money countries like Greece, Portugal, and Spain stand to gain from an improvement in VAT administration. For 2008, the potential increments went from 7% of GDP in Spain to 9.6% in Greece.

Now, consider what would happen if employer contributions to all kinds of social security programs were eliminated. The results are shown in Table 3.

In all cases except Spain, the loss in payroll tax collection would be, potentially, offset by the generalization of the VAT. The only reason why, in Spain, this is not the case is that the VAT rate (16%) is lower than in the other two countries. But, this could be remedied by raising the Spanish VAT rate to a level closer to that of the other countries.

Better than Devaluation

So far, we have shown that, in countries like Greece, Portugal, and Spain, it is possible to substitute a general tax on consumption, such as the VAT, for a tax on labour utilization, such as the employers’ contribution to social security, without sacrificing tax revenue since both taxes have a similar revenue-generation power. We can now show what the effect on competitiveness would be like. For this, consider Table 4. Columns 1 and 2 show, respectively, the amount of payroll taxes relative to GDP and the legal tax rates contributed by employers. The ratio between the two (Column 3) is the gross wage bill subject to payroll taxes. This, in turn, is the same as the cost of labour that firms operating in the formal sector would face in the absence of employer contributions. When these contributions are added, the total labour cost is as shown in Column (4) and the difference between Columns 4 and 3 is the reduction in labour costs due to the elimination of these contributions. As shown, this reduction is 19% in the case of Portugal, 22% in the case of Greece, and 24% in the case of Spain.

The relevant question is: how much nominal devaluation would be needed in Greece, Portugal, and Spain, assuming these countries were to exit the eurozone, to achieve the same reduction in labour costs in terms of euros that can be achieved through this measure? The answer depends on the passthrough between devaluation and wage inflation likely to be observed in those countries. While this effect may be dampened by unemployment, it cannot be too low given the high degree of openness that characterizes the three economies. Assuming, conservatively, that the passthrough is 50%, the nominal devaluation required to lower wages by 20% in euro terms is 40%, enough to jeopardize the solvency of the entire corporate sector—including financial institutions, whose outstanding liabilities are denominated in euro and other hard currencies—not to mention the solvency of the public sector, where the debt exposure is even higher.

Final Remarks

We do not ignore that a bold tax reform such as the one proposed here can make politicians and policymakers wary. Politicians may be concerned, for example, that changing the funding of social security would change its nature, either by taking away its social insurance characteristics or by making it less redistributive. This, however, would be a misconception. Payroll contributions to social security are different from insurance premiums or private retirement savings in that there is, typically, a low marginal link between individual contributions and benefits. The reason for this is that social security programs are redistributive by design.

The redistribution feature of social security programs does not arise from any progressivity in the funding structure of the programs, but from the fact that the benefits are, generally, more skewed than the contributions. It is this characteristic of social security programs that makes social security contributions, including those paid by employees, more akin to taxes than to actuarially fair insurance premiums or saving contributions. If so, the question becomes whether, from an income distribution perspective, funding social security with capped taxes on wages is more equitable than doing it with a proportional tax on consumption. The answer, quite clearly, is that it is not.

Policymakers, on the other hand, may be concerned about the fiscal implications of a tax reform that amounts to a major overhaul of the tax system at a time when fiscal consolidation is being pursued aggressively. At issue is the fact that the three countries discussed here have high fiscal deficits (see Table 5), and there is no guarantee that leveling the VAT rate will make revenues grow proportionally to the effective tax increase.

To address this issue, our proposal contemplates temporarily increasing the uniform VAT rate to 25% in Greece and Portugal and to 21% in Spain.2 The additional fiscal impact of this measure is shown in the table below, where it is estimated that the fiscal deficit would be reduced by 5.3% of GDP in Greece, 4.4% in Portugal, and 3.8% in Spain. Once again, since exports and capital formation are VAT-exempt, external competitiveness should not be affected.

1 See Domingo Cavallo and Joaquin Cottani, “For Greece, a ‘fiscal devaluation’ is a better solution than a ‘temporary holiday’ from the Eurozone,” VoxEU, 22 February 2010 (
2 Actually, Greece has already increased the general VAT rate twice this year in response to the crisis: from 19% to 21% in March and then again to 23% in May. Unfortunately, the disparity among VAT rates remains, notwithstanding minor adjustments in the other (reduced) rates.




Topics:  Europe's nations and regions Global crisis

Tags:  fiscal consolidation, Greece, Argentina, sovereign debt crisis

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