VAT gap in Portugal

Not too long ago, a blogger suggested that an increase in the VAT rates would not generate the expected tax revenue because of tax fraud. As I had no clue on the real severity of VAT tax evasion in Portugal, I had to spend sometime documenting myself.

Well, according to this study commissioned by the European Commission, Portugal behaves quite well with a VAT gap of 4%. The VAT gap (the gap between actual and theoretical revenues) is not a direct measure of fraud, just an upper bound. For details I defer the interested reader to the report that covers the period 2000-2006. The time series dimension is of some interest as it is probable that the gap increases during recessions. In any case, international markets should welcome Portuguese diligence.

This little pig went to the market, the others...

See here, and also here.

The end of Europe as we know it

The eurozone is in a deep crisis, which will have serious consequences for the Portuguese and for the European Union. In the beginning of the sovereign debt crisis, Greece, Portugal and Ireland owed thousands of millions of euros and the problem was theirs, i.e., they would have to correct their imbalances through austerity measures. In the current stage of the crisis, Spain, Italy, Belgium and France owe millions of millions of euros, and the debt crisis is now also a problem for the creditor countries – and the final word in the solution of the eurozone crisis is theirs.

Since the beginning of the sovereign debt crisis, several commentators have expressed the hope that surplus countries agree to three measures. First, to change the orientation of the ECB towards a more expansionary monetary policy. Second, to adopt themselves expansionary fiscal policies, which would stimulate imports of goods produced by deficit countries. Finally, countries such as Germany could also take measures to increase wages and thus further stimulate demand. Associated to this view is the idea that a permanent solution to the structural fragility of the euro is the creation of a “European government” that would collect taxes and distribute subsidies and other public expenditures at the European scale. This government would put into work a mechanism of “automatic stabilization” in the eurozone: when Portugal is in recession, as is the case, and Germany is in an expansion, taxes collected in Germany would pay, for instance, unemployment subsidies in Portugal. By definition, this European government would be financed by euro-bonds.

In that scenario, the countries currently in crisis, which implemented economic policies incompatible with the stability of the euro, would determine the economic policy of the wealthier countries and of the ECB. This solution is very unlikely to be accepted by most Germans and Central and Northern European peoples, who would most likely prefer to let the indebted countries default. This would lead to the end of the euro and also of the European Union as we know it; at the very least, the number of member countries would be significantly reduced. A period of economic, social and political chaos would follow, with abrupt falls in standards of living, accompanied by the resurgence of international tensions. This process would have unpredictable consequences, unthinkable in pre-crisis Western Europe. As for Portugal, after the chaos, it would probably return to its pre-European integration status: a poor and peripheral country, politically unstable.

However, eurozone countries may still choose alternative solutions, involving more active ECB policies and/or greater fiscal coordination, which we group into two scenarios.

In the first scenario, during the next few years, the ECB (and the EFSF) intervenes resolutely and in large scale in the sovereign debt market, buying debt issued by European countries with funding problems. At the same time, the countries in trouble successfully implement fiscal consolidation programmes, possibly aided by some form of soft restructuring of their debt. In a few years, investors regain some confidence in those countries and the ECB and the EFSF may stop buying public debt issued by them. At that time, the eurozone will return to the normality of its first years, but with higher spreads for less credible countries.

However, this solution has two problems. The first problem is that it does not guarantee that the behaviour of governments will change so as to avoid a repetition of the crisis – the moral hazard problem remains, and may even worsen in this context. The second problem is that the change in the behaviour of the ECB will hardly be accepted by the German public opinion. Clearly, financial markets do not believe this solution will work, a feeling deepened by the erratic behaviour and the lack of consensus among European leaders. The proposals to revise the stability and growth pact, namely through the establishment of automatic sanctions, are a way of trying to bypass this problem. But, if the stability and growth pact failed, why should one believe that the new proposals will be more effective (even assuming that they are accepted by all countries, which cannot be taken for granted)?

In the second scenario, the European countries reach a political agreement to reduce, if not eliminate, the probability that the eurozone faces a crisis of this kind. The measures include (besides ECB intervention and soft restructuring) a transfer of budgetary powers to a European entity designed by Central and Northern European countries. This entity is committed to presenting balanced budgets for each country under its supervision. National authorities may choose the level and composition of public expenditure, and the type of taxes. The intervention of that European entity in the budgetary process will guarantee that the budgetary targets are met, as it will be able to impose the measures required to correct deviations. For deficit countries, this solution should imply the continuation of austerity, with the goal of reducing the weight of public debt. The refinancing of debt and the financing of temporary deficits might employ euro-bonds, as a way to alleviate austerity.

This solution eliminates the moral hazard risk through a transfer of powers to a more credible entity. However, this would certainly be met with opposition from important sectors within eurozone countries, which would view it as a loss of sovereign powers and a submission to stupid rules (which in any case would be very hard to define).

Last Tuesday’s meeting between Angela Merkel and Nicolas Sarkozy suggests that European leaders are moving from the first to the second scenario. If none of these solutions work, the collapse of the euro, followed by European Union chaos, especially in peripheral countries, will become inevitable.

(with Pedro Bação)

The Ministry of Finance report on fiscal devaluation

The Portuguese Ministry of Finance has posted a report on the implementation of a fiscal devaluation in Portugal.

I wish to make a few comments:

1. The authors should state that the report is preliminary. The report does not contain any conclusion, therefore, in its current form, it is still incomplete and preliminary.

2. The report is acknowledged to be a patchwork of views of four different institutions (Bank of Portugal, Ministry of Finance, Ministry of the Economy and Employment, Ministry of Solidarity and Social Security). While a list of all four different stances is a useful starting point, the final document must find a coherent and unique position on the matter. After all there is only one entity that must fiscally devaluate, Portugal.

3. The structure of the document appears to be biased against the fiscal devaluation.

3.1. The first quarter of the study consists in a detailed description of the social security's financing sources. It is useful to know these details, and there is a lot of interesting information (see below Remark in 3.3). It is important to know which laws should be abrogated and/or changed if the government implements the reduction of the social security contributions paid by employers. The chapter ends with a comparison between Portugal and EU's fiscal revenues structures and states that Portugal relies more heavily than the rest of EU on indirect taxation (read VAT) and less on social contributions (paid by employers). These numbers are obviously influenced by the composition of aggregate demand and income shares. For example, in Germany private consumption (basically the tax basis for VAT) is around 56% of GDP and in the Netherlands private consumption is 45% of GDP. In Portugal private consumption is around 64% of GDP. I would imagine this section as an appendix and not as the initial chapter of the report.

3.2 The second section which addresses the macroeconomic effects (the core of the matter) of the fiscal devaluation is short. The evaluation is performed using a dynamic stochastic general equilibrium (DSGE) model developed at the Bank of Portugal. Two similar DSGE models developed by the ECB and the European Commission have also been used to confirm the results. Personally I believe that these models are very useful for theoretical guidance but should be complemented by more empirical approaches for a more robust quantitative evaluation of the suggested policy. [For the more analytical inclined readers : in the technical description of the macroeconomic effects, a neat identification of short term effects (fiscal devaluation), medium term effects (firm entry in the tradable sector) and long term effects (new steady state due to possible non neutral shift in aggregate labor demand and labor supply) is absent, which makes the quantitative results difficult to interpret].

3.3 The third section is the central part of the report and describes a menu of options to implement the measure. The benchmark measure, the only one that can be labeled as a fiscal devaluation, is the reduction of the payroll tax across all sectors compensated by an increase in VAT (and/or a decrease in public expenditure). The report correctly identifies the main weakness of the measure in the market power of the non-tradable sector (Remark: I noticed that in Table 3 Section1, a large non-tradable industry, or network industry, such as Telecommunication pays a payroll tax of 7.8%, as opposed to the general rate of 23.7%. Given that such a company-industry will not see its payroll tax being reduced the above weakness does not apply).

The alternatives suggested are not fiscal devaluations but could be labeled as :
a) Incentives to job creation (low payroll tax only for new jobs) ;
b) Export oriented Industrial policy (payroll reduction in export industries);
c) Tradable (?) oriented industrial policy (reduction of payroll tax only for lower wages).

3.4 The last page and a half is concerned with the financing of the payroll tax reduction. The last sentence briefly mentions that if the measure is implemented, the necessary fiscal revenues will have to be found by increasing the lower VAT rates. Obviously the financing of the reduction in the payroll tax is a (the) key aspect for the implementability of the measure. After all, who would disagree to lower labor costs if the sustainability of the social security system was secured? This is the section I would have expected the government to put more (all) efforts in order to reach an educated opinion on how much revenues an increase in the lower VAT rates could generate (0.5% of GDP, 1% of GDP, 2% of GDP…4% of GDP?).

As a final remark: I am confident international observers would welcome a report in English (only the executive summary and a technical appendix by the Bank of Portugal are in English), especially if the government plans to convince the troika not to implement the measure or to transform it in a different policy.

On the Economic and Budgetary Impact of Fiscal Devaluation in Portugal

Abstract
In this paper we show that fiscal devaluation, of the most dis puted issues in the current policy debate in Portugal, has the technical capacity to stimulate employment and investment and increase GDP while improving the foreign account position. More importantly, as this has been a point ignored in the debate, it can significantly contribute towards budgetary consolidation. Here