Sunday 29 June 2014

Fiscal Uncertainty

During the European sovereign debt crisis,  lending institutions conditioned rescue packages on austerity measures and growth enhancing measures.  The two main ideas behind this mix were that public spending needed to be reined in to sustainable levels, and that sustainability can ultimately be guaranteed by economic growth.

After a decade of hot money was over, the search for growth and competitiveness in peripheral countries was mostly targeted towards labour market rigidities.  However, the other (and probably more relevant, at least in the eurozone periphery  in 2014-see Hassan and Ottaviano on Italy) side of competitiveness has little do with wages and flexibility, and comes mostly from companies. Creating new companies, making existing ones more efficient, and closing unproductive ones should help with the the latter issue.

All of this requires investment and know how,  and a heavily indebted government is not in the position to provide either. Countries can make long run commitments to producing know how human capital ad ultimately raise productivity, by investing in education and research. This government cut expenditures at every level of education and research. The only possibility in the short run is to attract human, physical, financial and intellectual capital.

Portugal also exhibited a focus on the creation of new enterprises, and innovation in general. Lisbon is currently being marketed as a hotbed for startups, various governmental agencies have stakes in venture capital funds, incubators. The extent to which these measures are actually favouring (successful) entrepreneurship is not very clear, especially without serious valuation efforts.

Another mean of boosting productivity is to retain and attract skilled  individuals and efficient companies, which typically contribute to internal competitiveness and expanding exports (see for example Alfaro and Chen, 2013, also for a overview of recent literature).

Countries achieve the goal of attracting companies and individual through a mix of policies, whose typical ingredients include including tax breaks, tax holidays and other favorable fiscal treatments.

Was the mix implemented by the government optimal? If not, where could it have been improved? Assessing the combined effects of different measures is beyond the scope of this entry, and perhaps not possible at this stage. However, it seems that an area of immediate improvement is that of stability and predictability. Research on FDI (see for example Calvo, 2002) shows that changing taxes too often repels foreign companies.

Ironically, in the first master thesis I supervised at Nova,  Alexandra Lourenço, working for UKTI, a British government agency, was comparing empirically the relative attractiveness to investors of various European countries. Her study concluded that the negative correlation between the number of foreign subsidiaries and the variation of taxes, was strong and more significant than that between subsidiaries and the level of taxes.

How did the government do in this dimension? The combination of announcement, actual laws, and overturning sentences from the constitutional court paints a bleak picture.

Whether because of "unexpected" fiscal slippage, or because of the needs of political compromise requiring a tentative approach, Portugal has seen many variations on its tax rates and base. I will focus here on some examples of these changes, and only on those in which the same items were updated more than once.

As the numerous ball games with the Constitutional Court mostly concerned the governmental sector, I will not mention them here. Except to observe that they forced the government to several unexpected taps into the private sector to recoup income, generating uncertainty in (potential) investors or workers. For example, this increased the number of hikes on Personal Income Taxes, with each hike adding uncertainty in future expectations on fiscal issues.

Before these hikes the Portuguese government granted a special status (non habitual resident) to individuals not working in Portugal in the previous 5 years, and involved in high value added professions. Not only this rate is lower at 20% than the most rates for residents and non residents, but it also insured against the tax hikes which would accompany the bail out. Unfortunately, the government entirely forgot this insurance aspect and charged all exceptional tax surcharges on this tax regime too. Given the small number of individuals enjoying this regime (less than 100 in the country during 2012), revenues must have been low. The cost was destroying the attractiveness of insurance against fiscal uncertainty in a country in the process of raising taxes.

Uncertainty takes many forms, not just that of realised tax rates, but also that of unfulfilled announcements. Turning to social security contribution system, we cannot overlook the infamous TSU blooper of 2012, in which the government announced an increase in the TSU rate combined with a transfer of the burden from firms to workers. Regardless of the potential (but unrealised) effectiveness of the measures, we have to consider the costs of announcing what can be seen as medium-long term increases in labour costs. Unfortunately announcements have no benefits on revenues, but come with a cost on political capital and outside expectations.

Another, more common and less radical, type of excess uncertainty is that of delayed reform discussion, approval, and implementation. We can see  a case of this in the postponement during 2012 of local government taxation reform.

When talking about foreign investment, the main dish of of the menu has to be that of corporate taxation. The government announced an ambitious program of progressive reduction of the CIT rate over several years. It is yet to be seen, whether the announced future rates will be perceived at face value or whether previous twists and turns will be "priced in" and generate unexpectedly low corporate activity and investment, with the ensuing lower tax income, fuelling the need for new changes in the fiscal system.

Nova SBE will be hosting a debate on these and related topics on June 30, in the Ciclo de Debates Alfredo de Sousa: "O Investimento Estrangeiro em Portugal"

you can register at this link

Author: Guido Maretto


Alfaro, Laura, and Maggie X. Chen. "Market Reallocation and Knowledge Spillover: The Gains from Multinational Production." Harvard Business School Working Paper, No. 12-111, June 2012. (Revised June 2013.)

Calvo, Guillermo A., "Globalization Hazard and Delayed Reform in Emerging Markets",
Economía, Volume 2, Number 2, Spring 2002, pp. 1-29

Hassan, Fadi and Gianmarco I.P. Ottaviano, "Productivity in Italy: The great unlearning" (

Tuesday 10 June 2014

After a debate on Europe

I took part in a debate on Europe with a Danish, a German and a Spaniard. The moderator was Portuguese (I am Italian). We agreed that many socio-economic issues can only be solved (internalized) at the European level. I wish to present support for an (obvious) point I made during the debate: the existence of necessary common european policies must not weaken the fact that member states have to design policies and structural changes that address specific national issues. Take for example the labor markets. Here I present two figures for the countries represented in the debate plus France (I needed a sixth country to make the figure more symmetric and there is really pas d' Europe sans la France). The data start in 1998 and end 2014. The first figure shows the ratio of total employment over population (age between 15 and 74 years old). The second figure shows the share of those same workers by educational level attained. Just a few short comments. Italy has the lowest share of employed population. The lower Italian participation reflects the larger shadow economy but not only: women and young participation rates are very low relative to European standards. Certainly this is an important margin for the Italian economy. Now look at Portugal: participation is high (it declined strongly because of the crisis) but the labor force is relatively little educated (although there has been improvement). Spain employment-population rate followed the real estate bubble (here causality is easier to deduce) but has also slowly shifted its employed population towards highly educated workers. Denmark, the land of happiness (in the words of the Portuguese moderator), has an outstanding participation rate but the crisis appeared to have hit severely the labor market. Participation in France is a flat-line. Germany's participation was at par with France until 2005, then something changed, and participation started to increase (by 7-8 pp!) inexorably. 
(click to enlarge)