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Tax hike puts Spain's economy at risk

(5/5 | 3 votes)

Antonio España.- 07/21/2012

Perhaps you were told in your childhood the Brothers Grimm’s fairy tale "The Golden Goose." In this story, the son of a lumberjack, after various vicissitudes, finds a goose whose feathers were made of pure gold.

During his journey, he stays at an inn where the daughters of the innkeeper, seeing the golden goose, try to pluck a feather, getting stuck one to the other, and both to the golden goose.

As our hero does not let loose the goose while he keeps walking, the parade catch the attention of whoever finds it in his way, joining a crowd which is so grotesque that it even made a princess laugh, who had lost her smile because of a terrible disease.

Although our story is more sad than happy, the picture resembles that of the Spaniards, who carry with them a crowd of politicians and government officials, all wanting to pluck their golden feathers.

Spain's government 'plucking the goose'

The Grimm’s goose reminds me of that saying of Jean Baptiste Colbert, finance minister of Louis XIV, who stated that "the art of taxation consists in so plucking the goose as to obtain the largest amount of feathers with the least amount of hissing."

Indeed, that is what the Spanish government seems to be determined to do with the increase of value-added taxes (VAT) from 18 to 21 percent, which was approved this week.

Certainly, VAT is the most subtle form of taxation that exists, second just to inflation: we pay for it every day in small doses, feather by feather, on every purchase we make and hardly noticing it. The question is whether this goose has any feathers left.

VAT hike will possibly create more unemployment

Whether Spanish firms translate or not the VAT increase to the retail prices, it will undoubtedly erode their profit and loss, which by the way, are already distressed by the debt burden and weak finances.

Because if they decide not to pass it onto the customers in an attempt to maintain sales, margins will suffer as they will have to absorb the part not paid by the consumer.

On the contrary, if they decide to accommodate prices to the new VAT, businesses will lose customers as per the inescapable law of supply and demand. The higher the price of a product, the fewer the buyers are willing to purchase it.

We cannot know exactly when it will happen, or how many firms that will be affected, but eventually some entrepreneurs will be forced to cut costs, buy fewer goods or lower their quality and, ultimately, to lay off workers.

Impact on unemployment

What is even more important, it not only hurts those sectors that are closest to the consumers. It seems logical that the lower demand for final products will result in lower demand for the capital goods that are necessary for manufacturing them, so the contractionary effect of the measure will spread throughout the economy with similar consequences on employment.

Indeed, we could even go a step further in our reasoning to conclude that, to the extent that the increase in VAT reduces the disposable income of citizens, it also reduces their ability to save and, therefore, to deleverage and repay loans or invest in new capital goods.

Thus, in all cases, the VAT hike hurts the economy. It forces people to change their habits of consumption, savings and investment, while on the other hand, it reduces the resources that fuel the private sector and divert them to the public sector, which waste them in maintaining the privileges of politicians and special interest groups.

Public spending will probably increase

The effect may not be as immediate as the cash collection that this tax permits, since consumers will take some time to adjust their behavior to new circumstances, but rather sooner than later, market forces will eventually materialize in newly dismissed workers applying for unemployment benefits.

What does this mean? That the state will have to take care of paying a salary to a person that today, not only do not receive a pay, but effectively contributes to the Social Security system.

We can still take it even further. As a tax increase, which we have seen, reduces the purchasing power of families and worsens the finances of the companies, it will push some of them to default to pay their loans. This expected increase in non performing loans (NPL) can end up putting more pressure on the financial system and, eventually, translate to the public deficit, as long as banks are connected today to the artificial respiration of the state. When it rains, it pours.

Higher VAT may even reduce state revenues

You may have noticed the paradox. The surge in VAT will boost the proceeds of essential goods whose demand is not affected by price increase, while it will inevitably reduce tax collection from depressed sales of products and services whose demand, not being considered basic supplies, is elastic.

We can’t predict the balance of both effects, but in an advanced economy, not merely a subsistence one, it does not seem bizarre to think that non essential goods weight considerably more, so the result is likely to be a drop in revenues.

Furthermore, we can even expect that demand for staples will also fall in spite of being inelastic, that is, it does not vary, or varies only slightly, with increasing prices, as families who are already troubled, and hardly make it through the month, may be forced to the dramatic decision to cut even the purchase of essential goods.

Easily justified

Oddly enough, raising taxes is the easy solution for politicians. Even though it is unpopular, they are still able to find multiple justifications: “it is for the good of all,” “it helps keeping social services,” “if it weren't for the fraud, we would not have to raise them,” and so on.

But do not let them deceive us. The only justification for raising taxes is to keep the system politicians have built up with positions of confidence, public grants, duplication of administrative departments, intricate networks of half-owned enterprises, regional government embassies, supervisory bodies of all kinds, etc. I wonder when it will be the turn of that goose to be plucked.

Do you still wonder why the Spanish Treasury has had a bad time this week issuing fresh new bonds in the primary market and why the risk premium has topped 580 points in spite of the fact that the government’s new round of “austerity” measures was approved?

(5/5 | 3 votes)