Headstrong budgets

Rafael Pampillón. Professor. IE Business School

4 November 2010

General budgets are too optimistic in terms of both income and expenditure, resulting in a greater deficit than previously thought, which means the government will have to issue more debt.

The proposed general state budgets for the year 2011 (in Spanish and hereinafter, PGE-2011) that were passed by the government yesterday come at a time of stagnation of the Spanish economy. Indeed, according to the consensus reached by economists, the Spanish economy will grow by only 0.4% in 2011 and not by the 1.3% forecast in the PGE-2011. This 0.4% growth will come from the foreign sector (+1.3%), since national demand will fall by 0.9%. The negative growth of internal demand is the result of reduced public spending and falls in investments: the construction of homes and public works will more or less come to a standstill in 2011. Furthermore, private consumption will not get going and will grow below 1% for three reasons:

(a) Spanish families´ lack of trust in the future, which makes them save as a precaution

(b) huge debts, especially mortgage debts, assumed during the expansive phase of the cycle, which makes individuals save more and, therefore, consume less so that they can repay what they owe to banks and savings banks

(c) a high level of unemployment, which will increase in 2011.

TAXES AND STATE SPENDING

The increase in taxes that was passed yesterday is taking us down the wrong road: (1) it will produce hardly any increase to fiscal revenue; (2) any increase in taxes will worsen the economic situation and take us further away from leaving the crisis behind. We must remember that the increase in the progressiveness of direct taxes has negative effects on the economy, since it discourages work, increases the underground economy and fosters the idleness of those who could make the greatest contributions with their work. Furthermore, as it is applied to workers with higher academic qualifications, it can lead to a brain-drain situation and prevent highly qualified labour from entering the country. We must also remember that Spain now has an income tax scale that is above the average of our neighbouring countries.

As far as state spending is concerned, the payments planned for unemployment subsidies and benefits do not seem very credible. According to the PGE-2011, they will amount to only €30,140 million, a figure that is lower than the amount that will actually be spent. Why the difference? Because the PGE-2011 anticipates a 0.3% increase in employment for the coming year, when the analysts´ forecasts point to a fall in employment of 0.8%. Greater unemployment in labour and lower employment than the levels mentioned in the budgets will make private consumption grow below 1% instead of the positive growth of 1.8% suggested in the budgets. This will also mean lower revenue from VAT and income tax than the amounts considered in the PGE-2011.

Greater public deficit

These incorrect predictions will mean that the budgetary deficit will be slightly higher than the forecasts, which point to a 6% deficit for every level of government, when the consensus reached by economists suggests 7%. That greater deficit will have to be financed by public debt, which will, in turn, require higher public spending on interests to be paid by the state. Furthermore, this greater need for finance for the public sector will make finance for the private sector of the economy more expensive. In a situation like the present, with heavy credit restrictions, demanding loanable funds from financial markets is not a good idea, since it generates an "expulsion" effect (in other words, by capturing part of the finance, the public sector expels the private sector from the economy).

The consequence of higher spending on unemployment and debt interests coupled with lower revenue from VAT and income tax is greater public deficit. In addition, revenue depends on economic growth, which is estimated in the PGE-2011 at 1.3% instead of the 0.4% proposed by the consensus. It is apparent that the budgets paint a somewhat optimistic picture that may be somewhat damaging for the government´s credibility and, therefore, the trust of the economic players. Therefore, the government needs to consider another tax policy and a greater reduction of public spending, especially as far as the autonomous communities and local authorities are concerned. For example, many public subsidy policies could be eliminated, since they are not necessary and will not improve the economy´s productivity. Trust in our government would then improve (and improvement is indeed necessary), but more importantly, we would be on track for solving the problems that affect the Spanish economy.

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