What should a state budget look like?

Rafael Pampillón. Professor. IE Business School

29 July 2015

Spain’s general state Budget for 2016 should try to achieve a reduction in the national debt and include more cuts in public spending. 

A recent cabinet meeting of the Spanish government approved a cap of public spending for 2016 and a tax reduction effective as of July 1. It also revised the macro economic outlook for economic growth in Spain: a growth rate of 3.3% for this year and 3% in 2016. Nobody is in any doubt that the Spanish economy is entering an expansive phase with high levels of economic growth and job creation. On Thursday the IMF raised its estimates for growth in Spain to 3.1% for 2015 (half a point more than the previous estimate). 

Hence the General State Budget for the coming year (GSB - 2016) is being drawn up against a backdrop of strong growth trends in the Spanish economy. The measures we are currently seeing point to a more generous budget than normal for an expansive phase of the cycle. Although the cabinet approved a spending cap of 4.4% less than this year for the General State Budget of 2016, the expected public deficit for the Spain’s public administrations as a whole is still  high (2.8%). Income and expenditures are closely linked to economic growth, which means that higher levels of growth should translate into more tax income and less public spending, that is to say a reduction in public deficit. Hence, the General State Budget for 2016 should be more ambitious and try to achieve a lower level of public deficit. In the context of a critical phase in the cycle, if the Spanish government reduces taxes, as they did once again recently, it should also consider a greater reduction in public spending.  

Nevertheless, we have to take into consideration that due to substantial decentralization, the General State Budget represents no more than 50% of total spending in Spain. That is why controlling the deficit requires tools that oblige Spain’s autonomous communities to at least meet their fiscal commitments. That is where there is some room to continue making adjustments, basically in terms of spending, which in turn would give investors and creditors more confidence in Spain. The government should tackle, once and for all, the reform of its public administrations and, whatever happens, should withhold funding from any autonomy or local administration that does not meet the required budget control. With the economy in the throes of an expansive phase, all administrations should present a fiscal balance or surplus, and none of them should be able to incur a structural deficit, except in exceptional circumstances.  

Reducing the 2015 public deficit

Hence the adjustments being made to the public deficit in 2015 are clearly insufficient, and what is worse is that they are higher than the objective proposed by the government. Effectively, in the first quarter of 2015, the consolidated deficit balance of the public administrations, excluding local administration, stood at 1.1% of GDP, being just one tenth of a percent less than in April of 2014. For 2015 and 2016 economists expect a deficit of 4.4% and 3.2% of GDP respectively in public administrations, some two and four tenths of a percent greater than the government’s objective

The cause of this bigger deficit lies in public spending incurred throughout this year for electoral purposes.  A rise in spending has not been enough to compensate for reduced costs in other parts of the budget, such as unemployment benefits or the payment of interest on public debt, which are both dropping due to rising employment and falling rates of interest.

This high level of deficit means that Spain is the eurozone country with the greatest fiscal imbalance. That is bad news because with a rate of economic growth over 3% and the fact that more tax is being collected means that public administrations should be making greater efforts to reduce public deficit, and in turn the public debt as a percentage of GDP. Spain is a country that is deep in debt and needs to gain credibility among the creditors that are funding it. Fiscal policy has to become more restrictive in order to send markets a clear message that Spain is doing everything it can to reduce its deficit. Unfortunately the electoral interests of political parties mean that this is not happening.  

Electoral interests

Elections are not won by giving civil servants part of the bonuses that are owed to them or because people see a few more euros tacked on to their salary at the end of the month. Elections are won when a party knows how to communicate to the electorate what economic (and fiscal) policies Spain needs to improve the wellbeing of its citizens in the long term.  It must be explained to citizens that a more orthodox fiscal policy will permit a healthier economy and will inspire confidence among creditors. This greater confidence will impact entrepreneurs who will make greater investments and thus generate more employment. Spain needs, therefore, policies that will keep the economy moving in the direction of stability and growth.   

Spain has been moving in the right direction for four years. It is strengthening the virtuous circle of high levels of confidence, good economic results and rises in citizens’ wellbeing. For example, the high rate of growth of GDP this year has come coupled with job creation, growing levels of consumption, more house purchases, and more tax collection. Faster growth has also meant higher levels of tax income, which should enable the government to reduce the high level of public debt owed to creditors. 

I repeat, elections cannot be won by populist public spending. Elections are won, as has been seen in the latest by-elections in Spain, when parties promise and deliver the demands being made by civil society: open lists, elimination of corruption, elimination of candidates facing criminal charges, more internal democracy in parties by introduction primaries and eliminating some public administrations – small town councils and provincial governments. In other words, when there is a political will to undertake necessary reforms that will inject new life into politics and reduce public spending that is not strictly necessary.  

But furthermore the economy is cyclical and what could happen is that the current buoyant situation we are in could get worse as from 2017. And if this happens Spain would then have to apply a more expansive fiscal policy, which would make the debt level rise. Hence Spain’s minister of finance, Luis de Guindos, was mistaken when he said recently that the early reduction in personal tax that came into force on July 1 is compatible with meeting the public debt deficit of 4.2% of GDP for 2015.  He is mistaken for two reasons. 1) Analysts’ forecast show that the deficit for this year will be greater than that predicted by the government, and 2) because even if it were compatible, as he said, it would have been better to opt for reducing the public deficit before lowering tax.

The ideal solution would be to lower taxes but coupled with reduced public spending. The majority of empirical studies (and also the case of the Spanish economy) show that a restrictive fiscal policy increases production and employment. Moreover, fiscal adjustments based on cuts in public spending and the reforms that should be made in public administrations (which have not been carried out, nor are they likely to be) would probably be more successful than those based on generating higher levels of income. 

In short, the fifth state budget of Rajoy’s government, that of 2016, has been announced against the backdrop of a good economic performance by both Spain and Europe. His forecasts for growth of the economy and levels of employment, and, therefore, of state income and spending, are realistic. And the objective of deficit reduction he has proposed is easily attainable. In this context, it would not be a bad idea to reduce the deficit even more, thereby increasing finance markets’ confidence in Spain, lowering interest rates, and reducing spending on interest generated by debt.


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