The Euro Zone's Austerity Dilemma

WSJ: Raising Taxes to Close the Budget Gap Tops the List for Many Governments, but Spending Cuts Are Seen as More Effective

Austerity measures are battering growth across Europe, but policy makers are giving no hint of any letup in their insistence that government belt-tightening is the key to resolving the region's debt crisis.

Many governments may be increasing the pain, however, by not following what multinational organizations prescribe as the most effective budget-cutting practice: Cut government spending before raising taxes.

"International experience shows expenditure-based fiscal consolidation tends to be more successful" than increasing taxes, says the Organization for Economic Cooperation and Development in a recent report.

The by-now-conventional advice that spending cuts should be at least two-thirds of any fiscal cutback is based on the argument that higher tax rates can stifle enterprise. Boosting consumption taxes, such as the value-added tax, can also increase inflation, which makes central banks less likely to cut interest rates.

But in much of Europe, increasing taxes is easier politically than firing government workers or cutting their salaries.

Greece, the epicenter of the debt crisis, is a poster child for this phenomenon. The government is in the middle of an effort to squeeze its budget by close to 20% of gross domestic product. So far, about 55% of the €37 billion ($49 billion) of measures it has taken are from tax increases—including sharp rises in indirect taxes, such as VAT, and taxes on incomes and property.

 

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Some economists say that is as much a matter of necessity as design: Widespread tax evasion has forced the government to cover recurring shortfalls in revenue collection, even as it tries to shrink spending.

"In principle, spending cuts have less impact on the economy while tax increases create bigger distortions in the economy. And certainly, in the case of a wasteful state sector it is better to focus on the spending side," said Nikos Magginas, a senior economist at the National Bank of Greece. "But in Greece, the big issue is tax evasion, so it wasn't entirely wrong to make adjustments on the tax side."

That criticism and explanation are also heard in Italy, which is in the process of hacking its budget deficit by more than €81 billion, or almost 5% of GDP, to balance its budget next year. Almost all of that is to be achieved through higher taxes—to the chagrin of many of Prime Minister Mario Monti's former colleagues at Milan's Bocconi University.

Enrico Zanetti, a Venice-based tax lawyer and an active left-leaning politician, says as much as three-quarters of the budgetary gap is being plugged by higher taxes. Treasury officials point out that included are some "hidden wealth taxes" that have less impact on the incentive to work—such as a new property tax and a levy on financial portfolios. Still, a lot of the heavy lifting is being taken by a VAT increase this year.

Italy's case is also complicated by rampant tax evasion, officially estimated at 17% of GDP. (By comparison, the Internal Revenue Service estimated the U.S. "tax gap" caused by evasion at about $345 billion, or less than 3% of GDP, in 2005.) That means that in Italy, tax increases have a softer impact on the economy than in some other countries. Historically, Italian private-sector activity has tended to contract up to three times more after a public-spending cut than it does after a tax increase of equal magnitude, according to Bruno Chiarini, an economics professor at the University of Naples. "Budget measures more geared to spending cuts than higher taxes would have been even more recessionary," he said.

In France, austerity measures have been based mainly on tax increases—at least in the short term, before longer-term pension reforms kick in. Belgium, late to budget cuts because it didn't have a government for 18 months, has also underplayed spending cuts, economists say.

"Now we have austerity, it's too much geared towards raising taxes and not enough to reducing spending, which is a problem," said Paul De Grauwe, professor of economics at the Catholic University of Leuven in Belgium, and a former senator. "I hope in the next stage, because I am sure there will be a new program, that the balance is restored to greater emphasis on spending cuts."

In Spain, the emphasis also has been on raising taxes. Soon after coming to power in December, Prime Minister Mariano Rajoy's government presented a €15 billion austerity package of nearly equal parts spending cuts and tax increases.

Unlike a similar-size package in 2010 from his Socialist predecessor, José Luis Rodríguez Zapatero, that raised the VAT, Mr. Rajoy's effort increased income taxes. The government justifies this on the basis of social equity—raising the VAT hits poorer people harder than an equivalent increase in income taxes.

"The government is able to sell the reforms in a way that people can accept them," said Antonio Barroso, a London-based analyst for political consulting firm Eurasia. "That's extremely important for the political situation now in Spain."

Others have followed the prescription more closely—including bailout recipients Portugal and Ireland. In Portugal, 70% of 2012 budget adjustments will come from spending cuts and 30% from revenue increases. The government is cutting the public-sector wage bill, mainly through wage freezes, reductions in the number of public-sector workers through not hiring and early retirement, and eliminating holiday and Christmas payments. It is also cutting spending on other departments, including health and education.

Ireland is undertaking one of the most stringent austerity programs, which Brian Devine, chief economist at NCB Stockbrokers, says will eventually amount to 20% of GDP. It has followed the orthodoxy: two-thirds from budget cuts and a third from higher taxes. The economy returned to growth last year and is forecast to grow modestly this year, ahead of many of its debt-stricken partners. But that is usually attributed to a strong export performance.

The U.K.—outside the euro zone but also pursuing austerity—has promised three-quarters of its budget reduction will come from lower spending. Iain Begg, a professor at the London School of Economics, says he thinks the balance of spending cuts to tax increases that the government has deployed is about right.

—Frances Robinson, Jonathan House and Cassell Bryan-Low contributed to this article.

Write to Stephen Fidler, Alkman Granitsas