I think everyone agrees Portugal needs to cut its debt, and cutting the deficit is the way to do that—but the idea this has to happen in the very short-term is off base. What Portugal needs more than near-term debt reduction is long-term economic growth. Over time, higher growth means a larger tax base, which yields more revenue and, hence, smaller deficits (assuming public spending’s held in check). But to get long-term economic growth, Portugal needs a healthy, growing private sector—and this requires a favorable tax environment.
Unfortunately, the current bailout program incentivizes—requires, even—the opposite. In its efforts to comply with bailout terms, Portugal has hiked taxes over the past two years. But tax revenues have fallen despite the higher rates as the country’s recession has deepened. And while public-sector cuts have contributed to the recession, consumption and business investment have suffered too, as shown in the chart below.
Year over Year Changes
Source: Bank of Portugal, October 2012 Statistical Bulletin.
Public-sector job cuts have undoubtedly weighed on consumption. But VAT and income tax increases likely also played a role, and high corporate taxes likely weighed on business investment. According to the World Bank’s 2013 report on the ease of doing business, Portuguese firms’ marginal tax rate is 42.6%—among the world’s least competitive. The more money Portuguese firms pay in taxes, the less they can reinvest in technology, software, facilities, research, workers and the like—all of which could boost growth.
To boost the private sector, Portugal should cut taxes across the board—VAT, income and corporate. However, because of the troika’s mandated deficit targets, they can’t. To lower the deficit to 4% of GDP by the end of 2013 (assuming growth only falls by the IMF’s predicted 1%—a big if), Portuguese leaders had to cut €5.3 billion from the 2013 budget. But the public can’t take many more spending cuts, considering civil servants have already weathered considerable job losses, wage reductions and pension cuts. And privatization efforts, though better than in Greece, remain slow. To placate creditors, Portugal’s government is hiking taxes. The average income tax rate will rise from 9.8% to 13.2%, all earnings above minimum wage will face a 4% super tax, corporate tax rates will rise for firms turning over €1.5 million or more annually and financial transactions will be taxed at 0.3%. That amounts to roughly €4.2 billion more going from private citizens and businesses to the government—which means €4.2 billion less to spend and invest.
Now, imagine the troika drops the deficit target, permitting Portugal to lighten the tax burden. Yes, deficits might rise a bit in the very short term, but economic activity should rise over time. And if Portugal married those tax cuts with more economic reforms, the long-term results would be even better. We’ve often written that public-sector cuts give the private sector room to compete and grow—but unless Portugal cuts bureaucratic red tape, businesses and would-be entrepreneurs will have a tough time growing. According to the World Bank, while it’s fairly easy and cheap to register a new business in Portugal, getting that business off the ground is difficult. It takes 108 days, on average, to obtain all the necessary construction permits to build a structure and connect it to local infrastructure. Connecting to the power grid can take two months. Obtaining credit is more difficult in Portugal than in 103 other countries. The government could do much to make business owners’ and entrepreneurs’ lives much easier—which would incentivize more people to start businesses. All of which brings more growth and higher tax revenues over time.
And despite the troika’s fears to the contrary, if Portugal were to adopt this strategy, its debt yields might not automatically rise even if the deficit rises somewhat in the very short term. Investors are most concerned about Portugal’s ability to meet its obligations over time—and they likely understand regaining economic competitiveness is what enables this. If Portugal can implement enough credible economic reforms over the final year before it returns to primary debt markets, and the economy shows underlying strength, I’ve a hunch investors won’t demand an ultra-high premium on its sovereign debt. They might just see the potential for stronger growth and have more faith in Portugal’s ability to continue meeting long-term obligations—regardless of fluctuating deficits in the short-term.