During the credit crisis, the public debt of nearly all eurozone countries soared. On average, public debt rose by more than 20% of GDP. In a number of European countries, conditions deteriorated so much that they lost independent access to the financial markets. Governments recognise the need to restore order to their public finances. However, several countries face growth problems as well as budget problems. So while budget cuts are necessary government will need to restore their economies’ growth potential.
Europe’s public finances put back in order
| Date | 1 May 2012 |
|---|---|
| Theme | Europe |
After the strong budgetary deterioration following the eruption of the credit crisis, European government are now working hard to put their public finances back in order. In many cases, budget deficits need to be forcefully curbed. Doing so often requires a combination of spending cuts and tax increases. In addition, countries need to reinforce their economic growth potential.
Figure 2 illustrates that in 2009 average public spending in the eurozone increased from 46% of GDP to over 51% of GDP. This was mainly due to the fact that automatic stabilisers on the spending side (such as rising unemployment costs) were allowed to work freely while GDP contracted. Thus reducing the budget deficit begins with cuts in public spending. This position is supported by a wide range of economic literature, which concludes that spending cuts are more likely to result in a lasting reduction of the budget deficit than do tax and rates increases – provided that the cuts are made in public consumption, not in public investment. Curbing or postponing investments has at best a temporary positive effect on public finances, whereas in the longer run, it may harm economic growth.
But although spending cuts, as argued above, make for the best average results, a recent IMF study (Abbas et al., 2011) show that certain tax and/or rates increased may also help to achieve a lasting reduction of the budget deficit. What is meant are increases in public revenues that are not caused solely by an upturn of the business cycle. Such cyclical revenue rises do not lead to sustained improvement of public finances, because they may evaporate again at any time. The IMF findings notwithstanding, increasing marginal tax rates is still not beneficial to economic growth. However, the tax and social security burden may be increased in many countries without raising marginal rates. One way to achieve this is by pruning exemptions and deductions and by reducing opportunities to avoid or evade taxation.
Given persistently rising public debt, emerging ageing problems and increasing pressures from financial markets, many governments need to make haste in putting their financial house in order. European budget rules, too, compel countries to quickly reduce their budget deficits to below 3% of GDP. Together these conditions imply that many euro countries face tough and urgent consolidation tasks. Especially the euro countries that currently face limited access to financial markets should reduce their deficits rapidly. This will require measures regarding spending as well as revenues. Many countries simply do not have the luxury right now to rule out any specific measures such as tax increases. Moreover, spending cuts tend to do more harm to economic growth in the short run than tax burden increases.
In many countries, the deterioration of public finances is not only due to budgetary laxity but also to reduced competitiveness and imbalances in macroeconomic development. Especially in Spain and Ireland, rapid credit growth pushed up house prices and domestic spending, while in several southern euro countries persistently high inflation and wage growth caused a gradual erosion of competitiveness. Before the crisis, strongly rising house prices, wages and spending engendered exceptionally high tax revenues. Currently, however, tax revenues are strongly depressed by falling house prices, increased savings and subdued wage development needed to increase competitiveness. As a result, the public finance turnaround was far stronger in countries that faced such macroeconomic imbalances than elsewhere (Gilbert and Hessel, 2012). In addition, the current lack of economic growth holds back the recovery of public finances.
Therefore, in order to restore public finances to health, such macroeconomic issues should be attacked at their roots (DNB, 2012). Especially in south European countries, growth potential has fallen in recent years owing to declining competitiveness. Moreover, the future erosion of the workforce through demographic aging will further depress potential growth. Low potential growth causes debt dynamics to deteriorate – given a certain budget deficit, public debt will stabilise at a higher level. Curbing such a trend requires reforms to be made to the product and labour markets. Besides increasing the economic growth potential, such reforms also make public finances more resilient against future shocks.
Literature
- Abbas, S.A., F. Hasanov, P. Mauro and J. Park (2011). A statistical analysis of performance in the European Union. In: P. Mauro, Chipping Away at Public Debt
- DNB (2012), Towards enforceable minimum standards for structural policy in the euro area. DNBulletin, 28 February 2012
- Gilbert, N.D. and J.P.C. Hessel (2012). De Europese overheidsfinanciën tijdens de crisis. Economisch Statistische Berichten, Issue no. 4631, March 2012