Institute for Research in Economic and Fiscal issues

IREF Europe - Institute for Research in Economic and Fiscal issues

Fiscal competition
and economic freedom

The fallacy of low taxes in Spain: A comparative study of taxation

The current Socialist (PSOE) government in Spain has claimed in different occasions that the low fiscal pressure that Spain has experienced in 2008 and 2009, gives policy-makers a large leeway to raise taxes. Besides, this measure has been supported as necessary in order to maintain –or improve- the current government-run social safety net and the level of public infrastructures. Angel Martin explains why raising taxes in Spain is not a really good idea.

The financial and economic crisis in Europe has brought about a series of severe interdependent problems. The fragile health of public finances has been one of the most worrying issues, especially in countries like Greece, Ireland, Portugal and Spain, because of soaring public deficits and a growing cost of sovereign debt. Now, fiscal consolidation measures have been approved but substantial problems remain. In this paper, we deal with the fiscal situation of Spain, one of the most badly hit countries in the downturn in Europe. We focus our attention on the revenue side: Do we need more taxes to maintain the current social benefits and level of infrastructures?

The current Socialist (PSOE) government has claimed in different occasions that the low fiscal pressure (measured as the tax-to-GDP ratio) that Spain has experienced in 2008 and 2009, gives policy-makers a large leeway to raise taxes. Besides, this measure has been supported as necessary in order to maintain –or improve- the current government-run social safety net and the level of public infrastructures. It has also been presented as a means towards approaching our European neighbors in terms of welfare benefits.

The fiscal pre-crisis situation

According to the government’s understanding of the events that took place before and during the crisis, government did not play a major role in the process that led to the currently unsustainable situation of the Spanish public finances. Rather, they maintain that this has been an inevitable consequence of a serious financial crisis which mainly came from the United States. Given the low level of public debt and the surplus in the years before the downturn started, it is claimed that the government had acted responsibly in the boom phase of the cycle.

Should we buy that reading of recent history? Not necessarily, for there is another—in our view more credible— narrative of how the government dealt with the public finances during the boom and the bust, and how he reacted to the latter. It seems clear to us that the high growth in tax revenues was significantly dependent on the unsustainable housing bubble. Moreover, in spite of the 2 percent public surplus in 2006 and 2007, expenditures were increasing at a very fast pace. The comparison with Germany is illustrative in this regard (see graph below).

Rate of growth of total government expenditures: Spain vs. Germany

Source: Own elaboration based on Eurostat, "Government Finance Statistics"

Thus, the allegedly healthy state of public finances was another illusion created by the rapid and credit-induced growth the Spanish economy experienced. The government could have done much more to alleviate some of the consequences of the crisis and soften the spike in the deficit (e.g. by not having spent so much during the good years, or by adopting ambitious structural reforms, especially in the labor market).

The effect of the crisis on public revenues

The Spanish government has justified tax increases by pointing at the low tax-to-GDP ratio in Spain relative to other EU countries. True, from 2007 to 2009 this indicator has fallen in Spain in a way unprecedented in any of the European countries (see table below). But does this justify increasing the tax burden on Spanish citizens? Let’s see why this does not make much sense.

The truth is that this fall has been due, not to a significant reduction of tax rates, but to a dramatic decrease in tax revenues –- led by the Corporate Income Tax and the Value Added Tax revenues; a decrease that reflected the severe recession the Spanish economy was going through. The vertiginous increase of unemployment (see graph below) and the serious difficulties facing small and medium enterprises are the two key factors that may explain this sharp fall in revenues. Therefore, to a large extent, the remarkably lower fiscal pressure in the recent years can be imputed to an unusually severe real economic recession and to its effects on tax revenues.

Unemployment rate (%)

Source: Eurostat

In this context, there are several elements of government policies that, either because of omission or commission, have contributed to make things worse, especially concerning the too rigid and inefficient labor market, the general regulatory framework and the large increase in public indebtedness.

The government creates confusion by mixing two different concepts: low tax revenues (which are low due to low employment and productivity) with a nonexistent low tax burden.

A comparison of tax burdens

As shown above, the tax-to-GDP ratio is considerably lower in Spain than in most European countries. The government has conveniently used this indicator in support of his thesis, which maintains that Spanish individuals pay low taxes relative to other countries. But this measure may be misleading to compare the actual tax burden citizens from different countries bear.

A different picture arises if we use different indicators, such as the fiscal effort, which is roughly defined as the tax-to-GDP ratio adjusted to GDP per capita. This allows us to enter into the equation the level of relative wealth: the individuals of a rich country with a 50 percent fiscal pressure are not affected equally as the individuals of a poor country with the same fiscal pressure. The graph below shows that Spanish individuals face a higher fiscal effort than people from Sweden or Denmark. (Note: the Fiscal Effort Index has been calculated by simply dividing the tax-to-GDP ratios to the GDP per capita. The vertical axis in the graph below represents this index).

Fiscal Effort Index for 2008

Source: Own elaboration based on Eurostat

Furthermore, the indicator of the tax burden and administrative burden in paying taxes on medium-size companies (as measured by the Doing Business project), reveals that the Spanish companies pay almost 12 percentage points more in Social Security contributions than the average of the OECD countries.

This picture is reinforced when we analyze in a disaggregated form the main features of the major tax figures, such as the personal income tax (PIT), corporate income tax (CIT) and consumption tax (VAT). Interestingly, in Spain we have one of the highest tax burdens on capital, and one of the lowest on consumption (see table below for capital taxes. We have chosen five countries, which we believe are representative).

Implicit Tax Rates on Capital for 2008 (%)

Spain 32.8

Source: European Commission, "Taxation Trends in the European Union 2010"

Regarding personal income tax, it is true that the ratio of tax revenues derived from PIT to GDP is lower in Spain than in other countries. We should, however, remain careful in interpreting this figure, given that wages in Spain, and thus the PIT base, are lower than elsewhere. In 2009, for instance, average wage in Spain was below 24.000€, while it was above 33.000 in France, and reaching 40.000 in Germany. If we look at PIT rates for homogeneous levels of income, we find that the tax burden on labor income, excluding mandatory social contributions, is not lower in Spain (see table below).

Marginal PIT rate (%) according to level of income 2010

Source: Own elaboration based on several sources: European Commission, "Taxation Trends in the European Union 2010" and

Concluding remarks

In addition to the arguments presented above, we think that a substantial tax increase is a wrong-headed policy because of two main reasons. Firstly, because it might put an additional drag on the economic recovery process, which is being already quite difficult on its own. For a healthy recovery after the excessive indebtedness of the boom era, households need to adjust their financial position. By further reducing their disposable income, a tax increase will jeopardize the recovery..

Secondly, more tax revenues might be used to boost an already burdensome public sector. This would be bad news given the long term cost for society and the loss of competitiveness it would generate.

Rather than raising taxes, the Spanish economy urgently needs to lay the institutional foundations of a healthy market economy by introducing structural reforms to solve structural problems. There are many areas that require ambitious reform, but the following are the most remarkable ones in the context of our study. First, the extremely rigid and inefficient labor market should be largely liberalized in order to cut the cost of hiring and make labor relations more flexible. Secondly, the heavy administrative and bureaucratic burdens that entrepreneurs face should be drastically reduced, to provide them with a more attractive environment for their wealth-creating activities. These two measures are essential if we want to create employment. And thirdly, the expenditures of the public sector as a whole –which has to adjust its financial position as well- should be cut by a considerable amount, starting with the elimination of inefficient public spending programs and subsidies and the rationalization of the inefficient and extremely expensive federal government system.

NOTE: This text is a summary of a lengthy report published in Spanish at the Instituto Juan de Mariana.

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