IREF - Institute for Research in Economic and Fiscal issues
Fiscal competition and economic freedom
Last March 30, the Spanish Government announced its most important measures to reduce the fiscal deficit for 2012. These actions have been based on reducing public spending and, again, increasing taxes. “Again” because on December 30, 2011, the conservative new Government already raised the Personal Income Tax, making Spain one of Europe’s most heavily taxed countries.
Nevertheless, the current tax increase has focused on the Corporate Income Tax (CIT). According to the Government, the CIT hike has been approved "in order to avoid a continuing fall in the effective tax rate of corporate taxation, mainly in large companies, and in order to help fulfill the commitment to deficit reduction." Therefore, the Government’s goal has been to bring the effective CIT rate closer to the nominal CIT rate by reducing and sometimes eliminating altogether deductions and tax credits in the Spanish CIT.
First of all, it must be reminded that our nominal CIT rates are considerably higher than those in force in the rest of Europe. According to the last Taxation trends in the European Union report, Spanish CIT rate is almost 7 percentage points higher than the average of the EU-27.
It is also interesting to remember that, originally, deductions and tax credits on the CIT were introduced by successive governments to promote and stimulate economic growth. It is somewhat paradoxical that when it is more necessary than ever to boost economic productivity, the highest tax burdens are being imposed on businesses.
The government’s rationale for the CIT hike is that, as tax revenues are dropping dramatically, it is necessary to increase taxes. It does not matter why tax revenues have declined so strongly. No questions are asked about whether the current level of taxation may be too high for the bad economic conditions we are living; or if tax hikes will hinder the —much needed— deleveraging process of Spanish companies. On the contrary, the Government perspective is based on short term and static premises which do not take into account the dynamic consequences and effects of taxes on the economy. The new administration of President Rajoy only looks forward to collect some millions of revenue from companies –Eur. 5.350 million- that could have easily obtained by cutting the public spending further. Other argument used by the Government is that the CIT hike has been designed to mainly affect the large companies. Nevertheless, we should not forget that SMEs —and their employees— will also be harmed as far as they are suppliers of the large companies.
In short, punishing Spain’s leading companies is not a good incentive to attract foreign investment and revitalize the Spanish economy. Nor will our companies be favored in their search for funding if they are forced -by the tax increase-, to offer less profitable investment projects to the investors. In the following paragraphs, I will mention the main measures approved on March 30 related to the CIT hike, and some of their possible economic consequences:
The main measures approved: limiting CIT deductions 1. Deduction of goodwill As in other countries, goodwill can be deducted for CIT purposes. Until now, this deduction was limited to 5% annually. With the new bill approved last March 30, the limit is reduced to 1%. This measure will have a temporary effect, since -for now (!)- only applies for the years 2012 and 2013.
The economic effects of this measure are derived from the fact that the Spanish economy must change its entire structure. During the economic boom it was directed to construction and all adjacent industries, now it should be redirected to other more profitable and productive sectors actually demanded by consumers. This modification of the entire structure of production could be done, in part, through mergers and acquisitions: companies could use the assets of other companies—specially, the goodwill—adapting old business projects to new and more profitable business plans. Therefore, limiting the deduction of goodwill will penalize this type of corporate reorganizations, which are essential in a changing economy.
2. Free tax depreciation
Spanish provisions related to free tax depreciation allowed companies to freely depreciate for CIT purposes tangible assets and real estate acquired for business use. It was a way to let entrepreneurs freely calculate the deductible depreciation applicable to their new investments. This tax mechanism moderated corporate taxation in Spain during the previous Socialist administration of President Zapatero, although not being —strictly speaking— a reduction of the tax charge but a postponement of it. With the new amendment approved last Friday, March 30, this tax benefit is repealed. Only the SMEs that create jobs with their investments will be authorized to apply the free tax depreciation. However, the Government’s decision adopted will create a tax barrier for companies to renew or change their assets to be more competitive. It will also make companies more vulnerable financially in the year when they perform the investment as they will have to pay more CIT. Consequently, it will penalize growth and business productivity. As a side effect, it will be also detrimental to workers as they will be less productive due to the fact that the company will have fewer capital goods. Consequently, they will tend to earn lower wages and, therefore, tax revenue will be further reduced.
3. Interest-capping rule
Up to date, interest and other financial expenses paid by a company reduced taxable profits without limits. Nevertheless, with the announced amendment of last March 30, the financial expenses exceeding 30% of the EBITDA shall not be deductible. This limitation will be applied by the large companies as it only affects the financial expenses exceeding Eur. one million. The amount not deducted will be carried forward for the following 18 years (similarly to tax net operating losses). Also, it will be disallowed to deduct interest expenses of debt used in intra-group acquisitions of shares, unless the taxpayer can prove that these acquisitions are made for valid economic reasons, not merely for tax purposes.
Limiting the deductibility of financing expenses will reduce the profitability of investments in the companies and, therefore, their growth, and it will worsen the illiquidity problems in which Spanish companies are immersed.
Analysts who support this measure argue that large companies currently benefit from borrowing in Spain to invest abroad. In other words, Spain’s big companies would be incurring in more financial expenses in Spain –reducing their taxable profits—to earn more profits outside –which are not taxed under the Spanish CIT. According to this critique, there would be a problem of thin capitalization for Spain’s large companies that, consequently, would get a lower effective corporate taxation.
Nevertheless, the limitation of this deduction will not only harm our leading companies –and their owners, large and small investors—, it will also hinder the internationalization of Spanish entities that acquire a certain size and are impelled to expand their operations outside Spain under a strong international competition.
4. Minimum advance CIT payments for large enterprises
This is one of the most revenue-raising measures approved, which will only be in force for fiscal years 2012 and 2013. The goal of these payments is to anticipate funds to the Treasury. In Spain, companies make three advanced payments throughout the year.
The amendment adopted on Friday has set a minimum advanced payment for companies whose accounting profit exceeds Eur. 20 million a year: 8% of the accounting profits or 4% if at least 85% of its revenue comes from dividend income exempted or entitled to double tax deduction. This measure seeks to benefit from the liquidity of large companies. Advanced payments will now be fixed on the accounting profit -an amount far greater than the tax quota, the figure used before, which is reduced by deductions. Strictly speaking, this provision will not increase taxation, but will undermine the solvency of companies, degrade its liquidity and its future investments on capital goods or employees.
5. Limit of deductions
This is another temporary measure that will affect fiscal years 2012 and 2013. This provision will reduce the total amount of tax deductions. The current limit is 35% of the tax quota. With the new rule, this limit is reduced to 25%—this limitation includes the deduction related to the reinvestment of extraordinary profits -. In case the deduction for R & D exceeds 10% of the tax quota, the aforementioned limitation will be 50% of the tax quota -instead of 60% as before-.
With these provisions the Government will hinder the growth of Spanish businesses by penalizing their research and innovation. These limitations will hamper the cooperative research between University and the companies, harming our researchers, especially young people. As a corollary, Spanish products will be of poorer quality and national and international competition for Spanish companies will be much more difficult.
To summarize, the measures taken by the new conservative Government in Spain to reduce the fiscal deficit have been framed in two ways: very mild spending cuts and (estimated) increases in revenues through tax hikes -the last of which has been the reduction and elimination of various deductions and tax credits in the Spanish CIT.
With the CIT hike, the Government expects to raise Eur. 5,350 million. Regardless of the accuracy of such estimates, this CIT hike will have huge adverse effects on the economy by hindering the -needed- change of its structure of production and harming the solvency and competitiveness of the Spanish companies.
It seems that the new conservative Government does not understand that the deficit problem is a symptom of a disproportionate level of public spending, i.e., an excessive Government. Indeed, just eliminating duplicities and redundancies in the services provided by the Central and Regional Governments, Eur. 26,000 million could be saved –far more than the estimated revenues from tax hikes-. If that were not enough, an additional Eur. 30,000 millions could be saved by cutting inefficient Central Government spending, according to an analysis made by Juan Ramon Rallo of the Instituto Juan de Mariana. Consequently, by cutting unnecessary public spending, the Government could not only avoid increasing taxes but even reduce them, thus accelerating the Spanish economic recovery and improving the welfare of Spaniards.