Friday, March 25, 2011

The taxation liquidity trap

It was clear for a while that the Hungarian government's secret weapon to curb economic growth is a low tax economy. (Well, with a supposedly strong and active state, something that would most probably result in a despotic state instead, but it is a sidetrack here.) The reason they gave why the government does not want to join the new competitiveness pact of the EU was nothing else that the country wants to keep its tax-independence.* They argue that Hungary needs to regain competitiveness with the "most competitive tax system", i.e. with very low tax rates. Apart from the narrow-mindedness of such attempts one have to admit that rational argumentation never really could deter ECE politicians from operating and manipulating with the tax rates in the hope they will attract investment, make black and grey economy visible and kick-start local companies. In case someone refers to the fallout in budget revenues the usual answer is that higher growth rate will generate even more tax revenues.

Opinions are divided whether it is true or not and how much impact lower tax rates on real and potential growth has. I will not argue here that the assumption of the government can be wrong, because another phenomenon raised my interest, what I baptized as the taxation liquidity trap. The liquidity trap is a well-known phenomenon of economics, it is a situation when monetary policy has no or minor influence on activity because people fail to invest even if interest rates are low. However, in some cases liquidity trap is simply identified with the so-called zero bound, a situation when the institution setting the policy rate of a country hasn't any room left because interest rates already attained zero. (Although, theoretically negative interest rates are also possible, but it is rarely exercised.) If one assumes a really competitive environment regarding taxation something similar is conceivable considering taxes.

Suppose there is already a tax competition, what is in fact the situation across ECE. Countries tried to attract investment with ever lower tax rates and flat tax and as as during the boom years before the crisis it seemed to work politicians are still faithful to this idea. One can find tax rates in the region like the 10% in Bulgaria or Macedonia, 16% in Romania and Hungary (where there is in fact a two bracket corporate tax with 10 and 19% rates) 19% in Slovakia etc. For a while, under the pressure of the terrible situation of the budgets politicians accepted the IMF's view and refrained from every kind of serious tax cut. However, after Hungary "reformed" its tax system and introduced a new nominally 16%, de facto 20% flat tax the tax competition was revived.** Bulgaria plans even lower taxes, Romania a 10% or 12% flat-tax and so on. (The reason is never a thorough investigation of the situation in one's country. Such plans usually appear after a media outlet runs a tabloid story on companies immediately leaving the country and settling in one of its low tax neighbours. It is also noteworthy that the UK government joined this competition recently.)

Anyhow, it is clear that countries competing for investment and hoping to generate growth with lever lower taxes can easily outcompete each other for a while. But what happens when they arrive to the point of zero taxes? Well, in case the earlier tax cuts have proved themselves and delivered the envisaged result probably everything is right for a while. But what happens, if not? These countries simply will lose the means they see as the best way to curb growth, therefore they will be left without any hope for it. Furthermore, it is hard to expect a very long period of sustained growth, without minor or major recessions or periods of stagnation. If a country renounced taxes they hardly would have any means to counteract such slumps, especially as in this magnitude the abolition of taxes would mean a very low level of budget revenues. If and when a country reaches these levels of taxation it will arrive to a taxation liquidity trap and if earlier hopes for strong growth wouldn't materialize they will be stuck.

There is another effect of such policies on the state itself. The more revenue they eliminate the more constrained their budget will be the less chance they will have to regain the lost revenues even through stronger growth. A quick and rough back of the envelope calculation can prove it. If and when a country cuts its tax rate from 35 to 30 percent it can calculate a loss of 1/7 of revenues. With a 3% sustained growth - ceteris paribus - they can collect the same sum circa five years later. If higher growth through lower taxes would come true and they could achieve sustained 4% growth tax revenues will attain the earlier volume four years later. However, if and when a country cuts the same 5 percentage points from a 15% tax rate, they will practically never regain the lost amount of money. With the above mentioned pair of assumptions the revenues five years later would still not higher than 80% of the earlier revenues. At the end the government certainly have to cut budget expenditures and slowly dismantling the state as any tax hike would have an immediately negative effect on growth.***

* It is an horrific custom of theirs always to coin a new word they think of as an inventive way of communication. I fear it rather conveys stupidity.

** Normally it shouldn't have happened as the new Hungarian tax system is a huge tax raise for the 80% of the workforce and as the government insists that companies have to compensate their workers for their lost net revenue it is in fact a blow to cost competitiveness. However, not only Hungarian politicians are stupid, their regional peers also have no idea about what's going on around them and they bought it was a significant tax cut. Ironic, isn't it? Only the politicians in the neighbouring countries believe in this tax cut, no one else. :)

***There is a factor not taken into account here, the growth of revenues from indirect taxes in case higher sustained growth is achieved. It is not easy to simulate the across the economy effects of such tax cuts and the resulting higher growth. However, if empirical evidence could give any idea, ECE is momentarily experiencing a jobless recovery, exports soaring and internal demand flatlined. As a consequence relatively high growth rates are not accompanied with soaring revenues, because of the lower effective indirect tax rates on export, most notably the lack of VAT paid.

Friday, March 11, 2011

Hungary, even more path-dependent?

Hungary is again pushing forward on its path towards its demise with the so-called Széll Kálmán-plan and the Draft Constitution. It would be (or probably will be) entertaining to analyze the constitution in depth in the light of Fidesz's organic/integral nationalism, how it correpsonds to this idea.JUst as it would be important to give a more detailed coverage of the economic plicies of the government, sometimes seemingly sane, but considered in its entirety lunatic at all, again very much an expression of the above mentioned ideology. However, in this post I will only formulate some preliminary thoughts and conclusions on one of the most worrisome aspects of the new constitution.

1. The new constitution will implement a debt ceiling at 50% of the GDP (although the GDP they measure to will not necessarily be identical with the Eurostat/National Office of Statistics data, a separate law will define it). Legislation on taxes and social contribution, as well as on the pension system will be subject of laws passed by a qualified - 2/3 - majority. It seems an exteremely rigid framework for any meaningful economic policy, practically requiering consent of the government and the opposition even to minor changes.
2. The government promised to bring down the debt-to-GDP ratio to 50% until 2018. The nationalization of rpivate pension funds can kickstart it and the government predicts a ratio between 65-70% in 2014 but 15% is still a long way to go. (Between 1998 and 2001, during their tenure they are still very proud of, Fidesz reduced the debt level from 62% to 53%, or 9% of GDP, with tight budgets between 1998 and 2000 and GDP growth around 4%.) 15% (more realistically around 20%) in four years seems a daring promise.

I tend to conclude the political intention and the legal framework will create a peculiar situation. Firstly, it will certainly put Hungary in the straitjacket of almost another decade of strong austerity, after 5 years from this experience. Moody's had some calculation on the possible scenarios of debt reduction and they concluded the 50% level is attainable only with an extraordinarily benevolent international environment and not quite realistically high growth rates. I would characterize it as voluntarism, and an extremely dangerous form of it.
Furthermore, there is a risk that the package - or more precisely the declaration of intention - announced last week - is simply not calculated properly. For example the Ministry of National Economy wants to spend the revenue from the electronic toll system entirely on debt reduction, while the Ministry of National Development counts on it as a source for the maintenance of public roads. Or, the government is propelling forward with a legislative package on public instruction, with an estimated annual extra cost between 300-500 billion HUF while the entire ammount of budget savings is estimated around 900 billion per year. And there is the danger, that they simply misinterpreted Hungary's economic woes. It seems they believe in the magic mixture of flat-tax (actually a significant tax-hike on labour in case of about 85% of the employed workeforce) and super-flexible labor market (i.e. very low level of social aid and unemployment benefits) just like Bajnai or earlier the Reform Alliance.
Meanwhile important elements of command economy appeared, especially the central regulation of prices for public services and utilities. But after it turned out that the new flat-tax is in fact a tax-hike they put pressure on employers to raise wages, now they threaten with legislation on this issue. And they couldn't find a solution for the problem of the fx-denominated loans, for the indebtedness of local authorities - the majority of which was controlled by Fidesz since 2006 and deliberately taking the path of making debts - and the PPP projects. The flat tax, due to the above mentioned reasons probably will not bring a significant rise in internal demand and households are still struggling with their debt and with rising public utility costs. I'm not really optimistic, although I can imagine the markets temporarily buying the package and waking up to an even worse situation after austerity bites but fails to bring meaningful growth.

P.S. It is again worth to look at Romania with its totally incompetent government, After narrowly escaping colapse and pushing thorugh a hard austerity package, still far from reducing budget deficit significantly enough, they are in a hurry to implement tax cuts. Although tehre is still no convincing proof that it could bring growth alone and Romanian is sliding down to large scale poverty with last years measures. Moreover, it will create a whole in the budget eytremely hard to patch, just look at Hungary, what is happening there. The government had to accept austerity after it carried out tax cuts around 500 billion HUF. Now, they have to cut public expenses, unemployment benefits, social aid etc. in order to save the money they handed out nicely, as a gift for the very rich and a narrow upper-upper middle class.