When the facts change, I change my mind

About a year ago, I illustrated the standard debt-sustainability calculations with the case of Greece. If you plug in plausible numbers for growth, for interest rates, and for the debt stock, you get to a need for fiscal adjustment that is frightening. Indeed, it is so large – compared to, say, the fiscal tightening that undid the Weimar Republic – that one had to say “no way”. The necessary swing in the fiscal balance – from primary deficit to surplus – was around 10% of GDP.

Now, I am starting to think that this may not be mission impossible after all. The reason? It’s not what you think. For a while, much of the profession and, to a surprising degree, policy-makers seemed to have decided that the Alesina et al. view of fiscal adjustment was right – that you can cut yourself back to growth. The IMF has done some painstaking work last year, and this argument now looks pretty doubtful.

However, there is another story that can create a bit more hope. There is no question that countries that tax more are richer. Any scatterplot shows correlation is strong. Is it causal? Recent work by Besley and Persson says so. They look at the part of variation in tax capacity that can be explained by the history of military conflict after 1816. States with a history of lots of (expensive) wars still tax more; and that part of the variation is also strongly associated with being richer. Now, Dincecco and Prado (2010) have a new working paper in which they show that the number of battle deaths in the early modern period is also a good predictor of the taxman’s take today – and that this also explains how rich a country is. This strongly suggests that the link is causal – taxation is good for you.

Why? A lot of economics implies that high taxes should be bad. Disincentives for work and entrepreneurial activity are large; a bloated state is as likely as not to waste precious tax dollars. And yet, taxes also generate benefits. Besley and Persson show that capital markets work much better in countries where the government is more capable overall – enforcing laws, investing in education, building infrastructure, protecting property rights, ensuring that debts are collected. All of this costs money. Also, high tax revenue mostly means that everyone pays. The more uneven the tax burden, the lower the overall yield is likely to be. That would also imply that a high tax take is often associated with FEWER distortions.

It’s these kind of distortions in the PIIGS experiencing problems today that seem to suggest that maybe, there is a silver lining to the issue of excessive debts. In countries like Greece, Spain, and Portugal, the self-employed effectively escape taxation on a staggering scale. Many transactions take place with black money. Buying a house is often akin to a scene from a Hollywood gangster film – the buyer first goes to his or her bank, and exits with a suitcase full of cash. The cash is then exchanged at the notary’s office, before being paid in again by the seller. None of it is declared to the authorities. This is not some occasional, half-criminal type of transaction – this is the norm for house buyers today, in a Southern European EU country I know well. Taxation is hence not just too low relative to debt; it is also highly uneven, and hence, distortionary.

As Spain, Greece, and Portugal, desperate to plug their fiscal holes, are scrambling to find fresh funds, they will have to go after the areas of the economy they have largely far left alone – such as construction, property transactions, and the self-employed. Many of the citizens that should, by rights, have been working in large companies in the taxed part of the economy are today working in the self-employed sector; only tax fraud makes this worthwhile, since it compensates for the low productivity of their labor. As that gap narrows, overall output will increase, and the tax take will rise. In the short term, austerity may spell hard times for the Club Med and Ireland. And yet, tax reform done right, on the other hand, may very well pay rich rewards, not just in terms of revenue, but also in terms of economic efficiency. Maybe, Greece can pull it off after all.