More bad news from Europe. The crisis there is not over, not even close. If you’re one of my former students, note how much of this corresponds to things we tried to learn in my class.
On June 1, 2009, Air France flight 447 crashed into the Atlantic Ocean, killing all 228 people aboard. The disaster was caused by human error. With the plane already in a stall, the pilots pointed the nose upward, which was the exact opposite of what the situation required. When recovered, the cockpit voice recorder revealed that, before they hit the water, the pilots knew that they were going to crash.
With Spain’s economy already in a stall, the conservative government that was elected on November 30, 2011 first raised the top personal income tax rate from 45% to 52%. Then, on March 30, 2012 it announced corporate tax increases. In other words, Spain pointed their tax rates up in a situation where they should have pointed them down. Thus far, the response from the financial markets amounts to, “She’s going in!”
The ability of the Spanish government to service its debt is a function of the present value of Spain’s future GDP. Since the corporate tax increases were announced, the market interest rate on Spain’s 10-year bonds has risen to 5.98% from 5.35%. While this may not seem like much, this 63-basis-point move (assuming inflation at 2%) has the effect of reducing the present value of Spain’s future real GDP by 32%.
The interest rates on Spanish bonds went up because the markets perceived a higher probability of default. The only thing that could have caused this is a reduction in the expected long-term real growth rate of Spain’s economy.
A two-percentage-point reduction in future GDP growth (from 2% down to zero) would, by itself, cut the present value of future Spanish GDP by 60%. If you add the effects of lower expected economic growth and higher interest rates together, you get a two-thirds reduction in the expected present value of Spain’s future GDP.
With government debt expected to hit 80% of GDP by the end of 2012, Spain has become like a family with a big mortgage where the primary breadwinner has lost his job. Unless they find a way to increase their income, they are going to go bankrupt. It is only a matter of time.
If people want to know what life looks like in the “Prohibitive Range” of the Laffer Curve, all they have to do is to visit Athens. Greece is literally falling apart. Unfortunately, by raising taxes, Spain is making exactly the same mistake that the Greeks made.
The impact upon a modern economy of excessive tax rates is even worse than the Laffer Curve (which is an oversimplification) suggests. Not only do people choose to work less, but also capital begins to flee. The economy goes into a death spiral. GDP falls and unemployment rises, resulting in lower tax receipts and increased social welfare spending. This causes deficits to explode, which causes interest rates to rise, which in turn causes even higher deficits.
Unfortunately, thus far, one response of many European governments to falling revenues has been to increase tax rates. At least in Greece, the tax hikes were imposed by a socialist government. The tragedy of Spain (and, to a lesser extent, England and France), is that the voters elected so-called “conservatives”, only to see them raise taxes and accelerate their country’s economic death spiral. Where can the people turn, when both sides of the political aisle are peddling the same economic poison?
Just as the pilots of Air France 447 needed to reverse their “plane attitude policy” to avoid disaster, the Spanish government needs to reverse its tax policy to avoid an economic calamity. There is still time, but they can’t afford to wait much longer. Unemployment in Spain has already reached 23.9%, with the rate for people 25 and under at more than 50%. And, Spain is so large that it would not be possible for anyone to bail it out while its GDP is contracting at 2.0 – 3.0% per year (except perhaps the ECB, and then, only temporarily).
Large cuts in top personal and corporate tax rates would pull Spain out of its fiscal dive almost instantly. This is because the financial markets run on present value calculations. The markets would respond to higher expected Spanish GDP growth with lower interest rates and a renewed willingness to lend.
What is true for Greece, Portugal, Spain, Italy, France, etc, is also true for the U.S. The only way out of our deficit and debt problems is to cut tax rates and thereby increase GDP growth. Hopefully, in November, we will have the opportunity to elect a new president who understands this.