Corporate Affairs Breakfast: “The new tax order in Spain”

First thoughts upon the EU’s recommendations

• After the Spanish public deficit exceeded 7% and the EU had to bail out the financial sector of the country, the European Union made some recommendations for the Spanish government to implement, mostly regarding the financial sector but there were also a few ones that were more macroeconomic.

• One of the EU recommendations was a comprehensive tax reform, and the Government commissioned a group of economic experts to prepare a report with recommended measures to include in the tax reform (Mr. Pablo Hernández de Cos was part of that group of experts that participated in writing the report).

• Before the crisis, Spain grew a lot based on some unbalances that kept accumulating and, when the crisis struck, they almost caused an economic collapse. The real estate bubble was a very important factor, but the main one, according to Mr. Hernández de Cos, was the increase of the unitary labor costs, which grew more than in other European countries. High labor costs imply a loss in competitiveness, which makes exporting more difficult and easier to import, a situation that caused the Spanish external trade deficit to reach 10% of the GDP. Recently, the situation has reversed and Spain had the first positive external trade balance in 20 years.

• However, labor costs and wages are still high in relation with the productivity of the Spanish labor market. Ideally, it would be necessary to increase productivity in Spain, but this change does not come over night and it requires structural changes. Labor costs and productivity are not balanced and this is a problem.

• Competitiveness can be improved via an increase of the productivity or via tax measures, and the government focused first on doing a tax reform. The objective of the tax reform is to tackle unemployment and increase competitiveness.

• The worst part of the figures related to unemployment is not the percentage itself, but the fact that 60% of those unemployed have been in that situation for over a year, and for this group it is much more difficult to find a new job.

• In order to favor the reduction of unemployment, the group of experts proposed two different tax measures:
o Reduction in Social Security contributions, which are the most direct way to boost employment
o Reductions in Income Tax and Corporate Tax

The experts proposed to compensate these reductions with an increase on indirect taxation, especially VAT.

• One of the measures passed in 2014 by the Government to reduce labor costs by decreasing SS contributions was the 100€ flat rate measure for hiring new employees with an indefinite contract. The analysis of the Bank of Spain of this measure is not entirely positive because it is temporary, they would prefer a more permanent measure. Actually, analysts at the Bank of Spain were surprised with the impact of the measure because they thought it was going to be bigger. The reason might be, according to Mr. Hernández de Cos, that companies have to keep the workers for 36 months, and in the current circumstances it is difficult to commit to that.

• The experts committee wanted to propose a balanced tax reform, so in their report reductions on the Income Tax and SS contributions were compensated with increases in some other taxes, specially VAT. However, the Government decided to go another way. They decreased the Income Tax as an electoral measure but they did not pass any permanent reductions for SS contributions because they did not want to modify the VAT, which had been increased twice already during the crisis.

• Reducing the Income Tax boosts internal demand because it allows taxpayers to keep money in their pockets, but reducing Social Security contribution is a more direct incentive to boost employment and economic growth. The problem of reducing SS contributions is its effects on the SS budget, which is already having deficits for the past years. Nonetheless, Mr. Hernández de Cos said that this gap could be financed with the general taxation, especially through an increase of the VAT.
Fiscal pressure, i.e. tax collection in proportion with the GDP, is lower in Spain than in many EU countries. Spain collects less, particularly when it comes to indirect taxation, a type of taxes that economists consider less harmful.

• The reason why Spain collects less is not that it has lower rates than other countries on Income Tax, Corporate Tax or VAT, the truth is that the legal tax rates are not the effective rates. There is a wide array of deductions, exemptions and discounts in the tax code that cause that the amount collected does not correspond to the one it should be if the legal rates were applied. The Tax Benefits Report produced by the Government shows that the amount of all these exceptions equals 7% of the GDP. Without all these loopholes in the tax code, fiscal pressure in Spain would be in line with the EU average.

• Another reason to explain why Spain collects less than other countries while having similar rates is tax fraud. Mr. Hernández de Cos stated that even though it is true that there is more fraud in Spain than in many other EU countries, there are no real numbers to quantify it and the figure would probably not be as high as people think. For the expert of the Bank of Spain, fraud in Spain is inflated and the real problem is the enormous amount of loopholes in the tax code.

Environmental taxation is used very badly in the Spanish system, while, in opinion of Mr. Hernández de Cos, this type of taxes are very useful to collect money while correcting externalities. The experts committee that released the report proposed to eliminate most of the regional and local current environmental taxes because they are not really environment-related. Instead, they suggested new and more specific taxes to levy harmful activities for the environment, as well as increasing the tax on oil and fuel, which is still low in Spain compared to other countries.

• Over 40% of public expenditure is decentralized in the Autonomous Communities (mostly spent in education and health policies), but at the same time the decentralization in terms of collecting revenues is not so relevant. The Autonomous Communities do not have as much autonomy to manage their source of revenues so they end up having to request money from the central government, a situation which creates tension.

• It is important to promote more fiscal co-responsibility among Autonomous Communities. They spend their resources mostly in education and health policies and in both cases it is possible to implement copayment policies, which will make them more responsible in collecting the resources they need for all the expenses they are in charge of.

The Spanish system incentivizes companies not to grow. Spain is very proud of the number of SMEs (Small and Medium Enterprises) and self-employees that it has, so they receive tax benefits and subsidies. This is counter-productive because companies have then no incentive to grow, since if they do they lose those benefits, making the activity less beneficial. Big Spanish companies are as productive as in any other countries, and it is the same case with SMEs. Nevertheless, SMEs are less productive than big companies (due to economies of scale), and Spain has too many of them, causing a loss in productivity because the system does not help them to grow, it does the opposite.

• Moreover, if a company grows and its revenue exceeds a certain level the possibilities of being inspected by the Tax Agency increase, so again companies “prefer” not to grow or disintegrate their business.

• According to Mr. Hernández de Cos, the Spanish economy should not grow now based on an increase of consumption because both the public sector and private individuals and business have high levels of indebtedness, so it would be very risky. The expert stated that growth should be based on these issues (in order):
o External sector
o Foreign investment
o Private consumption
• Mr. Pablo Hernández de Cos thinks there is still room for improvement in some areas of taxation:
o Further reductions of corporate tax rates (down to 18-20%)
o Reducing Social Security contributions

• In conclusion, for Mr. Pablo Hernández de Cos, the tax reform that was passed by Congress this same week (it will enter in force in January 2015) has been a lost opportunity, because the government had absolute majority in both chambers of Congress to pass any measures they wanted, and they had the support of a report made by experts to back up deeper and more meaningful changes.