How to achieve fiscal consolidation?

31. August, 2010

Anyone dares to argue 'budget consolidation' is not one of the main challenges for the next two years? According to the Memorandum of Understanding with the lender, the budget needs to be consolidated by 800-900 million LVL over the next two years, probably 400 million LVL for 2011. Yet 'consolidation' is a term dreaded by the politicians. So far, no political party has unveiled a clear plan of how to achieve more reasonable levels of budget deficit.

Politicians probably know what needs to be done, they just don’t know whether they will be re-elected after they do this. Or, perhaps they think any unpopular decisions can be easily written off to international financial occupation.

And yet, some pieces of ‘consolidation’ begin to emerge. Two measures look almost certain. First, tax increases, including abolition of reduced VAT rates, a sharp increase in real estate tax, and a tax on luxury cars. Second, terminating payments to the 2nd (funded) pillar of the pension system, and channeling them to the current pensioners. I think the first measure is a step in the right direction. The second measure, however, is not a solution of any kind, but a mere postponement of the problem. Worsening demographic situation and (likely) mass migration mean that the purely redistributive pension system is unsustainable in the long run. Without pension reform, those already in their 30s and 40s today will not be able to get the pensions they expect. The reason is there simply won’t be enough young workers to pay these pensions by that time. That was the whole point of the pension reform and introduction of the funded pillar. Thus, terminating (and also reducing) payments to the second pillar ‘solves’ short-term problems by creating long term-problems. How is this different from simply selling a Latvenergo and using the proceeds to close the whole in a budget for a year or two? How is this different from Greece’s numerous ploys to disguise the size of its budget deficit?

I’d like to stop here but there is a problem. I have a strong opinion that a criticism of someone’s approach to consolidation entails an obligation to suggest an alternative. I just criticized, so here is what I think needs to be done.

Devising expenditure cuts on such a scale requires substantial investment in thinking how that needs to be done. At the moment, it does not seem like the government, or political opposition, has been either willing or capable of making such an intellectual investment. Thus, in all likelihood, all the fancy words like structural reform, optimization of public expenditure, etc are just this. Words. Hence, apart of planned tax increases, the only decent blueprint for consolidation is the World Bank’s menu, which contains about 500 million LVL worth of measures on the expenditure side. About half of these are related to the social budget, including pensions. This means that consolidation would have to involve pension cuts, focusing on those who experienced the largest windfall gains (i.e. recent pensioners whose pensions were affected by the ‘salary bubble’).

Yes, I understand the implications of what I am suggesting. This is not an easy choice. I have grandparents, too, and their pensions are barely sufficient to survive. And yet, falling incomes, huge number of unemployed, and increased migration mean that there is simply no resources to keep pensions at their current levels. Pensioners have to take part in the consolidation, just like teachers, doctors, policemen, and everyone else. There are alternatives, but their long-term negative consequences could far exceed today’s benefits to the pensioners. If the price of keeping the pensions is to ruin the lives of their children and grandchildren, would the pensioners themselves be willing to pay this price?

And yet, such a step inevitably brings the misery of pensioners into the spotlight. Pensions of many old people have been below subsistence also before the crisis. Why? There are many reasons. Some politicians have shamelessly used the social budget to plug the holes in the central government budget, and also to finance populist policies, such as overly generous maternity benefits. And yet, the main reason is widespread tax evasion, exemplified by infamous ‘envelope wages’. I think that involving pensioners in budget consolidation implies a responsibility to address the issue of low pensions. Thus, I would combine reducing pensions today with a pledge to eliminate envelope wages in two years time, thereby achieving an increase in pensions for the (surviving) pensioners. A very clear and specific promise, the one that’s easy to monitor.

I think this is possible. One year for researching the problem, planning, and preparations. One year for the measures to take effect. Broadly, the measures would consist of both a ‘carrot’ and a ‘stick’. Here is a broad outline.

Stage 1: Remove the ‘carrot’

Why are there ‘envelope wages’? One of the main reasons is exorbitant taxation of wages. A combination of personal income tax and a social tax imply a tax wedge of about 45% – one of the world’s highest. In other words, after all taxes are paid, an employee gets slightly more than half of what he costs to the employer. This creates an incentive for an ‘envelope wage’: an employee is paid more than his after-tax wage, and costs less than a wage-with-taxes. All at the expense of the taxes, of course. Moreover, both employer and the employee benefit, so none has an incentive to report the crime. This is what makes ‘envelope wages’ very hard to detect. The tax on income – a combined burden of personal income tax and social tax – is what constitutes a carrot. Thus, incentive for ‘envelope wages’ need to be reduced by transferring the tax burden from taxation of income to taxing assets, such as the real estate. This is the main reason I’ve been advocating a reduction of social tax rate and an increase in the tax on real estate. For example, reduce the social tax rate to a total of 20% (about 33% now) and make it payable half by employee and half by the employer (even though this statutory incidence does not really matter). Increase taxation of real estate so that a family with average income pays the same amount of taxes, i.e. it pays less in social taxes, but more for the real estate.

Of course, this also requires work with the real estate tax: abolishing real estate stamp duty (2% on sales price) to remove incentive to underreport transaction prices, review cadastral values, sort out tax liabilities of the unemployed, pensioners, etc. The devil is in the detail, of course. But it can be done.

Stage 2: The surge of ‘sticks’

Reducing the incentive for envelope wages will have some effect, but is unlikely to be sufficient as long as sufficient sanctions are in place. I do not have a full understanding of the underpinning of ‘envelope wages’ in this country – one needs a thorough research of this. However, my intuition and the bits and pieces of evidence tells me the following. First, it’s concentrated in the small business sector. Large businesses are likely to find it hard to practice this as they’re on the tax authorities’ radar, and there is too much at stake. Second, it’s probably near universal. That is, ‘honest’ businesses are likely an exception, than the rule. Third, ‘envelope wages’ and, probably, also VAT evasion, bestow a competitive advantage. This is what explains why tax evasion is so universal. It is this last feature that is likely to be key to how to fight it. In short, I think small businesses are all in a massive ‘prisoner’s dilemma’ as concerns tax evasion.

Let me explain. Consider a auto repair shop business, with many small firms in fierce competition. These firms have an option to evade taxes, e.g. VAT and income taxes, which allows charging a lower price. Suppose every business pays all the taxes and, as a result, there is some prevailing price in the market. At this price, all firms earn just about ‘normal’ profits. Then, any business that starts paying ‘envelope wages’ receives the benefit of lower labor costs and, therefore, can afford to charge a slightly lower price and, therefore, compete away the customers from other repair shops. The other firms face a choice: mimic behavior of the tax evader, or lose their customers and go bankrupt. Thus, tax evasion is likely to spread very quickly. Once everyone is engaged in tax evasion, for any one firm to start paying taxes is equivalent to suicide. The reasoning is the same. Paying all taxes implies higher costs and, therefore, higher prices. If prices are higher compared to the competitors, the result is losing customers and going out of business. Thus, it might be in the collective interest of all firms to pay taxes, but it is in private interests of any individual firm not to pay any taxes.

The implication is that piecemeal measures will not work. An increase in tax inspections by 10, 20, or 30 percent will not work. Whatever the fines, the firms will not start paying taxes as long as other firms don’t pay. Market discipline is a far better policeman than the tax authorities are. If some firms faces a fine that is ‘too large’, it would make more sense to shut down the firm and open a new one. The implication is clear. What we need is a surge (a parallel to U.S. tactic in Afghanistan and Iraq) of ‘sticks’. I am talking about a massive, coordinated, and simultaneous attack on tax evasion by a fully revamped State Revenue Service (SRS). I am talking about potentially doubling (if necessary – tripling) the budget of SRS so it could have better people, more of them, and the best technology out there. I don’t have the detailed blueprint, of course, but I know it can be done. There are many countries out there who are very good at collecting taxes. There is no reason why Latvia can’t become one of them.

To sum up, I think politicians should spend more time thinking about what’s the right thing to do, and then spend even more time explaining the voters why that is the right thing to do. In contrast, what we see is massive cowardice across the political spectrum. Our problem is that there are too many ‘politicians’. We badly need statesmen, individuals who have the guts to do what they think is right, regardless of what the voters think about it. raksts

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