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Juncal CuñadoSchool of CC. Economics and Business Administration, University of Navarra

Implications of the tax cut

Fri, 21 May 2010 07:20:40 +0000 Published in Expansion (Madrid)

The recent events experienced by the equity and public debt markets, the danger of debt sustainability, and international pressure from our European partners forced the Spanish government to carry out a tough fiscal adjustment.

Specifically, these measures are aimed at reducing the public deficit by 0.5 percentage points more in 2010 and by 1 percentage point more in 2011 than agreed in the Austerity Plan C by the Executive last January. At this point, we wonder what will be the implications of this demanding cut in the expense and public investment.

Firstly, the main objective goal was achieved, which is to reduce tension in both equity and debt markets. The cut announced by the Government allowed the Spanish bond yield differential against the German bond to almost halve, while the Ibex 35 reacted with rises on the same day as the tax cut advertisement . The volatility of the last few days is due to uncertainty about the impact of these measures and doubts as to whether or not additional adjustments will be necessary.

Secondly, the fall in civil servants' salaries, the elimination of the "baby check", the freezing of pensions and the rest of the measures, together with the VAT increase, will have a negative effect on the consumption of Spanish families, which will lead to a fall in aggregate demand and, therefore, in output. At a time like the present, when it seems that the Economics is beginning to recover (with a GDP growth rate in the first quarter of 0.1% compared to the previous quarter), the deficit cut could delay this recovery.

Thirdly, and under a "less Keynesian" point of view of Economics, there are different authors who argue that a tax cut could have positive effects on private investment, to the extent that it could increase the expected benefits of this investment.

A group of economists led by Alberto Alesina (Professor of Economic Policy at Harvard), in a article published in the American Economic Review in 2002, analyzed the effects of fiscal policy on private business investment.

The main results obtained suggest that a 1% reduction in the public expense (relative to GDP) can increase investment (also relative to GDP) by 0.2% in the first year, 0.5% in the first two years and up to 0.8% after the first five years.


In addition, the results show that the positive impact on investment is greater when the tax cut is made via public wages, to the extent that wage adjustments, also in the private sector, can have a positive impact on investment returns and, therefore, on an increase in investment and employment.

In this case, investment would increase by 0.5%, 1.8% and 2.8% after 1, 2 and 5 years, although this adjustment requires flexible conditions in the labor market. However, in a country with such a rigid work market as ours, it is difficult for this adjustment effect on wages, profits, investment and employment to take place. We will have to wait for the already announced, although not yet implemented, reform of the labor market to observe these changes.

Finally, it is also necessary to evaluate the cost that the announced mobilizations by trade unions and public employees, including a possible general strike, may have on the Spanish Economics . The Government should be concerned, because in addition to the impact of the tax cut on the economic status , its political impact will also have to be assessed, since it should not be forgotten that the status of the Economics and this subject of measures have a significant effect on the electoral result .