In the last five years, in order to finance the large budget deficits in Europe, governments increased taxes; in the case of France and Greece, there was an increase of almost 5% in the total burden of GDP. France now levies 55% of its GDP in tax and in the case of Greece increases in taxes are starting to not bring more revenue. A new approach seems to come:
“In January France announced plans to cut payroll taxes by €30 billion. [In March] Italy unveiled income-tax cuts worth €10 billion for those earning less than €25,000 a year. [In the same month] Britain proposed tax cuts for most people on low or medium incomes. Ireland and Spain are also planning tax cuts (…).” (i.)
Most part of these countries are planning to finance this tax cuts through public-spending cuts, since borrowing is no longer possible due to the high levels of debt (just Italy has a public debt of 133% of GDP). Politicians believe that this will be the best way to incentive economic growth and increase competitiveness since in the euro-zone is not possible to devalue or lower their own interest rates. Also, politicians know now that they cannot repeat the same mistake that they did in the past, tax cuts financed by borrowing do not lead to growth in the long term. The explanation is that tax cuts have two effects: the substitution effect, which raises the economic activity in the short run by decreasing leisure and increasing consumption, saving and investment; and the income effect, which leads to an increase in consumption and leisure, leading to a lower labour supply; the total effect is ambiguous but if in addition the tax cuts are not financed by spending cuts but instead through an increase in external borrowing (just like Greece or Italy did in the past), it will lead to higher public debt and a reduction in long term growth. (ii.)
Some economists believe that more than tax cuts, what Europe really need is a tax reform. They suggest that instead of Italy’s approach to cut income taxes, it should reduce employer-paid social security charges, to lower labour costs and incentive companies to hire more workers and increase investment. They also suggest Italy to abolish IRAP (Italy’s regional production tax). Italy is one of the few OCDE member countries that taxes what firms produce rather than profits after expenses, raising business costs and lowering incentives to invest and hire. (iii.)
What politicians need to understand is that not all tax changes permit growth. Tax reforms need to be used to promote more labour, saving and investment, and in some successful cases they can also create trade-offs between equity and efficiency.
(i.) The Economist; Lighting the Load. Austerity-hit countries in Europe try a new approach: cutting taxes, Mar 22nd http://www.economist.com/news/europe/21599396-austerity-hit-countries-europe-try-new-approach-cutting-taxes-lightening-load
(ii,) Gale, W.; Sanwick, A.; Effects of Income Tax Changes on Economic Growth; Economics Studies at Brookings http://www.brookings.edu/~/media/research/files/papers/2014/09/09%20effects%20income%20tax%20changes%20economic%20growth%20gale%20samwick/09_effects_income_tax_changes_economic_growth_gale_samwick.pdf
(iii,) The Economist; The Case for Radical Reform; Mar 24th http://www.economist.com/blogs/freeexchange/2014/03/taxation?zid=295&ah=0bca374e65f2354d553956ea65f756e0