Deficit law leaves dilemma: raise taxes or cut spending?

After writing a deficit cap clause into the Constitution, Spain must stick to a long-term ceiling except in times of natural disaster, recession, or extraordinary emergencies and even then only with approval of Congress.

An accompanying law to be enacted by June 30 next year would set the actual limit for the structural deficit at 0.4 percent of GDP from 2020. The reform also obliges Spain to reduce public debt to within the European Union limit of 60 percent of GDP.

One thing is sending a message to the international money markets that Spain is serious about putting its financial house in order, but how will future governments balance the books. By reducing Spain's welfare state, or by raising taxes?

In the shorter term, with two months ahead of general elections, economists, labor leaders, and academics are demanding that the Socialists and Popular Party (PP), which pushed the law through Congress in September, now explain how they intend to keep their pledge. So far, all we know is that the Socialists plan to raise more money by reintroducing a wealth tax, and some kind of levy on the banks. The PP has already showed that it believes in spending cuts, having begun cutbacks in the regional governments it has taken over following the May regional elections.

Nobel Prize-winning economist Paul Krugman is a critic of tough fiscal policies, arguing that they are suffocating economic recovery, and that deficits are not necessarily dangerous: "The experience of the past two years has overwhelmingly confirmed what some of us tried to argue from the beginning: the deficits we're running right now - deficits we should be running, because deficit spending helps support a depressed economy - are no threat at all. And by obsessing over a non-existent threat, Washington has been making the real problem, mass unemployment, which is eating away at the foundations of our nation, much worse," he wrote in a recent article.

Former United Left leader Nicolás Sartorius, now the vice-president of the Fundación Alternativas think-tank says that the deficit cap means an end to fiscal policy. "We will be left with no fiscal capacity until Europe steps in to create a common policy, as happened when we lost the peseta and monetary policy."

But Juergen B. Donges, a member of Germany's Council of Economic Experts and a professor at the University of Cologne says that governments' hands are not necessarily tied once they accept a commitment to deficit reduction. "They just have to decide on their priorities. If a government wants to implement social policy it can, but it will have to take other spending needs into account."

Germany has set a limit of 0.35 percent of GDP for its budget deficit. Donges says it is important to remember that like Germany, Spain has set a limit on its structural deficit, "not the cyclical deficit." In other words, the two countries are free to implement measures to counter cyclical downturns. "The idea is to limit spending that mortgages future budgets year after year," he says.

In 2009, Spain's public spending deficit was 11.1 percent of GDP, or 111 billion euros. If the limit in 2020 is 0.4 percent of GDP, that means the deficit would be equivalent to 4 billion euros. That means cutting spending by almost 40 billion eurosa year between now and 2020.

Alfredo Pastor of the IESE business school says that the constitutional requirement to limit the deficit sends out the wrong message. "It is a disgrace to put this in the Constitution. It is the job of government and Congress to control the deficit. Putting it into law gives the impression that they do not know how to do their job," says the former secretary of state for the economy under prime minister Felipe González. "This is a purely cosmetic measure aimed at calming the markets that will have little impact, because the markets are more concerned with the slowdown of growth," he says. "I think that there will be exceptions for times of crisis."

What margin does the government have to raise tax rates? Other countries hard hit by the crisis, like Portugal, Ireland, Greece, and Iceland have all introduced tax hikes over the past 10 years, raising them again last year. The top rate of income tax in the four countries is now around 45 percent. But Spain, along with France, Germany, and Italy, saw the top tax bands fall over the last decade, to 43 percent in the case of Spain.

José García Montalvo, a professor of economics at the Pompeu-Fabra University in Barcelona, says that the crisis has been a reality check for Spain: "A society like ours, which doesn't like paying taxes has to understand that it is putting the welfare state at risk. The politicians have to tell the electorate whether they are in favor of raising taxes or cutting spending."