OECD urges Spain to further hike VAT and make firing even cheaper

After a year of a draconian spending cuts and tax hikes under the government of Prime Minister Mariano Rajoy, the OECD on Friday recommended another battery of measures -- some of them radical -- in its latest report on the Spanish economy.

The Organization for Economic Cooperation and Development’s Christmas wish list includes further value-added tax rate hikes, making it even cheaper to sack workers, an overhaul of the pension system to lower benefits, the elimination of partial retirement, the removal of tax deductions for contributions to private pension schemes, the withdrawal of some fiscal breaks on existing mortgages on the family home and a tightening of the conditions for entitlement to unemployment benefits.

The report confirms forecasts for Spain included in the OECD’s Economic Outlook report released earlier this year, which envisage unemployment climbing above the unprecedented figure of six million and staying there for the next two years.

“Spain is immersed in a prolonged recession. The depressing impact on activity of private sector deleveraging and the need for sizeable fiscal consolidation following the bust of the domestic credit boom has been compounded by the euro-area debt crisis and structural rigidities in the labor market, resulting in an increase in unemployment and a banking crisis,” the report says.

“The prospect of an immediate recovery remains remote as deleveraging of the private sector still has a long way to go while the feedback loop between government finances and the banking sector remains strong,” the report adds.

The Paris-based organization said a swift completion of the overhaul of the financial sector is essential, while confidence in public finances needs to be restored. The OECD also believes the drastic labor-market reform introduced in February by the Rajoy administration still falls short of the mark.

Despite the austerity drive, the OECD forecast predicted that the government would not meet its deficit-reduction targets. It put emphasis on controlling the finances of the regions and backed calls for the establishment of a truly independent watchdog to oversee public spending.

Pensions

While praising the overhaul of the state pension system introduced by the previous Socialist government extending the retirement age from 65 to 67, the OECD said more had to be done to ensure the system’s viability. Among other things, it called for the swift introduction of an “indexation formula linking pension system parameters to changes in life expectancy,” something that is not currently planned in Spain until 2027.

It also called for the calculation period for setting the size of the pension a retiree receives to be increased from the current last 25 years of working life to the whole working life and to increase the number of years of contributions to obtain a maximum pension from the current 37 years. “These settings do not sufficiently acknowledge long contributory careers, penalize people with stable earnings throughout their working lives, and not incentivize extending working lives after the relevant periods of contribution have been reached,” the report says.

Tax changes

The OECD believes the tax regime in Spain is overly focused on labor. While lauding the government’s decision to raise the standard value-added tax rate from 18 percent to 21 percent and the reduced rate to 10 percent from eight percent, it argued that the standard rate should be extended to more goods and services.

“A number of sectors continue to benefit from substantially reduced rates and the VAT tax base should be broadened further, moving most goods and services to the full rate,” it said. It identified tourist-related and transport services, which are currently taxed at 10 percent.

In terms of tax breaks, the OECD argued that those applied to private pension contributions should be eliminated as these “mostly benefit middle- and high-income households. The OECD welcomed the government’s decision to do away with tax benefits on new mortgages for the family home as of the start of next year, but suggested they also be further extended for existing mortgages.

Labor reform

While describing the labor reform of February this year as a “substantial step in the right direction,” the OECD suggested more needed to be done. The government cut compensation for unfair dismissals from 45 days' wages up to a maximum of 42 months for every year worked to 33 days and a maximum of two years.

“Severance pay for unjustified dismissal should be cut further as even at 33 days’ wages, firing costs for unfair dismissal remain high in international comparison,” the report says.

The agency noted that there are still big differences in the compensation paid to temporary and permanent workers. “If the reform does not prove effective in reducing duality substantially, moving to a single contract with initially low but gradually increasing severance payments could reduce the difference in dismissal costs of temporary and permanent contracts,” the OECD suggested.

The OECD also recommended that the government consider reducing the maximum period of entitlement to unemployment benefits from the current two years and called for strict enforcement of conditions for receiving it, such as proof that the unemployed worker has been looking for work.