Tax hikes 'self defeating' when trying to cut government debt: ECB paper

[February 08, 2016]  By Francesco Canepa

FRANKFURT (Reuters) - Raising taxes is "self defeating" when a country tries to bring down the ratio between its public debt and economic output, according to a research paper published by the European Central Bank on Monday and based on the euro zone's recent history.

The ECB, along with the European Commission and the International Monetary Fund, has been part of a Troika of institutions that has imposed austerity measures, including both tax hikes and spending cuts, on overly indebted euro zone countries such as Greece and Portugal in return for loans.

The paper, authored by Maria Grazia Attinasi, a member of the ECB's fiscal policies division, and Bank of Italy economist Luca Metelli, found that higher taxes fail to bring down the ratio between a country's debt and its gross domestic product (GDP).

"When fiscal consolidation is implemented via an increase in taxation, the debt-to-GDP ratio reverts back to its pre-shock level only in the long run, thus failing to generate an improvement in the debt ratio, and producing what we call a self-defeating fiscal consolidation," Attinasi and Metelli wrote in the paper.

They added that a reduction in government spending was more likely to generate a lasting reduction in the debt-to-GDP ratio.

Their findings were based on data from 11 euro zone countries, including bailout recipients Greece, Portugal and Ireland, between 2000 and 2012.

Greece's 2010 bailout program included cuts to government spending worth 7 percent of the country's GDP, coupled with tax increases equivalent to 4 percent of the economic output.

Greece's government debt-to-GDP ratio rose to 180 percent at the end of 2014 from 127 percent five years earlier, before the first bailout program, according to Eurostat data.

Portugal and Ireland also saw their debt-to-GDP ratios surge after entering into bailout programs that relied on higher tax revenues for around one third of the total fiscal adjustment.

In recent months, the ECB has repeatedly called for euro zone fiscal policies to be eased, albeit within the limit of European Union rules, so to support the region's anemic economic recovery.

"The findings of our analysis are of particular policy relevance in the context of the debate on the merits of fiscal consolidation as the main tool to restore debt sustainability in the euro area countries," the authors of the paper wrote.

The paper expresses the views of its authors, not those of the ECB.

(Reporting by Francesco Canepa; Editing by Catherine Evans)

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