Time to Burst Spain’s Public-Sector Bubble

This week Prime Minister Mariano Rajoy announced new tax hikes and spending cuts to reduce Spain’s monstrous budget deficit, prompting demonstrators to join striking coal miners to protest the austerity measures on the streets of Madrid. But for all the talk of tough cuts, Spain’s default risks have not nearly been eliminated. The Spanish state still spends at a level far surpassing the economy’s capacity to yield revenues to support it.

Among this week’s measures—which Spain’s cabinet will officially approve today—is a hike in the rate of VAT to 21% from 18%. Civil servants’ wages are being slashed by 7%, unemployment benefits beyond the sixth month will be reduced by 15%, and some bureaucratic expenditures and subsidies will be cut by a third. The planned increase in the retirement age to 67 from 65 will be sped up, and the pension amount for new entrants will be lowered.

Until now, the Rajoy government had tried to maintain the oversized public sector by raising taxes on families and enterprises. As one of his first actions after entering office, Mr. Rajoy raised marginal income-tax rates, placing them at some of the highest levels in Europe. In March, his government closed corporate tax loopholes but didn’t lower the headline rate, thereby imposing, in effect, a tax hike on many businesses. Like many of his fellow European heads of government, Mr. Rajoy has preferred to impose austerity on the private sector rather than on the state.

This week’s spending cuts are a step in the right direction, but Madrid is still far from a sustainable fiscal position. It’s not even certain whether the new measures will allow the Spanish government to meet its EU-mandated target of a 6.3% deficit for 2012 given that only five months of the year remain.

The sad part of this story is that the bloat in the Spanish public sector is actually quite recent. Government spending swelled thanks to the extraordinary revenue growth provided by the housing bubble. Between 2001 and 2007, total revenues grew by 67% while expenditures increased by 57%. Spain ran modest budget surpluses for a few of those years, but those vanished as bubble revenues ran out while spending continued to grow. A 1.9% surplus in 2007 turned into an 11.2% deficit in just two years.

By the end of 2011, public expenditures were 75% higher (33% higher after adjusting for inflation) than a decade before.

In fact, Spain would have a balanced budget today if Madrid had frozen its spending per capita during the bubble years of 2001 and 2007, as Germany did. If the Spanish government wants to balance its books, it only needs to burst the public-sector bubble that was born out of the financial and housing bubbles.

Public spending would shrink by €21 billion, for instance, if the real income and number of civil servants per citizen were reduced to 2001 levels. If pensions were cut (in real terms) to 2001 levels, that would reduce expenditures by some €20 billion. Another €15-20 billion would be saved if unemployment benefits were consolidated. Eliminating subsidies to nonproductive industries, associations, trade unions and politicians would save more than €20 billion.

In other words, rationalizing some of the most patently inflated portions of Spain’s public sector would provide around €80 billion in savings. That would reduce our 2011 deficit by 90%—without any tax hikes.

The good news is that Prime Minister Rajoy has finally admitted that all budget items must be considered for cuts, even those which up to now were said to be untouchable. But for Spain’s economy to grow and not simply to stabilize, we need both additional spending cuts and tax cuts—precisely what the People’s Party had promised to do before last year’s elections. It is time for Mr. Rajoy to deliver on that pledge.

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