Comment on: Saving Europe? The unpleasantarithmetic of fiscal austerity in integrated economies

Juan Carlos ConesaStony Brook University

Cambridge, September 2016

Are the countries in Southern Europe solvent?

Conesa Discussion on: Saving EU Cambridge, September 2016 2 / 17

Are the countries in Southern Europe solvent?

Is it feasible to increase taxes in order to restore fiscal solvency in the EUgiven the increase in debt observed in the data?

This paper provides very little room for optimism

Conesa Discussion on: Saving EU Cambridge, September 2016 3 / 17

Are the countries in Southern Europe solvent?

Is it feasible to increase taxes in order to restore fiscal solvency in the EUgiven the increase in debt observed in the data?

This paper provides very little room for optimism

I will argue in this discussion that things might be even worst than whatthis paper implies

Conesa Discussion on: Saving EU Cambridge, September 2016 4 / 17

The economic environment

General equilibrium infinitely lived model with two twists:Endogenous capacity utilization ⇒ capital income taxes aredistortionaryLimited depreciation allowance

Standard setup for the specification of capital ownership and itstaxation

Conesa Discussion on: Saving EU Cambridge, September 2016 5 / 17

Basic Experiment: Can southern countries pay for debt?

Dynamic Laffer curves substantially below the closed economyscenario usually considered in the literature (Trabandt and Uhlig, andothers)

A lot lower for capital income taxes, maybe some hope with largeincreases on labor income taxes

Tax competition (strategic interactions) makes things worse

Conesa Discussion on: Saving EU Cambridge, September 2016 6 / 17

Basic Experiment: Can southern countries pay for debt?

Dynamic Laffer curves substantially below the closed economyscenario usually considered in the literature (Trabandt and Uhlig, andothers)

A lot lower for capital income taxes, maybe some hope with largeincreases on labor income taxes

Tax competition (strategic interactions) make things worse

I think it is even worse

Conesa Discussion on: Saving EU Cambridge, September 2016 7 / 17

Why do I think it is worse?

1st: Mendoza, Razin, Tesar estimates of tax rates are too low(indicating there is still room)

They are average tax rates, marginals are much higherStill they do not seem to include social security taxes (?). My owncalculations using the same methodology yield much larger effectivemarginal tax ratesIf that were true, room for tax increases is not there (Trabandt-Uhligargue Europe near pick of Laffer curves)

2nd: Southern countries have already made huge effort

3rd: The “standard setup” used underestimates the ability of firms to“escape” taxation

Conesa Discussion on: Saving EU Cambridge, September 2016 8 / 17

1st: Our (Conesa-Kehoe) estimate of effective marginaltaxes in Spain

Conesa Discussion on: Saving EU Cambridge, September 2016 9 / 17

2nd: Magnitude of recession (GDP)

Conesa Discussion on: Saving EU Cambridge, September 2016 10 / 17

2nd: Magnitude of recession (fiscal revenues)

Conesa Discussion on: Saving EU Cambridge, September 2016 11 / 17

2nd: Fiscal adjustment

GDP down by 10%

Fiscal revenues down by 15%

Government expenditures have gone down by 10%

Still large deficit remains

Tim was wrong: Huge effort done, yet more to do (deficit remains).Higher interest rates won’t help

Conesa Discussion on: Saving EU Cambridge, September 2016 12 / 17

So...

This paper leaves only room for increases in labor income taxes

Yet, VAT revenues in Southern countries are lower than in Northerncountries

Bringing up revenues and further cutting expenditures will be extremelydifficult

Reforms to entitlement/welfare programs are unavoidable in SouthernEurope, more so given projected demographics

Precedent: Scandinavian experience after large crisis of early nineties

Conesa Discussion on: Saving EU Cambridge, September 2016 13 / 17

3rd: No hope for capital income taxes. What do I mean bythe “standard setup”?

The standard budget constraint is: ct + kt+1 = wt + (1+ rt − δ) kt

This is equivalent to: ct + νt (st+1 − st) = wt + dtst , where st denotesholdings of shares, νt denotes price of shares, and dt denotes dividendpayments

In this scenario, firms own capital and the objective function of the firm isdynamic: max

∑∞t=0 ptdt , where dt = f (kt , nt)− wtnt − xt

Easy to prove these two scenarios are equivalent, i.e.ν0 =

∑∞t=0 ptdt = (1+ r0 − δ) k0

Conesa Discussion on: Saving EU Cambridge, September 2016 14 / 17

Capital income taxation in practice

In the standard setup capital income taxes are levied as τ(r − δ)k

As in Strulig and Trimborn (2012) or Conesa and Dominguez (2013),in practice

Dividend taxesCorporate taxesCapital gains taxes

In the data, firms find many ways to avoid taxation (Slemrod,Chetty-Saez)

Conesa Discussion on: Saving EU Cambridge, September 2016 15 / 17

Why does that matter?

Trabandt and Uhlig report European countries close to top of Laffer curves

Strulig and Trimborn (2012) argue things are even worst in alternativesetup (nearly flat Laffer curves for ALL forms of capital income taxation)

Conesa and Dominguez (2013) solve for optimal policy and argue corporatetaxes should be zero, and dividend taxes should be set equal to labor taxes

Conesa Discussion on: Saving EU Cambridge, September 2016 16 / 17

Also related to literature on tax competition

Klein, Quadrini, Rios-Rull (Markov perfect equilibrium) study US vsEU

Explains US higher reliance on capital taxes than EUMain reason is smaller size of public sector

Soojin Kim (impact of migration) study UK vs rest-of-EURelative to only capital mobility, mobility of labor implies lower capitaltaxes in UK and higher rest-of-EU capital taxesReason is higher productivity in UK (attractive for workers)

Conesa Discussion on: Saving EU Cambridge, September 2016 17 / 17