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Tuesday, 1 December 2015

UNDER-TAXING GREECE

Acknowledgement 5/1/2016: This post owes much to the thinking of A. Doxiadis and his book, Το Αόρατο Ρήγμα, on the structural characteristics of the Greek economy; as well as to conversations on tax with Gregory Farmakis. That's not to say either has endorsed the post of course. All errors etc are my own.

One of the stylised facts of the Greek crisis has been that Greece never truly overspent (barring perhaps 2009); if anything, it under-taxed. It's not hard to understand where this argument comes from - just compare revenue and spending as a % of GDP between Greece and the EU or the Eurozone average - the data are available here.

Clearly, in 1995 government spending in Greece was well below the EU average. It caught up quickly, but even so was still very close to the EU average around the 2005-7 period, especially after allowing for higher interest costs. Revenues, on the other hand, lagged the EU average by a persistent 4 percentage points each year since accession. On the face of it, it's more credible to look at Greece as a story of under-funding of the state than one of overspending.

Advocates of the under-funding hypothesis also point to the (unfortunately, now discontinued) dataset of tax by economic functions. This generally suggests that Greece has been taxing, eg., consumption more than the rest of Europe, while taxes on capital, once above the EU average, have fallen steadily and payroll taxes on employers have been persistently lower than the EU average (data here and here). Greek governments, the narrative goes, gave tax breaks to some industries, turned a blind eye to avoidance and evasion of social security contributions by others, then let taxpayers foot the bill.

This narrative eventually made its way, via the Trade Union movement, to the Greek Parliament's debt audit report - the definitive account of that kangaroo court that called itself the 'Debt Truth Committee.' It was one of the better-documented claims made in the report.
And it is wrong.

1. Greece is not what you think it is

Upset about Greece's low government revenues? Spare a thought for Tunisia's government, whose revenues are only ca. 24% of GDP- just over half the EU average. Is Tunisia's government under-funded? To be sure, it is less good at extracting tax from its population than the average EU country; but no one would dream of using an EU average as the yardstick for Tunisia.

Yet, by virtue of being an EU country, Greece is often benchmarked against the continent.The assumption is that Greece is a similar sort of country as its EU peers and the Greek state should rightfully expect similar revenues. If there is a difference in revenue, it is due to lower tax effort: a combination of lower tax rates or a lower level of tax compliance, which the state tolerates. In reality, this comparison is invalid. Greece may not be like Tunisia, but it is also not a mini-Germany, a mini-Spain or a large Portugal for that matter. It is structurally less well placed to yield large tax revenues.

The reasons are simple. All other things being equal, it's harder to tax the self-employed; of whom we have proportionately many more than other European countries. It's harder to tax the poor; of whom we also have more; and harder to tax retirees, of whom we also have more; finally, it's hard to tax chronically unprofitable micro-enterprises; of whom we also have more.

To illustrate how big the effect of these structural characteristics is, I wanted to focus on one example. Let's look at the components of market output that a government can reasonably expect to tax - the operating surpluses of financial corporations; the operating surpluses of non-financial corporations; the operating surpluses of organisations serving households; and the mixed income of households. You can find all of these figures here; unfortunately the figures are not expressed as % of GDP, which has to be done manually by comparing with these figures.

Once you run the figures, one set of numbers stands out - household mixed income. As pg 200 of Eurostat's ESA2010 manual explains, this is the income of self-employed people working in unincorporated businesses (ie not companies); it includes the income of business owners and their families. Hence the term 'mixed': these are part wages and part profits, and the two can only be separated arbitrarily.

Greece, as you might expect from my introduction, has the second-highest share of mixed income as a share of GDP in Europe, and had the highest bar none pre-crisis. But, whatever lazy journalists tell you, this structural issue is not common to all of the PIIGS countries. Greece stands alone amongst peripheral Euro countries in having its operating surpluses distributed in this way. At 23.7% of GDP in 2008, mixed household income as a share of total output was over three times higher than in Cyprus; more than twice as high as in Spain; nearly twice as high as in Portugal; and over 40% higher than in Italy. Spain was more or less on a par with Germany on this metric. In fact, to find economies similar to Greece's in their dependence on household mixed income, you need to go as far as Poland and Slovakia.





But what does this mean for tax? Well, there is a good correlation in Europe between mixed income as a share of GDP and the amount a government can raise from taxes on income and profits (data on this here). In fact, all of the high-tax/high spend Nordic economies have tiny mixed income contributions to GDP; while those with high mixed income contributions tend to be recent accession countries. The correlation isn't perfect of course, and I am guilty of cherry-picking; the correlation becomes less neat after 2008. I believe the reason for this is the increased tax effort of some economies over others during and after the crisis; as tax effort rose most amongst those countries with the lowest tax revenue, it makes sense for the correlation to weaken. In fact, in later years the curve tends to flatten as all countries apparently aim to raise at least 5% of GDP in income and corporation tax.



Now look very closely at the revenue/mixed income graph. First- it suggests that tax effort in Greece may, if anything, have been relatively high pre-crisis. In a slightly different study looking at structural influences on tax revenues, the World Bank's researchers have found much the same thing, although for completeness I should note their colleagues at the IMF and IGC have found the opposite.

Yet another way of approaching this would be to consider how far along the Greek laffer curve we were in 2010. As veteran readers know, we have an estimate of this from Trabandt & Uhlig (2012), who found that 2010 Greece could only increase its tax take by 2.4% of GDP by raising capital taxes before it started falling again. It could increase it by a maximum of 4.8% of 2010 GDP by also maximising labour taxes. True enough, Greece has never since managed to get to that peak, but even without a major recession it seems the best we could ever do would be to catch-up to the EU average.

Now the tax to mixed income graph we discussed earlier suggests that, if the mixed income contribution in Greece were to fall to where Spain's is (ie by 12 percentage points - which is to say, very substantially), we might expect income and corporation tax revenues to rise by a good 4% of GDP - incidentally the same margin by which our government revenues have chronically lagged those of the rest of Europe.

Does all of this not sound familiar? This over-reliance on self-employment and very small businesses is precisely the same distortion that is responsible for the bulk of Greece's lead over the rest of Europe in terms of hours worked per person. Isn't it time we reviewed this properly? I know you've heard it said a million times that small businesses are the backbone of the economy, and that entrepreneurs will save Greece/Europe/the world; I have worked in small business advocacy for years and I have some sympathy for this view. But not all self-employment is enterprising and not all small family businesses are small and family-run for the right reasons. A Greek self-employed pharmacist may be an entrepreneur; but some of their colleagues are also effectively civil servants with a profit margin. A Greek freelancer may be a flexible go-getter; or they may be an employee whom the employer doesn't want on their books so they can avoid national insurance contributions.

Here's a heretical proposal; why not adopt the change in mixed income as % of GDP as a simple indicator of structural change? Whether it is a good thing, I cannot say. But it is worth noting that, by this token, Spain, Croatia and Bulgaria are the star post-crisis reformers; much more so than Greece.

UPDATE 22/12: I've looked into why the mixed income of Greek households has fallen as a share of GDP here. In summary, and with the exception of construction and law firms, there is no evidence that this is a sign of 'reform' - Greece's mixed income-generating sectors are withering on the vine rather than formalising.

An ideological aside

I don't wish for readers to interpret the above as a suggestion that the Greek economy must be reformed into a shape that maximises tax revenue. Paying taxes is nobody's idea of the meaning of life or the purpose of economic activity. But we need to accept that the current setup leads to low revenues, almost inescapably. We can choose to accept a low-revenue, low-spend equilibrium; tax ourselves to the gills to achieve a high-spend, high-ttax equilibrium with very low output, or aim for a low-revenue, high-spend and high output equilibrium and accept the hardship that will surely come whenever the credit line next dries up. There is no other choice.

2. Tax revenue is not what you think it is

In addition to misunderstanding what kind of country Greece is, the discussion of Greek tax effort also ignores what tax revenues are, and why ours are different than many other EU countries'.

Tax revenue isn't just money the state takes. Some tax revenue is also money the state makes. It is a return on past public investment. By this I don't mean tax revenues resulting from fiscal multiplier effects, which should be small on a cyclical basis if the public finances are consistently well managed. I am referring to tax revenues resulting from the deepening of physical, social or human capital as a result of public spending.

Essentially, when a government invests productively, it builds public capital which in turn boosts the productivity of the private sector. Better roads and ports enable trade. A nation-wide electricity grid makes appliances more reliable and homes more valuable. A fibre-optic network brings more people within reach of their peers and of online retailers. More educated, informed, empowered or healthier people are both more productive and more demanding. Simply- and well-regulated industries are more trustworthy and productive. At the extreme, the state can sometimes build entirely new kinds of intellectual capital; it can become a venture capitalist of sorts, creating whole new fledgling industries for the private sector to explore - the premise, after all, of Mariana Mazzucato's Entrepreneurial State.

The better an investor the state is, and the more it allocates funds to investment rather than consumption, the more its tax revenue will tend to grow as a share of GDP, holding tax effort and state capacity constant. The share of its tax revenue that reflects returns on investment will grow, while the share of revenue that reflects coercion and rents will shrink. If, on the other hand, government spending fails to build valuable capital and improve productivity across the economy, then over time returns on public spending will fall as a share of GDP - forcing the state to increase its tax effort or its capacity just to stay still.

The right amounts, the wrong places

Is there reason to believe that this has happened to Greece in the run-up to the crisis? Yes. We invested broadly the right amounts, but got very little by way of returns. Government gross fixed capital formation was not low in the pre-crisis era, and with the exception of the year 2005 it was almost unwavering at ca. 3.5% of GDP (Eurostat claims that none of this was defence spending, by the way). That put us ahead of places like Norway or Sweden, but just short of Spain or Ireland and way behind Portugal.


The problem then was not the allocation of public spending between consumption and investment, but rather the quality of public investment and its complementarity with private investment.
There are some very good long-term calculations for Greece, in two studies in particular. Kamps (2004) finds very strong returns on public investment between 1961-2001, more so than in other EU countries; but these are what are known as partial returns - ie they look at the returns on public spending without considering the losses from crowding out of, or by, private investment. Using data from 1960 to 2005, Alfonso and St Aubin (2008) confirm the finding of strong partial returns on public investment, but find negative total returns due the negative response of public investment to private investment. The actual, total effect of public investment in Greece was negative .

 A second ideological aside 

In discussing the money that government makes I do not pretend that all government spending builds capital; that all of it is efficient, or has high or even positive returns; or that the private sector would not, left to its own devices, have used the same funds better. All I am saying is that, undeniably, some tax revenue is a return on public investment.



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