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Portugal’s Budget Crisis: A Gordian Knot of Conflicting Policy Goals by Sven R. Larson

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Portugal’s Budget Crisis: A Gordian Knot of Conflicting Policy Goals

On December 7, the European Conservative reported that Portugal’s national parliament had been dissolved by President Marcelo Rebelo de Sousa. Prime Minister António Costa’s government fell after having lost a budget vote. 

The Portuguese political crisis comes on the heels of a political crisis in Sweden, where the incumbent prime minister also lost a budget vote in parliament. However, unlike Sweden, where parliament just held another vote for prime minister, Portugal will hold a snap election on January 30. Eight parties, spanning the ideological spectrum from communists to national conservatives, will compete for 230 seats and the levers of government power. 

One of the top priorities for the new parliament will be to pass a budget. Given the nature of the budget impasse that led to the current political crisis, it is unlikely that the election will change much. The budget crisis started making headlines in October but has been simmering for many years; the events of this fall were just another battle in an ongoing war between incompatible policy goals. 

At the heart of the budget deadlock are three policy goals: economic growth, a balanced budget, and more funding for the welfare state. The conflict between these three goals is not unique to the Costa budget, nor is it unique to Portugal. This is a Europe-wide volcano that happened to erupt in Portugal, and has led to an attention-grabbing political crisis. 

According to Euronews.com, the budget crisis erupted when the left decided that Prime Minister Costa’s budget failed to adequately increase funding for entitlement benefits. They wanted to see more money to boost “the purchasing power of ordinary Portuguese citizens.” They also demanded that the budget “improve public services.” 

While the budget did propose increases in pensions, especially for retirees with lower benefits, and an increase in the minimum wage, that was apparently not enough. Reuters reports that the Communist and Left Bloc parties refused to accept the Costa budget on the grounds that it did not do enough in terms of “protection for workers.”

The left-wing parties then went on to criticize Prime Minister Costa of being “too focused on deficit cuts.” 

In those words lies the very core of the policy-goal conflict that brought down the Portuguese government. 

This conflict is not to be taken lightly. It has been less than a decade since the European Union forced Portugal to implement a series of harsh budget-balancing policies. During the austerity crisis, which for Europe as a whole lasted from 2009 to 2014, the EU enforced strictly the rules on government debt and budget deficits laid out in the Stability and Growth Pact. Formally known as Article 126 of the Treaty of the Functioning of the European Union, the Pact mandates that member states limit their consolidated government debt to 60% of gross domestic product (GDP). Current budget deficits must not exceed three percent of GDP.

During the austerity crisis, Brussels made deficit-relief money for Portugal conditional on the Portuguese parliament tossing aside all other policy priorities in order to balance its budget. As a result, the parliament sharply increased sales, property, and income taxes. They also cut tax deductions and entitlement benefits. 

The austerity measures led to political protests and some social unrest. The country paid a high price for the austerity policies, which is why Prime Minister Costa, according to Reuters, wants to protect Portugal’s “hard-earned international credibility.” 

The prime minister’s concerns are valid. Today, Portugal finds itself again staring down into the austerity dungeon. Its current debt is back to where it was at the height of the austerity crisis. In 2014 government debt reached 134% of gross domestic product (GDP) up from 72% of GDP in 2007. By 2019, the Portuguese government was able to move the ratio below 120%. But as of the second quarter of 2021, the debt-to-GDP ratio was above 135%. 

This is due to the economic shutdown of 2020; fortunately, that shutdown led the EU to suspend fiscal enforcement actions under the Stability and Growth Pact. Prime Minister Costa wanted to take advantage of this leeway, which may end by 2023. 

It is going to take a significant amount of work by the Portuguese government to bring the debt down to levels tolerated by the EU. Costa himself has expressed hope that Portugal can do this by next year. This is questionable, especially since the welfare state accounts for two-thirds of Portuguese government spending. Once deficit hawks clash with welfare statists, the parliament in Lisbon could easily end up back in the same fiscal impasse. 

Economists often suggest growth-promoting economic policies as a way to break this deadlock. By stimulating business investments and increased workforce participation, government can look forward to higher tax revenue and solve its deficit problems without cutting welfare-state spending. 

This solution to the conflict between deficits and welfare-state funding is not new; rather, it is as old as the redistributive welfare state itself. It was defined in detail for the first time by Swedish economist Gunnar Myrdal in his and his wife Alva Myrdal’s book 1934 book Kris i befolkningsfrågan (“The Demographic Crisis” in English; the book has never been translated). Mr. Myrdal, the economic architect of the Swedish welfare state, acknowledged that the taxes needed to fund the welfare state would stifle economic growth. Therefore, he said, government would need to implement certain policies to stimulate growth.

None of Mr. Myrdal’s policies are of a kind that can reasonably be implemented in 2021, but today we find the Portuguese government trying hard to follow Myrdal’s overall policy recommendations. 

There is still hope of a creative solution to the problem. Beyond their ambitions to increase public-sector investments and thereby stimulate economic growth, Prime Minister Costa and his cabinet did not reach very far into the bucket of growth policy measures. 

They could have used taxes, but the tax side of their budget was plagued by the same policy conflicts as the spending side. On the one hand, the Costa budget proposed some mild changes to corporate taxes to encourage corporate investments; on the other hand, on the personal-income tax side they overwhelmingly promoted the welfare state and its underlying ideology of economic redistribution.

A detailed, English-language account of the Costa budget is available from leading Portuguese legal and business consulting firm Macedo Vitorino. On the personal-income side of the tax code, the Costa budget proposed two adjustments to lower the tax burden:

  • An extension from three to five years of the conditional partial tax exemption for employees aged 18-26. Eligible individuals can exempt from tax 10% to 30% of their income;
  • An increase in the number of tax brackets from seven to nine, with the two new brackets modestly reducing the tax rates for low and moderate incomes.

Tax cuts of all kinds, including conditional deductions and rebates, are good for overall economic activity. This means they also help stimulate economic growth. 

At the same time, however, the design of these two reductions also introduces disincentives toward activities that would help the economy grow. Young people usually make less money than older workers, which means that the extension of the youth deduction also benefits workers with lower incomes. When the individuals who benefit from the youth tax exemption grow older, they face a sharp rise in their tax burden. The less money they make, the less impactful will the exemption loss be. Therefore, they are encouraged to stay in low-paying jobs as long as they can.

The addition of two more brackets to the tax code has a similarly discouraging effect on workers’ income progression. The tax burden is reduced somewhat for middle-class families, but the two brackets also steepen the marginal income-tax ladder. 

In plain English, this means that the reward for earning more money shrinks with every extra €1,000 a taxpayer earns. It is essential for economic growth that workers want to improve their skills and education. By making it more expensive to do so, the youth tax rebate and the steeper marginal-tax ladder actually raise the bar for growth in the Portuguese economy. 

But there is more. The Costa budget also proposed two measures to raise taxes:

  • The top tax rate of 48% applies from €75,009 instead of €80,882;
  • Income earners who reach this highest bracket will no longer pay a 28% tax rate on net capital gains, but must instead add those earnings to their work-based income. 

This is a significant twenty-percentage-point tax hike for high-income taxpayers. Statistically, as a household’s income increases, it tends to rely increasingly on income from capital gains, dividends, and other forms of investment-based earnings. This increase would likely motivate high-earning taxpayers to relocate to a lower-tax jurisdiction, bringing with them both household spending, business investments and tax payments.

Again, the ideological preference for income redistribution trumps the policy goal of economic growth.

A small number of changes to the corporate income tax, including a partial deduction of investment expenses, are not strong enough to encourage the economic growth needed to solve Portugal’s budgetary Gordian knot. In fact, the investment-cost deduction, known as the Recovery Tax Incentive (RTI) is restricted in its application to such a degree that if it were to be implemented, it could prove to entirely ineffective. Corporations using the RTI cannot lay off employees or distribute stock dividends for three years. 

The budget traps the Portuguese parliament in a policy conflict that will require more than just another election. So long as the ideological preference in the government’s fiscal policy leans in favor of the welfare state, the growth-stifling measures will continue to also set the tone for the economy as a whole. Plain and simple: low GDP growth, slow tax-revenue growth, and perennial deficit problems.

Portugal needs a new economic direction. The parliament that is elected on January 30 should break with tradition and focus all its fiscal-policy efforts on growing the economy. The need for this shift is urgent: according to an analysis by Fitch Solutions, political uncertainty has increased with the elevated budget battle—and uncertainty is poison for business investments.

A new direction means prioritizing economic growth over funding for the welfare state. Practical policy reforms must include deregulating the Portuguese labor market; according to the Index of Economic Freedom, published by the American think tank the Heritage Foundation, Portugal has one of the most excessively regulated labor markets in Europe. With a labor freedom score of only 44.1, the country is far behind the Czech Republic (an index score of 77.1), Ireland (76.1), and Lithuania (74.4). 

It is common in economic policy to use tax reforms to stimulate economic growth. On the personal side, fewer tax brackets are preferable to more. For every tax bracket removed, the cost of increasing one’s income is reduced. The corporate side is different, but simplicity, transparency, and predictability are often just as important as a low tax rate. 

Entitlement reform can also help stimulate growth and stabilize the budget. Rather than using benefits programs to redistribute income, the Portuguese parliament could redesign its entitlement-program roster to provide a dignified, but last-resort level of benefits. 

With a welfare state more in tune with the conservative principles of the British Beveridge Report than the Scandinavian model for economic redistribution, Portugal would be able to reduce taxes and regulations. This would stimulate economic growth and put the economy on a higher growth path than has been the case in the past. 

Most of all, these reforms would give the citizens of Portugal a fair chance to gainfully support themselves without having to rely on government handouts to make ends meet. At the end of the day, there is no better guarantee for peace, prosperity, and a thriving democracy than an independent, self-determining citizenry.

Sven R. Larson is a political economist and author. He received a Ph.D. in Economics from Roskilde University, Denmark. Originally from Sweden, he lives in America where for the past 16 years he has worked in politics and public policy. He has written several books, including Democracy or Socialism: The Fateful Question for America in 2024.

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