Portuguese Fiscal Policy Assessment

Abstract: This work tries to do an overview of the Portuguese Fiscal situation ex-post the 2008 financial crisis. There is a short description of the GDP evolution and how it affected fiscal revenues and expenditures: revenues decreased with the crisis and then got up with taxes increasing and expenditures add an upward trend (from 2008-2010, for 2011 everything is projected). Moreover, we compute four types of fiscal balances (total, primary, adjusted from GDP and structural) and conclude that all of them incur a deficit and the huge gap is between the total and primary deficit, showing that the debt service is becoming heavier.

Course: Macroeconomic Policies Fall semester 2010 Professor: Joo Amador Teacher Assistant: Sharmin Sazedj

Diogo Silva no. 9395 Francisco Palmares no. 9647 Gustavo Direitinho no. 9320 Pedro Casimiro no. 9467

Introduction This work consists on a fiscal assessment of an European Monetary Union country. The country chosen to analyze was Portugal and the time range goes from 2008 to 2011 (2011 is a projection). The fiscal data (including projections) comes from the Stability and Growth program and Governmental Budget Bill 2011, mainly. The structure starts with a description of the economic activity (mainly GDP and output gap), fiscal revenues and outlays (and their components), and the deficit generated (including adjustments from economic environment and temporary measures, as well as fiscal policy cyclicality). After determining these flux variables, we compute and examine the sustainability of the public-debt stock variable. Finally we make a recommendation to future fiscal policy in order to ensure the sustainability of future generations and to fight the external pressures of foreign creditors. Evolution of the Economic Activity The description of the economic activity is important because it influences fiscal revenues, expenditures and deficits through the automatic stabilizers mechanism [insofar that a decrease in GDP (increase in unemployment) leads to less transactions and profits (thus less fiscal revenues) and higher unemployment benefits (therefore higher costs)] and all these variables are expressed as percentage of nominal GDP. Looking at graph 1, in 2009 Portugal faced a recession due to the world financial crisis, with a decrease in the real GDP of 2,7%. The components that contributed the most for this descent was the fall of investment and private consumption, with a variation of 11,1% and -0,8%, respectively. The only component that smoothed the drop of the GDP was the public expenditure item that registered an increase of 3,5%. In 2010, the product is expected to rise about 0,7%, driven mostly by the increase in private consumption, investment and net exports. In the following year (2011), GDP is expected to decrease 1% due to austerity fiscal measures, according to European Commissions forecasts. Regarding the output gap, since 2009, this indicator was negative. Portugal is, since 2009, producing more or less 2% under its potential GDP and this situation is not expected to change in the next years, which represents a negative situation for the expenditures and revenues. Please look at graph 2.

Portugals Fiscal Situation Our data was gathered from Growth and Stability Program of Portugal on March 2010, with some updates for 2011 from the European Commission forecasts and Government Budget Bill 2011.
Fiscal Revenues (graph 3)

Fiscal Expenditures (graph 4)

2009: -Highest drop ever (12%) -Total taxes fell by 11% -Social Contributions fell by 13% -Other revenues grew by 8%

2009: -Increment of 5% (reached 49% of GDP) -All components of the expenditure increased

2010: -Expected to increase by 6,5% (due to June increasing in VAT and Income Taxes) -Other revenues increased 20% -Temporary measures corresponded to 1,14% of GDP1

2010: -Small increase (1,7%) -Investment, Personnel Outlays, Social Transfers went up but by a smaller rate -Interest expenses were the only with an increasing rate, by 26%

2011: -Slight increase (1%) -Taxes revenues are expected to increase by 5,8% -Social Contributions go up by 2,2% -Other revenues will face a break of 6,6%

2011: -Public expenditures will decrease by almost 5%, according to the Governmental Budget -Investment, public servants wages and social transfers are the most punished -Interest payments keep growing (7%)

Confirming the Automatic Stabilizers dynamics! Link between the aggregates (in our sample): -Correlation between fiscal revenues and outlays is positive (0,278) -Correlation between fiscal revenues (absolute values) and real GDP growth (0,8328) -Correlation between fiscal expenditures (absolute values) and real GDP growth (-0,4824) Fiscal Policy is counter-cyclical

Total Fiscal Balance (the joint result of revenues and expenditures) graph 5: -In our sample, the government always incurred in a deficit (negative fiscal balance), although the decreasing from 2009 to 2011. The deficits registered have always out ruled the maximum of 3% of GDP (fulfilling ECs rules). -The pressure of external creditors imposed Portuguese Government to drastically reduce the deficit. The interest payments of government debt are the only factor that keeps an increasing movement. -2009: Highest value for the fiscal deficit (revenues fell by 12% and expenditures rose by 5%) 9,4% of GDP. Major reasoning: -Drop in output subsequent to the financial crisis, much weight on revenues drop. -2010: Fiscal deficit reached 7,56%. Major reasoning: -Economic recovery and Revenues increasing (measures from the Stability and Growth Program in March augment of 1% on VAT, Income Taxes, privatizations and other extraordinary measures, like the Retirement funds transfer from Portugal Telecom to the State) -2011: The deficit holds its reducing path, now to 4,83% of GDP. Major reasoning: Not only taxes will go up (like 2% on VAT) approximately 1% of GDP - but also expenditures are reduced approximately 2% of GDP, due to the weak financing conditions of the Portuguese Economy (from State and banks to households). A negative factor coming from these measures is the expected reduction on GDP by 1%. 3
1 Transfer of Portugal Telecoms Funds Retirement to States accounts

Evolution of the four fiscal balances There are four types of fiscal balances. We made the division to observe the impact of interests, economic evolutions and temporary policies on fiscal balance and reach fiscal balance that reflects more the structural / basis policies of the government. All deficits are positively correlated because the revenues account is in all of them: -Total fiscal balance. Simply the difference between fiscal revenues and public expenditures (if it is negative we have a deficit, if it is positive we have a surplus) graph 5 (already described on the previous scheme); -Primary fiscal balance, computed as the difference between fiscal revenues and public outlays excluding interest expenditures graph 5. We noticed that in 2008 the balance was positive (no interest payments would make the total balance positive), for 2009 the evolution is similar to total fiscal balance, from 2010 onwards the primary balance enhances while the total balance worsens this is the effect of an interest rate increasing on government bonds. -Cyclically adjusted fiscal balance, equaling the primary fiscal balance minus the effects of economic developments (GDP variation) on public finance. To calculate the latter, we used the 0.5 elasticity of public expenditures to GDP () suggested by the European Commission and the output gap (extracted from Bank of Portugals annual report) graph 5. Cyclically adjusted fiscal balance = Primary Balance *[ -(*Output gap)] The elasticity factor can be seen as the sensibility of fiscal balance to output deviations (unemployment deviations). The sign is always positive, a 1% increase in the output gap (real GDP grows more than potential) causes the fiscal balance to go up, ceteris paribus. The huge change in the output gap (recession) is responsible for the worsening of 4% of GDP on the total fiscal balance. It behaves from then on negatively without any more relevance, i.e. the output gap is negative thus the automatic stabilizers put a downward pressure on total fiscal balance. -Cyclically adjusted fiscal balance, adjusted for temporary measures (structural balance). Temporary measures are extraordinary actions whose effects concern just one period of time (graph 6). This indicator can be seen on graph 5 and tells us what would be the fiscal balance without the extraordinary cash inflows.
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For 2008, without the temporary measures, fiscal balance would be near zero instead of positive. For 2009 they were zero. The reduction on the deficit for 2010 had very helpful temporary measures, specifically the transfer of Portugal Telecoms Retirement Funds to the state. Otherwise, the recovery of the fiscal balance would be slower (as the structural balance shows). This shows the difficult for the State to contain expenditures, dragged by the post 25th of April upward expenditure trend, graph 7. Even worse, because Public investment is decreasing (graph 4), this waste of resources is allocated to consumption and interests (vicious cycle). Dynamics of Public debt The definition of a deficit (flux variable) is how much is added to the public debt (stock variable) from one period to another. So the public debt must have been increasing. The important point here is that it reached levels above 60%, going against the rules of the European Commission. The special fighting measures invoked by the 2008 financial crisis put Portugal on a dangerous side of indebted countries. From this sentence follows the issue of public debt sustainability. Using the equation given on Dornbusch and Fischer Macroeconomics book2, the variation of the debt must be equal to zero to ensure sustainability, so deficit on 2011 must equal zero. The results obtained are on graph 8. It should be interpreted as the governments amount of savings required to ensure that debt doesnt increase, given the conditions of the economy: inflation, interests and GDP growth. To be more rigorous with our work, we computed the governments amount of savings needed in order to comply the 60% maximum imposed by European Institutions on public debt GDP ratio. The results are scary and can be viewed at graph 9.

The values are impossible to perform. Even for the debt to be constant they are really hard.
2-

x b * r y) or, according to ECs rules (b = 60%), x [b * (i y )]

b , b=debt-GDP, x=primary balance (1 y )(1 )

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An ordinary median Portuguese habitant must save 4306 and give it to the State to fulfil the EC rule, corresponding this amount to 26,55% of his/her wealth (for 2010). For 2011, the value get worse and rise up to 5656,51, 33,04% of GDP per head. Recommendations Given our analysis and the current upward pressure for sovereign bonds interest on the financial markets, the Portuguese state is forced to save more, containing the growing debt. To achieve this goal, in the short-run, the government can follow two different paths: -Reduce Expenditures: Comparing to Europe, Portugal had follow the same pattern of its European counterparts until 2009. In 2010, the average expenditures of European countries fell sharply in opposition to the Portuguese one that had maintained its increasing pattern (graph 10). In 2010, European public outlays are expected to equal Portugals. -Raise public revenues: The average of their European tax revenues (graph 11) have fallen in the time period considered, while the Portuguese ones fell sharply (2009) and rose (2010). The fact of the Portuguese tax burden being bellow the EU average may lead people to believe that Portuguese tax burden can converge to the EU average. However, we have to take in to account that a rise in tax burden could worse GDP growth. Furthermore, EU burden is higher but the quality of its public services is also higher. Please look at graph 12. In the medium-run government can adopt structural policies, fighting the problem via economic growth: The Portuguese state should adopt some structural reforms, such as in labor market, attracting more investors (less bureaucracy), making the country more competitive. Basically, enable GDP to grow, which in turn would help fixing public debt sustainability. To conclude the state must distinguish two types of approaches, one for short-run time period, in which is imperative to reduce government expenditures or in a last resort case increase even more the tax burden to accomplish EU norms (Deficit=3% of GDP). And another approach for the long run scenario, undertake structural measures with the single objective of increasing GDP growth rate (certainly an issue for another future work).

References: Stability and Growth Program of Portugal, March 2010 -

http://www.portugal.gov.pt/pt/GC18/Documentos/MFAP/PEC2010_2013.pdf General Governmental Budget Bill for 2011 (useful to make updates for 2011) http://www.min-financas.pt/inf_economica/OE2011/Rel-2011.pdf; financas.pt/discursos/Apres_OE2011.pdf Bank of Portugals Autumn Bulletin 2010 http://www.bportugal.pt/pthttp://www.min-

PT/EstudosEconomicos/Publicacoes/BoletimEconomico/Publicacoes/bol_outono10_p.pdf European Commission, Economic and Financial Affairs division -

http://ec.europa.eu/economy_finance/sgp/convergence/programmes/index_en.htm Dornbusch, Rudiger, Fischer, Stanley, Startz, Richard, Macroeconomics, 10th Edition. www.pordata.pt www.publico.pt www.ecb.int

Annexes: Graph 1:
3.0% 2.0% 1.0% 0.0% -1.0% -2.0% -3.0% -4.0% -5.0% 2008 2009 2010 2011 Real GDP (homologous variation) Nominal GDP (homologous variation)
Source: SGP 2010, Governmen tal Budget 2011

Graph 2:

Output Gap
0.50% 0.00% -0.50% -1.00% -1.50% -2.00% -2.50% -3.00% 2008 2009 2010 2011
Output Gap

Source: Annual Report of Bank of Portugal

Graph 3 (Evolution):
25.00% 20.00% 15.00% 10.00% 5.00% 0.00% 2009 -5.00% -10.00% -15.00% 2010 2011 Social Contributions Other revenues Total taxes Total revenues
Source: SGP 2010, Governmen tal Budget 2011

80.00%

60.00%

Social Transfers Interest payments

40.00%
Subsidies

20.00%

Investment Other outlays

0.00% 2009 -20.00% 2010 2011

Total expenditure

-40.00%

Graph 4 (Evolution): Graph 5:

2.00%
Source: SGP 2010, Governmen Source: tal Budget SGP 2010, 2011 Governmen tal Budget 2011

0.00% 2008 -2.00% 2009 2010 2011

Total fiscal balance

Primary fiscal balance

-4.00%

Cyclically adjusted fiscal balance Cyclically adjusted fiscal balance, adjusted for temporary measures

-6.00%

-8.00%

-10.00%

Temporary measures (% GDP)

1.40% 1.20% 1.00% 0.80% 0.60% 0.40% 0.20% 0.00% 2008 2009 2010 2011
Temporary measures (% GDP)

Graph 6:
Source: Annual Report of Bank of Portugal

Graph 7:

Source: Banco de Portugal (http://pedroarrojagrupofinanceiro.blogspot.com/2009/01/despesa.html)

Graph 8:

Sustainability of public debt

5.000% 4.000% 3.000% 2.000% 1.000% 0.000% 2008 2009 2010 2011
Sustainability of public debt

Source: SGP 2010, Bulletin of Bank of Portugal

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Sustainability of public debt (60% GDP)

0.35 0.3 0.25 0.2 0.15 0.1 0.05 0 2008 2009 2010 2011
Sustainability of public debt (60% GDP)

Graph 9:
Source: SGP 2010, Bulletin of Bank of Portugal

Graph 10:
52.00% 51.00% 50.00% 49.00% 48.00% 47.00% 46.00% 45.00% 44.00% 43.00% 2008 2009 2010
Government expenditure EU-15 (% of GDP) Despesa Total (% PIB)
Source: Eurodata (through Pordata website)

Graph 11:
46.00% 45.00% 44.00% 43.00% 42.00% 41.00% 40.00% 39.00% 38.00% 37.00% 2008 2009 2010
Receita Total Government revenue EU - 15 (%GDP)
Source: Eurodata (through Pordata website)

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Graph 12:
45.00% 40.00% 35.00% 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% 2008 2009 2010
Tax Burden PT

Source: Eurodata (through Pordata website)

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