Hurray for High Taxes!? - May 2009


 

Nobody likes high taxes. They kill the incentive to work or invest. They are, however, the unavoidable result of a political decision in favor of a high level of public services, such as education, healthcare, infrastructure and social security. Relative to the US, the Netherlands has a large public sector and high taxes, with a top marginal income tax rate of 52 percent. In the current crisis, a welcome side effect of high taxes becomes apparent: they cause so-called automatic stabilization. Automatically (that is, without any discretionary policy measures), tax receipts will drop sharply and cause the budget balance to deteriorate dramatically. But why does this lead to ‘stabilization’?

Suppose a Dutch worker sees his gross monthly income fall by 100 euros because of the crisis. His net income will fall by ‘only’ 50-60 euros; the remainder of the burden will be borne by the Public Treasury. As a result, public debt will increase, but the level of public expenditure will not be cut. In the US, where marginal tax rates are lower, this automatic stabilization is significantly weaker. A US worker, who experiences a 100 dollar (gross) wage cut, sees his net income fall by some 70-80 dollars, which means that he has to cut his personal consumption by more than his Dutch colleague does.
 
Public expenditure can cause automatic stabilization as well. Social security is more generous and comprehensive in the Netherlands than in the US, which means that during an economic downturn, social security spending will rise faster on this side of the ocean. Thanks to social security, a Dutch worker who loses his job will maintain more purchasing power than his suffering American counterpart.
 
What does this mean on a macro level? The Dutch budget will deteriorate quickly, from a surplus of 1% of GDP in 2008 to a projected deficit of 5.6% of GDP in 2010. This is largely the result of automatically falling receipts and rising expenditure. As this automatic stabilization is much weaker in the US, the current situation calls for more discretionary fiscal stimulation there than is required in the Netherlands. Fiscal stimulation packages in general have to pass the test of the three T’s (temporary, timely and targeted). This is where an additional benefit of high taxes becomes clear. The resulting automatic stabilization is by definition timely, temporary and to a certain extent targeted: it affects those individuals and firms that experience a drop in income - and those alone.
 
The above holds true if the automatic stabilizers are allowed to operate freely - that is, if the Brussels deficit ceiling of 3% is ignored and does not incite budget cuts.
 
The above article was written by Mark Roscam Abbing, Head of the sector Short-term Analysis and Fiscal Affairs with the Netherlands Bureau for Policy Analysis.