Austerity is not the only option
Financial Times : July 8, 2010 : Michael Hudson
As Europe’s banking crisis deepens and the US economy stalls, most discussions of how to stabilise national finances assume only two options: “internal devaluation” (shrinking the economy by cutting public spending) and currency devaluation. Both aim to make countries more competitive: the first using unemployment to lower wages and imports, the second lowering export prices.
The Baltic states, in particular, have applied the first option to an extreme degree. Government cuts have shrunk the gross domestic product of Latvia and Lithuania by more than 20 per cent in two years, while wages in Latvia’s public sector have fallen by 30 per cent. The hope is that falling wages and prices will see economies “earn their way out of debt”, creating a trade surplus to earn euros that, in turn, can pay the debts that fuelled the post-2002 property bubble.
The second option has been tried less often. Those eastern European countries that have not yet joined the euro know that currency depreciation would delay their planned European Union membership. It would also raise the price of energy and other essential imports, aggravating the economic squeeze and trade deficit. Most leaders therefore find currency devaluation so unthinkable that, at first glance, austerity seems to be the only choice.
The problem is that austerity prompts strikes and slowdowns, which, in turn, shrink the domestic market, investment and tax receipts. As unemployment spreads and wages fall, mortgage arrears and defaults soar. Property prices have plunged too. Some business owners are even now taking a novel approach to escaping their debts: emigration.
Facing these two unpalatable options, some of eastern Europe’s leaders have begun to realise that there is, in fact, a third option: radical reform of the tax system. Taxes in most post-Soviet eastern European economies, along with countries such as Greece, are regressive. They add to the price of labour and industry while under-taxing property. Latvia is an extreme example: its flat taxes fall almost entirely on employment, meaning workers take home less than half of what employers pay.
The good news is that these high taxes on labour leave open the option of shifting taxes on to other areas, in particular land. Lowering taxes on wages would reduce the cost of employment without squeezing take-home pay and living standards. Raising taxes on property, meanwhile, would leave less value to be capitalised into bank loans, thus guarding against future indebtedness.
Hong Kong, for example, promoted its economic take-off by relying mainly on collecting the land’s rental value, enabling it to minimise employment taxes (currently 15 per cent). Yet throughout the former Soviet sphere, real estate taxes often have been only a fraction of 1 per cent until this year. This low tax on land was part of the reason for the property bubbles in these countries, because untaxed land value was paid to banks, which, in turn, lent it out to bid up prices all the more. Shifting the burden of tax from labour to land would actually hold down the price of housing and commercial space, because rental value that is taxed would not be recycled into new mortgages.
Housing costs typically absorb 40 per cent of family budgets in eastern European countries. Lowering this rate would help to boost demand elsewhere in the economy. A reduction to 20 per cent – the typical rate in Germany’s much less indebted economy, where lending has been more responsible – could even provide further scope for wage moderation without lowering living standards.
The main issue in eastern Europe and beyond over the coming years will be whether economies can free themselves from the twin burdens of heavily taxed wages and inflated housing prices, while avoiding an overdose of needless austerity. The clear alternative is a reformed system that focuses on taxing the rising land values created by general prosperity, or economic rent. It is worth remembering that taxing the “free lunch” of rising land values was part of the original liberalism of Adam Smith, John Stuart Mill and the Progressive Era reformers in the US, all of whom sought to make their economies more competitive. Today, tax reform is again the best option to help countries around the world regain their competitiveness.