Thursday 24 November 2011

European Tax incentives.

Taxes define the state
Historically, one of the key hallmarks of a successful state is the ability to impose and collect taxes. From ancient Egyptian times, to the Roman era and more recently to the Ottoman and American empires, tax collecting is not just a money raising activity but delimits the scope of the state’s power and its effectiveness. Sometimes it goes even further as a means of defining citizenship or nationhood. It comes therefore as no surprise that a sure sign of a failed society or a mismanaged state, is its inefficiency and negligence to collect taxes. Following this, the only way to claim that we have a united Europe is to have some form of united tax and tax collecting mechanisms that are accountable to the people of Europe. This has to be done in a democratic way and NOT some unelected officials. We have to adhere to the principle of "No Taxation Without Representation".

In this respect, the demands of the IMF on the Greek government to improve their tax collecting efficiency goes beyond a pure technocratic measure. It is akin to a call to rebuild a state and a society that lays in (Greek) ruins.

Greek tax incentives
Before attempting to provide explanations of the mechanisms that are responsible for this mess it is instructive to illuminate the mess Greece is in.

In essence, the Greek tax laws are very complicated. On average 5 tax laws are passed every year (17  in 2010) with tax officers unable to keep abreast of the most recent whims of their ministerial masters. While in the late 80’s tax arrears totaled €200mln in 2010 that figure is a staggering €33bln. The information technology revolution seems to have escaped the attention of the modern Greek state where paper filing is still king. Sporadic attempts to introduce computers only resulted in a proliferation of different systems and databases that do not communicate with each other. As a result the cost of collecting taxes is 2-3 times the European average. Corruption among tax officers is rife and has never been dealt with effectively. Tax evasion cases take on average 7-10years to be resolved in Greek courts by which time a tax amnesty is bound to happen. There is one tax amnesty almost every 3 years, which by amazing coincidence correlates highly with election time (Nov 2010, is the 10th since 1985, and more to come). Thus, one can argue that it is almost a state policy not to collect taxes.
In fact most economists would describe the Greeks as acting rationally within their own economic habitat. Volunteering to pay taxes is not a human trait. Some say it is a God given right to avoid paying taxes. 

Why Governments need to collect taxes. Incentives

On the surface, one is puzzled by the inability of the Greek government and the political establishment to raise tax revenue as this is the lifeblood of the state and the essential nutrition of the bureaucracy and the political elite. A clue is given by the exponential growth of tax arrears in the years 1995-2010. Governments have a big incentive to develop the economy and the tax collecting effectiveness, because, this is how they survive and exercise their power.
Against this incentive, a Government needs to balance the unpopularity of the taxes they are imposing and in modern democracies this costs votes. Thus a healthy equilibrium is reached and we have a functional state.

Incentives were altered in Europe. Moral hazard

This equilibrium of incentives was violated in Greece and in other peripheral countries, first in the 90‘s by the extension of European subsidies with no strings attached (a cost free cow to be milked) and secondly by the entry into the Euro system and the availability of borrowing at very low rates. Politicians did not have to make hard financial and political choices. They used the subsidies in order to get re-elected and the cheap borrowing to cover any shortcomings. Economic productivity was decimated as traditional industries fell prey to the rising globalization and was replaced by borrowing. GDP growth came from consumption which was fueled by even more cheap borrowing. Why bother with fixing the tax system when you can borrow at low rates with the implicit European guarantee? The spread of the Greek bonds to the Bund which now stands at roughly astronomical levels was at 30 basis point in 2002 and was close to 70-100 for most of the time. One can mitigate his unpopularity by yet one more tax amnesty. It is possible to delay dealing with hot potatoes until the opposition is in power and then to sabotage any attempts to fix things in order to get re-elected once more. Politicians became debt junkies.

Moral hazard and the disequilibrium of incentives is a very powerful force. It is like compound interest. It acts on a long timescale and it passes undetectable on a daily basis. Slowly, the voices of reason and common sense started fading away. Politicians who advocated restrain and prudence became political eccentricities and increasingly unelectable. Populism rose and an arms race of nepotism and exuberant political pledges took over.

The roots of what has happened in Greece are completely analogous to the situation in Arab states that discovered oil or to African states with mineral deposits. In all cases the shift of economic incentives for the ruling party/government acted as a retarding force for the economy and created dysfunctional and failed states. In the Arab world, oil supported totalitarian regimes and in Africa contributed to economic misery, civil wars and gun democracy. In Greece and in other EU countries the subsidies and cheap funding supported the profligate policies of hungry for re-election politicians.

The European bail out of Greece and of other peripheral states, is dealing with the symptoms of the crisis and not with the root causes. None of the moral hazards or the imbalances of political incentives is dealt with in a European level. Once the IMF finishes its work and leaves, the irresponsible behavior will resume in Greece and in other European member states. By that time a more coherent bail out package would exist and a transfer of creditworthiness can resume from the rich north to the south either through a European Bond (I do not mean  a proper Eurobond but the joined guarantee one) or some other mechanism.

This is not what European citizens want. The current crisis is an opportunity to reset the core European foundations on a more concrete and moral footing ready to meet the challenges of the future. In this respect the current crisis could do us a great service only if we draw the right conclusions and act on them.We need a more democratically accountable Europe, one that citizens would be proud to be members of not just a union dictated by unelected officials. This is the time to address this democratic deficit. This is the time to address the Fiscal union. Failing this time is an option that should not be exercised.