Portugal: Selected Issues

Portugal’s economy is in deep recession, and the crisis has opened up a large output gap, with severe consequences for employment and government revenue. While the focus is on the medium- and long-term, this analysis also offers insights on how deep the output gap is. It also highlights ways in which policies and reforms can promote growth over the longer haul and suggests that achieving a 2-percent growth rate over the long term—consistent with moderate convergence growth—is a realistic objective.

Abstract

Portugal’s economy is in deep recession, and the crisis has opened up a large output gap, with severe consequences for employment and government revenue. While the focus is on the medium- and long-term, this analysis also offers insights on how deep the output gap is. It also highlights ways in which policies and reforms can promote growth over the longer haul and suggests that achieving a 2-percent growth rate over the long term—consistent with moderate convergence growth—is a realistic objective.

IV. Growth-Friendly, Equitable, and Sustainable Fiscal Reform in Portugal1

A. The Scale of the Challenge

1. Fiscal policy in Portugal has traditionally been lax.2 Over the last 30-odd years, the government has incurred a structural deficit each year. Even in recent years, when output growth has been slow, public spending growth has been very high. For example, expenditure grew by 33 percent in real terms between 2000 and 2010, mainly fueled by the expansion of social protection, while real GDP increased by 6 percent. The increase in primary spending was more pronounced still. The fiscal space created by the membership of the euro area (interest payments decreased by about 3 percentage points of GDP between 1995 and 2005) was more than offset by permanent spending increases. Moreover, revenues failed to keep pace with the spending trajectory, despite improvements in tax administration. Two consolidation episodes were implemented in the last decade, but were short-lived.3 In particular, the 2006–07 adjustment was followed by a significant fiscal stimulus in 2009. Fiscal policy has been pro-cyclical for most of the years since 1995.4 As a result, fiscal imbalances accumulated over time.

uA04fig01

Fiscal Policy and Cyclical Position

(Year-on-year change)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A004

Source: Cunha e Braz (2009), Eurostat, IMF Staff estimates
uA04fig02

Growth in Public Spending 2000-2010

(Percent Change Year on Year)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A004

Sources: WEO; and IMF staff estimates.
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General Government Fiscal Indicators1/

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A004

Sources: Eurostat; and IMF staff calculations1/ Includes one-off transactions

2. The deterioration of the fiscal accounts was accompanied by aggressive off-budget spending, leading to a buildup of substantial contingent liabilities. The most important of these off-balance transactions was capital spending implemented through PPPs (15 percent of GDP in cumulative investment at 2012 prices, substantially above international practice). On average, this implied around 1 percentage point of GDP higher fiscal deficits over the period in which these concessions were granted (1995–2010). In light of a weak public financial management framework, these investments took place in the absence of an effective value-for-money assessment to ascertain their fiscal sustainability. The budgetary impact of this policy is projected to peak in 2014–16, but payments will last till about 2040. Similarly, the state-owned-enterprise (SOE) sector also expanded greatly, often to circumvent stricter policies applied to the general government entities, minimizing the impact of relevant transactions on the deficit and debt indicators.

3. The effect has been to leave Portugal as one of the most indebted countries in the euro area. With the advent of the global financial crisis and subsequent recession, plus the reclassification of hitherto off-balance sheet items and entities in the general government perimeter, public debt has increased sharply from about 65 percent of GDP in 2006 to some 120 percent of GDP at end-2012. Moreover, there remain sizable contingent liabilities posing a risk to the sovereign, including about 11 percent of GDP in SOE debt currently being serviced by companies classified outside the general government.

uA04fig04

Debt Composition

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A004

Sources: Eurostat; Bank of Portugal; MOF; and IMF staff calculations.

4. Since late 2010, the government has adopted an ambitious fiscal consolidation program to reduce the large fiscal imbalances. Under the EU/IMF-supported program (signed in May 2011), a sharp improvement in the primary balance to stabilize debt and a strengthening of fiscal institutions are central objectives.5 In particular, the structural primary balance is targeted to improve by some 9¾ percentage points of GDP between 2011 and 2014 to reach a surplus of 3½ percent of GDP in 2014. This will help stabilize debt at some 122 percent of GDP by 2014. The planned composition of this sizable adjustment envisaged a more expenditure-led consolidation. However, particularly in 2013, the consolidation effort tilted more towards the revenue side. Looking ahead, designing a fiscal policy with smaller output losses would require rebalancing this adjustment mix.

5. But the ongoing fiscal adjustment is a first step; putting the adjustment on a more permanent footing is the next hurdle. Going forward, if public debt is to decline to more manageable levels, Portugal needs to generate large primary surpluses for an extended period. For example, under an illustrative scenario, lowering public debt to 60 percent of GDP by 2030 requires an average primary surplus over this period of some 4 percent of GDP. Assuming total revenues remain at around 42 percent of GDP (higher than the pre-crisis levels), then primary spending would need to be reduced by about 5¼ percentage points of GDP relative to its 2013 level. And if, instead, public debt is to be reduced to 80 percent of GDP by 2030, the corresponding primary surplus would be 3 percent of GDP and, thus, a 3¾ percentage points of GDP reduction in primary spending from its current level would be needed.6

uA04fig05

Long-term Revenues and Spending 1/

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A004

Source: IMF staff calculations.1/ Targeting 60% of GDP Debt by 2030.

6. Moreover, spending pressures related to population aging would need to be accommodated within the lower spending envelope in the coming years. The old-age dependency ratio is projected to increase from 26.9 to 38.3 percent between 2010 and 2030, putting pressures on pension and long-term health care spending.7 Over the long run, the projected increase due to higher health care costs, mainly driven by technology changes, poses greater pressures on public finances than pensions spending—the latter has a more moderate spending path due to the 2007 pension reform (see below).

7. Reducing public debt and spending will thus require a careful assessment of the size and the role of public spending in Portugal, and how to pay for it. If the current level of spending is to be maintained, then taxes would need to increase significantly more in the coming years. The discomfort regarding the tax increases in the 2013 budget, however, points to limited appetite for further tax increases. The alternative would be significant spending cuts. And there may be scope to do this in a manner that will not compromise (and maybe even improve) public service delivery and equity. There appears to be room to move toward the efficiency frontier on various public spending outlays, implying that public services could be sustained in some areas with lesser inputs if efficiency can be increased. Moreover, Portugal has one of the most regressive market income distributions among OECD countries, which is not significantly corrected by fiscal policies, despite the generosity of the social security system. At a minimum, there is scope to better direct social benefits to those at risk of poverty.

uA04fig06

Redistribution through taxes and transfers

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A004

Source: OECD.1/ In ascending order of disposable income.

B. Towards A More Efficient and Better Targeted Expenditure Profile

Overall Considerations on Expenditure Policy

Spending Level

8. Public spending in Portugal is high relative to countries with a similar level of development. Although Portugal’s total expenditure as a share of GDP remains below the euro area average, it has been above the OECD average since 2005. This difference reached its peak in 2010, when Portugal’s public spending—at 51.4 percent of GDP—surpassed the OECD average by nearly 3½ percentage points.8 This large size of government reflects a divergence between real growth of public spending and output growth over the past decade. Although many other countries also increased spending, often at a faster rate than Portugal, this was generally accompanied by stronger output growth. The increase in the Portuguese public sector was, however, accompanied by anemic growth over the last decade. It is also noteworthy that the rapid increase in public spending preceded the global financial crisis, rather than being a consequence of the crisis or higher interest payments since then.

uA04fig07

Real Growth in Total Spending and GDP, 2000-2010

(Percent)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A004

Sources: OECD; Eurostat; and IMF staff calculations.
uA04fig08

Total Expenditure and GDP per Capita, 2010

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A004

Spending Mix

9. Spending is heavily concentrated in pensions and wages. These two categories represented 57 percent of primary spending in 2012. In terms of the functional composition, Portugal has relatively high spending on social protection, education, and law enforcement compared to OECD countries. On the other hand, health care spending is broadly in line with OECD countries and even below European peers. Finally, capital expenditures have declined sharply since the crisis and currently are about 2 percent of GDP. If the off-budget spending in PPPs is taken into consideration, this amount would go up. And in terms of spending outcomes, Portugal has high ratings in terms of the quality of its overall infrastructure (see Appendix II).

Public Expenditure, 2010

(Percent of GDP)

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Social Spending

Level of Spending and Equality

10. The increase in old-age pension payments is a major factor for the sharp expansion in total spending over the last decade. Social protection programs (including pensions, family benefits, and unemployment benefits) increased by some 8½ percentage points of GDP between 2000 and 2012, more than half of which was due to pensions. Some of the increase in social protection was well motivated since social protection spending in Portugal in 2000 was 3 percentage points below the 15-percent-of-GDP average in OECD countries at that time. Currently, however, social protection spending is around 2 percentage points of GDP beyond what Portugal’s level of development would suggest.

uA04fig09

Public Spending Increase, 2000-2012

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A004

11. But the high spending on social protection has not been effective in alleviating poverty. Public cash transfers9 account for a higher share of households’ disposable income in Portugal than in the average OECD country—20 percent for the working-age households and 74 percent for the retirement-age households compared to the OECD averages of 16 percent and 68 percent, respectively. But the cash transfers are highly regressive because a larger share of these transfers goes to the richer households. This is true for both cash transfers aimed at working-age households and for retirement-age households. Only in Turkey and Mexico are public cash transfers more regressive. This suggests that cash transfers programs, as currently configured in Portugal, may even be exacerbating inequality. This is partly explained by the reliance on contributory social insurance programs (including pensions and unemployment benefits) which generally go to the relatively well-off households instead of targeted social assistance programs which generally go to the most needy.

uA04fig10

Public Cash Benefits as a Share of Household Disposable Income, Households Aged 15-64

(Percent)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A004

Source: OECD
uA04fig11

Public Cash Benefits as a Share of Household Disposable Income, Households Above Retirement Age

(Percent)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A004

uA04fig12

Index of Progressivity of Cash Benefits, Households Aged 15-64 1/

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A004

Source: OECD1/ Negative=more progressive, 0=neutral, positive=more reggressive.
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Index of Progressivity of Cash Benefits, Households Aged 65 and Older1/

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A004

Pensions

12. Policy changes rather than demographic factors such as aging have been the key contributor to the sizable increase in pension spending. Between 2000 and 2012, pension spending increased by some 5½ percentage points of GDP. Specifically:

  • Around 45 percent of this increase is due to policy changes that increased the relative generosity of pensions (including increases to the minimum pension in the early 2000s), and another 10 percent has been due to increases in the number of retirees beyond what is implied by aging. In particular, the economic replacement rate—the ratio of pension spending per individual aged 65 and older to GDP per worker—reached 37 percent in 2010, about 10 percentage points higher than in 2000.

  • Only about 30 percent of the spending increase was due to population aging.

  • The natural maturation process of the pension system might have also put pressure on spending. However, this is likely to be a small factor since most pensioners receive minimum pensions and the benefit formulas have changed to account for full contribution careers.

  • The remaining 15 percent corresponds to macroeconomic factors (for example, employment dropped from about 72 percent of the population aged 15–64 in 2000 to nearly 65 percent of the population aged 15–64 in 2012).

uA04fig14

Evolution of Replacement Rates, 2000-2010

(Pension spending per population 65 and older as a percent of GDP per worker)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A004

Sources: OECD; Eurostat; and IMF staff calculations.

13. Pension expenditure is also relatively inefficient at reducing old-age poverty. Despite one of the highest pension spending-to-GDP ratios in the EU, the risk of being in poverty at old age is among the highest in Portugal.10 Hence, old-age spending is inefficient: each percentage point of pension spending reduces old-age poverty by only 4.9 percentage points, well below the European average of 7 percentage points. Part of the reason for this is that 40 percent of old age pension spending goes to the top 10 percent of the income distribution in the whole population. This poor allocation of pensions suggests that there is room to reevaluate benefits without compromising equity goals.11

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Poverty Rates and Pension Spending, 2010

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A004

Sources: Eurostat; and IMF staff calculations.
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Percentage Point Reduction in Poverty Rates for Each Percentage Point of GDP Spent in Pensions

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A004

14. The inefficacy of the public pension spending at reducing old-age poverty can partly be explained by the difference in benefits for workers in the private and public sectors. Pensioners from the civil service, namely CGA (special system for the civil service workers) beneficiaries, account for about 15 percent of all retirees but receive 35 percent of all pension spending. The average old-age pension in the civil service system is more than three times the average of an old-age pension in the general regime. The differences in pensions exceed the differences in earnings. This suggests that civil service pensions have a premium of at least 20 percent relative to private sector pensions. This is further exacerbated by considering that civil servants work fewer hours per week and, in many cases (e.g., for the military, diplomats, and justice officers), have a benefit formula that counts more than one year of contributions for each year of work. In addition, the slow transition under the recent reform still allows many to retire early: nearly 55 percent of all new retirees of the public pension system were younger than age 60 in 2012.

Comparative Indicators Between CGA (Public System) and GCR (General Regime)

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15. Measures adopted in recent years have started addressing some of these problems, but only in a limited way. The 2002–07 pension reforms were successful in containing long-term pressures due to the adoption of, among other measures, equal benefits across all workers (civil service and private sector), a sustainability factor linked to life expectancy, and higher penalties for early retirement. Indeed, after taking into account these reforms, pension spending is projected to increase by 0.7 percentage points of GDP over 2010–30 rather than by about 4½ percentage points of GDP—an increase that would have taken place due to demographics in the absence of policy changes.12 Still the reforms so far have not addressed the current high level of pension spending. Some recent measures have helped alleviate this problem, but in a provisory way. These include the temporary suspension of the 13th and 14th payments in 2012, the suspension of the 14th payment in 2013, and the introduction of progressive benefit reductions.13 There seems to be further scope to address the short-term fiscal pressures while increasing the equity of the pension system. Options to consider include further reducing benefits for current pensioners (particularly for the more generous civil service regime), and fully equalizing benefit formulas for all future pensioners (including for years of service prior to enacted reforms that have generally been grandfathered under old, more generous formulas). In addition, benefit eligibility for future pensioners could be curtailed for example by increasing the statutory retirement age (currently 65 years old).

Non-pension Social Benefits

16. Non-pension social spending comprises various programs that are not particularly expensive compared with peer countries, but are poorly targeted. The programs include unemployment insurance (generous for those who qualify but with very low coverage), family benefits (e.g. parental leave, children benefits), and others (e.g. funeral expenses). These programs are not sufficiently targeted at the needy. For instance, in 2009 the top 20 percent of income earners received 33.8 percent of total social protection spending, while the bottom 20 percent received 13.2 percent. Options to increase the efficiency and equity of this spending could include: improving the coverage of the unemployment benefits scheme while reducing its generosity; expanding means-testing for family allowances; and enhancing targeting and rationalizing remaining benefits, including by avoiding fragmentation.

Wage Bill

17. The public sector wage bill in Portugal has traditionally been high relative to peer countries. The wage premium for public employees in Portugal is about 10 percent above the average European country, even after controlling for factors associated with earnings level (marital status, education, labor market experience, managerial responsibility, full time status, and geographical variables) (Giordano and others, 2011). Most of this disparity is explained by the relatively high pay for workers with lower qualifications. Recent efforts have helped to reduce the wage bill (from 12.7 percent of GDP in 2009 to a projected 10.4 percent of GDP in 2013), due to temporary compensation cuts and employment restrictions. In terms of wage levels, efforts have focused on reducing high wages, which has further flattened the public wage structure. In terms of employment levels, the effort so far has focused on attrition and, hence, has not been the right tool to curb excess employment, which is concentrated in the areas of education and security. These are the sectors that show inefficiencies and employ more people than peer countries, even after controlling for number of students and inhabitants. Finally, the Portuguese public sector works the least hours (35 hours per week) among OECD countries, which leads to a widespread use of overtime pay, particularly in the health sector.

uA04fig17

Total compensation of public employees, 2000-2010

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A004

Sources: OECD and IMF Staff calculations
uA04fig18

Wage Differential Between Public and Private Workers, 2004-2007

(Percent)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A004

Source: Giordano and others (2011)

18. Among the reform options are to review both public employment and wage levels. The measures taken to date to rationalize the wage bill pose two problems: first, they have been of a temporary nature, and, second, the attrition policy mainly moved spending from the wage bill outlay to pensions, thus, not contributing to a net permanent reduction in public expenditure. Looking ahead, a mix of policy tools could be considered to reduce the wage bill: (i) adopting a compensation policy that encourages meritocracy and higher education, while reducing the wage premium in the public sector; (ii) increasing working hours in the public sector to improve productivity and reduce recourse to overtime pay; and (iii) targeting a permanent reduction in the number of employees in areas with excess employment.

Education and Health Sectors

19. Reforms in education could have a potentially large impact on efficiency and equity. The share of spending devoted to public education (6½ percent of GDP) is among the highest in the OECD—as noted above, mainly on account of the wage bill. But educational attainment indicators are below peer countries, suggesting scope to improve the efficiency in the sector. For example, only 48.2 percent of population aged 25–34 attains upper secondary education or higher, well below the OECD average of 81.5 percent. Only Mexico and Turkey have lower educational attainment rates for this age cohort. Moreover, standardized assessments indicate that, while Portugal’s performance has been improving toward the OECD average in reading, scores remain below the OECD average in mathematics and science. Despite the improvement in PISA scores for those in the system, the issue of coverage also remains unaddressed. The high dropout rates in primary/secondary education is leading to very low shares of the population with tertiary degrees (about 10 percent), one of the lowest among peers. The main driver of costs and inefficiencies in the education sector is the low pupil-to-teacher ratios that reflects the presence of many teachers with reduced or no teaching assignments. Improving the efficiency of spending and raising the educational outcomes is key to support productivity and contribute to long-term economic growth.

20. Given that the bulk of the education in Portugal is publicly financed, the state plays a key role not only in policy-making but also in implementation. Beyond the considering reductions in the number of excess teachers and wage premiums, a new strategy for the education sector could be developed to reduce Portugal’s human capital gap. Hence, fiscal consolidation could be the trigger for a more structural objective than just short-term savings. In particular, the school network could be further rationalized, given that primary schools are facing decreasing demand (due to demographics) and some have unused capacity. On the other hand, college education faces increasing demand but the legal restrictions to cost-recovery in the public university system may be a limiting factor on the availability of new resources for this area. Also, vocational education could be further developed to better match labor market needs.

21. Efficiency increases in the health sector are also important to contain the long-term pressure caused by ageing and technology. At some 7 percent of GDP in 2010, spending on health care in Portugal is in line with the OECD average. Ongoing reforms are reducing health spending further, particularly with regards to pharmaceutical costs—which were above European levels in 2010. As a result, further budgetary savings are hard to envisage within the scope of services currently defined. However, long-term projections are more worrisome: in the absence of reforms that limit rate of growth in health care costs, the continuation of historic trends would lead to public health care spending increase by 2½ to 4½ percentage points of GDP over the next two decades.14 This is one of the largest projected increases in public health care spending among the advanced economies, and would bring the Portuguese health spending to about 10 percent of GDP by 2030—clearly incompatible with the debt-reducing objectives. Therefore, the current far-reaching health care reform is a step in the right direction to address this issue, but the government will need to assess over time if the scope of the reform is sufficient to contain these costs. Some options that could be further explored are: raising user fees for those who can afford them and for nonessential medical procedures; continue rationalizing the hospital network and tighten the performance benchmarking system; and keep reducing the fragmentation of the system (e.g., parallel systems for public employees).

uA04fig19

Projected Increase in Health Care Spending, 2010-2030

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A004

Sources: OECD; Eurostat; and IMF staff calculations.

PPPs and SOEs

22. Rationalizing a series of public and quasi-public entities that have been a source of drag on the fiscal accounts is crucial for achieving long-term sustainability. The amount spent on PPPs increased fourfold between 2008 and 2011, when it reached about 1 percent of GDP. Moreover, contingent claims arising from PPP contracts have created an additional burden. For instance, spending on PPPs in 2011 was 25 percent higher than projected due to these claims. The NPV of gross spending on PPPs is estimated at 14.6 percent of GDP at 2012 values, or about 8 percent of GDP in net terms (if toll revenues are considered).15

23. Current policies aim at putting the SOE sector in operational balance. Even though this is a positive initial achievement, the financial results of these companies will still pose a significant burden over the medium term. For instance, in 2011 SOEs’ overall deficit was 0.8 percent of GDP and its negative net worth about 0.6 percent of GDP.16 These results reflect a sizable deterioration in the financial balance of SOEs between 2010 and 2011, which more than offset the improvement in the operational accounts. Overcoming this imbalance over the long term would require sustained structural reforms, in particular in the transport sector. The government has started improving the SOEs’ financial management, strengthening its operational efficiency, and pursuing a privatization program. A key long-term objective to reduce its burden on the public accounts would be to bring the SOE sector into overall balance.

C. Designing a Growth-Oriented Tax Policy

Overall Considerations for Reforming the Portuguese Tax System

The Tax Level

24. Portugal’s tax burden has historically been below the European average, but the ongoing consolidation is pushing it to a higher level. Indeed, relative to its per capita income17, the tax effort in Portugal was in line with average in 2011, also taking into account the generally high level of taxation in Europe.18 This level is being pushed further in light of the 2013 tax measures, with a projected tax burden of 37 percent of GDP. This suggests that increasing the tax burden much above current levels could be particularly difficult (from a tax administration perspective) and relatively distortionary (retarding growth).

uA04fig20

Tax-to-GDP Ratio and GDP Per Capita, 2000

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A004

Sources: Eurostat; and IMF staff calculations.
uA04fig21

Tax-to-GDP Ratio and GDP Per Capita, 2011

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A004

The Tax Mix

25. Portugal has opted for taxing capital more intensely than peer countries, while labor taxation has been lighter than European average. The higher implicit tax rate (ITR)19 on capital relative to labor income in Portugal contrasts with the practice of most other European countries. The lower overall ITR on labor is being pushed up following the significant increases in personal income tax rates in the 2013 budget. However, the high taxation of capital is an important issue to be addressed in order to boost the country’s attractiveness to investment and to support job creation. For instance, a shift from capital to consumption taxation (e.g. exploring some space to further streamline tax expenditures), could go in the direction of a growth-enhancing tax reform.

uA04fig22

Implicit Tax Rates

(Percent)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A004

Sources: European Commission (2012); and IMF staff calculations.
Growth-Oriented Reforms20

26. There is extensive use of tax expenditures with a view to promoting growth and equity but the pay-off seems questionable.21 Without rules to cap their usage and in the absence of a periodic reassessment of their effectiveness, tax benefits were expanded and reached 9 percent of GDP in 2010. Traditionally, there has been a weak institutional framework to estimate and assess policy in this area. Following recent initiatives to reduce the scope of tax expenditures, these are projected to decline to around 6 percent of GDP in 2013—a still high level. Portugal’s tax expenditures are poorly targeted, which may generate significant, although unintended, economic distortions. There is scope to streamline non-productive tax expenditures, which could be supported by a general evaluation based on a cost-benefit analysis. For those tax expenditures that will remain in the system, their granting criteria could be made more objective, ideally under a rules-based approach. In specific cases, better targeting to increase the effectiveness of the tax incentives could be justified (e.g. in the tradable and high value-added sectors).

27. Simplifying the tax system and modernizing the tax administration would help to improve the business environment. Beyond reducing tax expenditures (which make tax compliance more complex and less transparent), there is scope to: reduce the number of taxes and surcharges applied on similar bases (in particular, in corporate and personal income taxation); and streamline the VAT rates (see below). On the administrative front, Portugal has made significant advances in e-government, including electronic tax returns. The merger of three agencies into a unified revenue administration and the implementation of a Large Taxpayer Unit have been key recent accomplishments. But the allocation of resources in the revenue administration could still be improved, particularly by reducing the excessively large network of local offices and assigning resources according to a modern taxpayer compliance strategy. Improving third-party information access to effectively combat evasion is paramount to ensuring a level playing field for economic agents.22 Reforms to the judicial system are also important, given that an average tax resolution case of about 4 years is likely to discourage investments, especially large ones—which tend to be subject to more complex and longer disputes. Overall, a study on compliance costs could support a targeted proposal for simplifying the system.23

uA04fig23

Tax Expenditures Estimates

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A004

Sources: Portuguese Authorities; and IMF staff calculations.

Consumption Taxation

28. There is also scope to improve the efficiency of the VAT. The VAT C-efficiency indicator (which reflects a compliance gap and a policy gap) stood at 46.8 in 2010, slightly below European average (about 50). The existence of two reduced rates may explain this lower-than-average C-efficiency indicator. Compliance may be another reason but there is no official estimate of the VAT compliance gap. The significant reduction in the number of the goods and services subject to the reduced and intermediate rates in 2012 was a positive policy to improve the VAT C-efficiency. However, there is still some scope for a further widening of the tax base. Alternatives include a revenue-neutral adoption of a two-rate VAT (the rationalization of the reduced rates could open space for a reduction in the standard rate), or a revenue-generating reform by increasing the VAT C-efficiency to offset, for example, a more competitive CIT rate (see below).

uA04fig24

VAT C-Efficiency

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A004

Sources: European Commission (2012); and IMF staff calculations.

29. Equity concerns are the main argument for maintaining the reduced VAT rates. However, in absolute terms, higher income earners end up benefiting much more from such tax expenditure.24 This reinforces the argument that reduced VAT rates are not a well-targeted instrument to deliver social support, which should be achieved through targeted social policy.25 Moreover, some of the goods and services currently subject to the reduced and intermediate rates do not seem to target basic necessities (e.g. wines, cultural events, processed food).

Labor Taxation

30. The labor tax wedge in Portugal is low relative to European peers but higher compared to a broader group of OECD countries.26 In terms of composition, employers’ contribution in the total tax wedge is on average larger in Portugal than in other European countries. The sweeping changes in personal income taxation that will be adopted starting in 2013 will likely alter this profile. Looking forward, in order to encourage employment, policies could aim at (i) reducing the total tax wedge, (ii) focusing on a targeted reduction of the employers’ social security contribution (SSC) for low-paid workers, as employment demand tends to be relatively elastic among low-wage earners; and (iii) assessing the scope to broaden the SSC.

uA04fig25

Tax Wedge, 20111/

(Percent of Labor Costs)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A004

Sources: OECD; and IMF staff calculations.1/ For a single individual without children at the income level of the average worker

31. Over the medium term, it is possible to continue improving the PIT. Portugal is one of the few countries that apply a mandatory family unit concept.27 This imposes a high marginal tax burden on secondary earners, especially when the spouse earns a high income. It may cause disincentives for labor-market participation or for increasing work activity, especially because secondary earners are found to be relatively elastic in their labor supply. Recognizing this, most countries apply the tax to individual incomes, rather than to family incomes. Other issues that could be addressed are: (i) reducing fragmentation and simplifying the tax by eliminating the existence of multiple schemes (the general PIT, the extraordinary surcharge, and the solidarity surcharge); (ii) continuing to enlarge the taxable income (for example, some social security incomes—such as maternity leave—are not in the scope of the tax, even if earned by richer taxpayers); (iii) further reducing tax expenditures, in particular on education, health, and housing (given that Portugal’s education and health system are publicly provided and deliver universal coverage, tax expenditures in these areas are mainly a regressive policy enjoyed by the higher-income earners); and (iv) reassessing the statutory rate structure in the aftermath of the crisis (at 54 percent, the top rate will be one of the highest in Europe and may encourage tax evasion).

uA04fig26

PIT Revenue 2011

(Percentage of GDP)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A004

Sources: Eurostat; and IMF staff calculations.
uA04fig27

PIT Rate Structure 2010

(Percent)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A004

Source: Torres and Brys (2012); IMF staff calc1/ AW = Average Weight

Corporate Income Taxation

32. Portugal’s corporate income tax rate (CIT) is high relative to its peers. The CIT rate (31.5 percent) is higher than the European average (23.5 percent) and has moved in the opposite direction from peers in recent years. As a result, revenue collections as a share of GDP have been above the European average. Even though it is difficult to establish causality between high rates and a narrow capital base, Portugal has a smaller capital tax base28 than the regional average (the European capital base range is from 18.7 percent of GDP in Slovenia and about 40 percent of GDP in Ireland and the Netherlands, while Portugal stands at 22.5 percent of GDP). Thus, it may be taxing too much a limited economic base, and likely discouraging its expansion. This policy may reduce incentives to attract FDI. In order to address this problem, rather than reducing the overall rate, there has been a greater tendency in recent years to grant tax incentives. The effect of this has been to reduce the effective rate for some activities, but the policy has been less effective at increasing the total volume of FDI.29 Reasons for the relative ineffectiveness of tax incentives in Portugal may include poor design as well as the temporary and uncertain nature of the benefit.

33. In addition, the CIT structure is complex—comprising three different taxes that are not levied on a unified base. These include: the standard CIT, the State surcharge (which has two different rates depending on the profit level), and the Municipal surcharge (which has rates that vary from zero to 1.5 percent across municipalities, and may include a special rate for SMEs). Portugal is one of a few EU countries that levy a CIT at a sub-national government level. Such a tax is not appropriate for local governments, in particular for countries with small municipalities with high spillover effects. Its base is volatile and it is concentrated in rich jurisdictions. Lisbon alone accounts for 35 percent of total Municipal surcharge while poorer municipalities do not have scope to levy it. The two autonomous regions can also apply reduced CIT rates, a practice that may increase the risk of arbitration and avoidance schemes.

uA04fig28

CIT Revenues and CIT Rates

(Percent of GDP)

Citation: IMF Staff Country Reports 2013, 019; 10.5089/9781475589498.002.A004

Sources: European Commission (2012); and IMF staff calculations.

34. A comprehensive CIT reform aiming at rate reduction, base broadening, and simplification could support growth. Even though tax incentives could be used as a limited and targeted way of affecting resource allocation, the CIT system should build its advantages by attaining a lower ordinary rate, deep simplification, and stability. A leaner system could benefit from phasing out the Municipal and State surcharges. This would support reducing the overall CIT rate toward European average, while the rate differentiation between the mainland and the regions could be abolished, eliminating the problems posed by levying different rates within the same country on such a volatile base. A simplified regime for SMEs could also be analyzed, in order to facilitate compliance and control. Another important reform, which is already on the government’s agenda, is to address the CIT debt bias.30 Finally, the international aspects of the CIT design (e.g. transfer pricing rules, the country’s double taxation treaties, and holding regimes) could be revised with the view of encouraging investment and modernizing the Portuguese system. The government has recently announced that it will launch a reform along some of these lines, which is seen as a preferable option compared with sporadic interventions on base composition and applicable rates.

Property Taxation

35. The reform to be implemented in 2013 will likely push the Portuguese property taxation above the European average. Such policy is positive since property taxes seem to have a less adverse impact on the allocation of resources in the economy. It can also impose a higher burden on wealthier households owning more valuable real-estate property, which is a policy recently followed by the government. Moreover, this is a very stable tax base, well suited to local governments. Property tax revenues stood at 1.2 percent of GDP in 2010, already in line with the EU-27 average (1.3 percent of GDP). A medium-term challenge for Portugal could be: to shift the burden from the transaction property tax to the recurrent property tax; and to broaden the base for rural property taxation. Unwinding the distortive transaction tax would likely be feasible only after the ongoing reforms of the recurrent tax stabilize. On the other hand, the taxable value of rural properties has not been reassessed for a long period, resulting in a very low participation in the total recurrent property tax. Increasing rural property taxation could also help promote a more efficient use of land.

D. Conclusions

36. All in all, Portugal faces the significant challenge of completing its fiscal consolidation effort and enhancing the equity and efficiency of fiscal policy. To reduce public debt to the 80 percent of GDP mark by 2030, primary spending needs to be reduced by around 3¾ percent of GDP from its current level. Addressing this challenge requires a well-articulated design and successful implementation of specific policies. Crucial questions refer to choosing the appropriate level and composition of taxation and spending, clarifying the options regarding who will pay for and who will benefit from the public sector. The path of an expenditure-led adjustment seems more appropriate, given that the tax effort in Portugal is already aligned with the country’s income level. Given the relative regressivity of the existing spending policies in Portugal, there may be scope to reduce spending in some areas while enhancing equity. On the revenue side, even though the space to increase taxes is limited, there are some areas of the tax system that could be reformed to facilitate higher investment. In particular, the existing high tax burden on capital could be recalibrated toward consumption taxes. The reduction of sizable untargeted tax expenditures could generate space for rate reductions in the corporate and personal income taxes. Finally, simplifying the system and improving tax compliance would ensure a level playing field for doing business in Portugal.

Appendix I. General Government Fiscal Accounts

(Percent of GDP)
article image
Sources: Portuguese statistical authorities and IMF staff projections

Appendix II. Expenditure Outcomes

uA04fig29
Sources: OECD; Eurostat; and IMF staff calculations.

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1

Prepared by Andrea Lemgruber and Mauricio Soto (both FAD). Upaasna Gupta (EUR), Ariel Binder and Asad Zaman (both FAD) provided excellent research assistance. We are grateful to staff at the Minister of Finance, Bank of Portugal, European Commission, and European Central Bank for helpful comments. Usual disclaimers apply.

2

For a review of Portugal’s pre-crisis public finances developments, see Cunha e Braz (2009).

3

During the 2006–07 adjustment, relevant structural measures were adopted, such as the pension reform and changes in the civil service promotion rules.

4

The cyclical fiscal position is measured here by looking at changes at the structural primary balance.

5

In order to underpin the adjustment and minimize fiscal risks going forward, the authorities launched a broad fiscal structural agenda aiming at containing fiscal risks and streamlining the public sector. Such an agenda included the adoption of a new budgetary framework law, the operational restructuring and privatization of the SOE sector, a comprehensive health reform, and the modernization of the revenue administration.

6

These estimates do not take the effects of the cycle into consideration. They assume the revenue-to-GDP ratio remains constant and primary expenditure do not fluctuate with the cycle. Fiscal space generated as the output gap closes would help ease the estimated adjustment and/or could be used for tax rate reductions (see section III).

7

According to the Ageing Report 2012, the old-age dependency ratio measures the projected number of elderly persons (65 years old and above) and the projected number of persons in working age (from 15 to 64 years old).

8

In 2010, expenditure in Portugal included about 2¼ percent of GDP in one-off measures. Even without these measures, spending remained higher than the OECD average and above the countries at similar levels of GDP per capita. The acquisition of two submarines may also explain higher spending on order and safety compared to peers.

9

Public cash transfers include pensions (old age, disability, and survivor), sick leave, family benefits, unemployment insurance, and housing (cash) benefits.

10

The at-risk-of-poverty here is defined as the share of persons 65 and older with incomes below 40 percent of the national median income (after social transfers). Using a threshold of 60 percent of median income for the at-risk-of-poverty measure does not alter the conclusion: about 20 percent of the elderly have incomes below 60 percent of the median income, above a 16 percent average in Europe; each percentage point in spending on old-age, disability, and survivors benefits reduces at-risk-of-poverty rates (60 percent threshold) by 4.3 percentage points compared to 7 percentage points on average for Europe.

11

The large share of pensions going to households in the top percentiles of income distribution reflects in part the nature of social insurance, under which those who contribute more receive higher benefits. Reforms to increase equity require careful measures to avoid moral hazard. For example, focusing on benefit reductions for high-end pensions could potentially erode the link between contributions and benefits and increase incentives for informality.

12

See IMF (2011) and EC (2012). Note that these projections do not take into account the current consolidation efforts.

13

Pensions are reduced progressively (from a 3.5 percent reduction for monthly pensions of €1,350 to 10 percent reduction to pensions €3,750 per month and above). In addition, an extra 15 percent reduction is applied to pensions above €5,030 per month and 40 percent for those above €7,545 per month.

14

Portugal experienced one of the highest increases in public health spending over the last three decades—spending went from under 4 percent of GDP in the early 1980s to nearly 7 percent of GDP by 2010. Note that the EC 2012 Aging Report projects an increase in public health spending of 0.7 percentage points of GDP over 2015–30 taking into account mainly the demographic trend. This lower increase relative to the IMF estimates reflects an assumption that technology does not increase costs, which would be a sharp break from past trends (IMF, 2010).

15

See Ministério das Finanças (2012), Parcerias Público-Privadas e Concessões, Relatório 2012, Agosto/2012.

16

See Ministério das Finanças (2012), Setor Empresarial do Estado, Relatório 2012, Julho/2012.

17

Even though the level of taxation is the result of a political and societal choice, the capacity to tax seems to be positively correlated to the income per capita of a country. See Gupta (2007), and Pessino and Fenochietto (2010).

18

Pessino and Fenochietto (2010) suggest that Portugal’s tax effort is above average when compared to a larger set of countries.

19

The implicit tax rate is the result of the tax revenues divided by its underlying economic base.

20

A growth-oriented tax reform aims at minimizing the distortive nature of taxation. There are certain bases that are more sensitive to taxation due to their mobile nature. For instance, capital is highly volatile and, indeed, over the past years there has been a worldwide trend to reduce CIT rates. On the other hand, given its immobile nature, property taxes seem to have a minimal impact on economic behavior. However, the option for efficiency needs to be informed by an appropriate balance between certain trade-offs, for example on how to increase efficiency without hurting equity. Usually, equity considerations should be taken into account in the context of a broader set of fiscal policies, involving the effects of taxes and expenditures on income distribution. Some recent empirical studies have suggested that a shift from income (in particular, corporate income) to consumption and property taxation would be growth-enhancing (OECD, 2010 a, OECD, 2010 b, and EC, 2011).

21

Tax expenditures are government revenues foregone as a result of preferential tax treatment of specific sectors, activities, regions, or agents, namely: exemptions (exclusions from the tax base), allowances (deductions from the base), credits (deductions from liability), rate reliefs (reductions of the tax rate), and deferrals (postponement of payments).

22

Recent studies estimate the shadow economy in Portugal at around 19–23 percent of GDP (see Schneider 2011, and Murphy 2012).

23

OECD (2011) estimates the administrative cost in Portugal at 1.4 percent of total net revenues, higher than the EU average (1 percent of total net revenues). Also, the number of hours devoted to tax compliance in Portugal is estimated at 275 hours, one of the highest in Europe, while EU average stands at 184 hours (PwC, 2012).

24

Different papers have shown the use of direct transfers to poorer families as a more effective way to promote equity (Atkinson and Stiglitz, 1976, Deaton and Stern, 1986, Mirrless Review). A study done for Mexico demonstrates that the bulk of the benefits of the VAT zero rate accrues to the better-off. OECD (2010a) mentions that “[D]istributional arguments in favor of VAT rate differentiation may be more persuasive where countries do not have the administrative capacity to provide more direct transfers to poorer households.”

25

A study on UK shows that, if the zero-rating were abolished, the country could raise 0.79 percent of GDP in revenues even after compensating the poor. See www.imf.org/external/np/fad/news/2011/docs/Keen2.pdf.

26

OECD Taxing Wages (2012), OECD average does not include Chile and Mexico.

27

In Europe, only Luxemburg and France adopt this principle of mandatory family unit, while Spain, Germany, and Ireland offer the option to declare jointly. All other countries adopt individual taxation.

28

The capital tax base is the denominator of the ITR on capital, and is an approximation of the world-wide capital and business incomes of residents for domestic tax purposes. It comprises the net operating surplus, interests, insurance property income attributed to policy holders, rents on land and dividends for the sectors non-financial and financial corporations, households, self-employed, non-profit organizations, general government and rest of the world. For a detailed methodological description, see European Commission (2012), Taxation Trends in the EU.

29

An important consideration about tax incentives nonetheless is that they cannot make up for deeper constraints on investment such as competitiveness, especially if embedded in a tax structure that is misaligned with international practice.

30

See Goretti and Souto (2012), SI Chapter III.

Portugal: Selected Issues Paper
Author: International Monetary Fund. European Dept.