Taxes and deflation

Autor: Emilio J. González | Thu, 28 Nov 2013

Emilio J. González, Professor of Economic Structure at the Universidad Autónoma de Madrid 

The Spanish economy has been in a deflationary environment since last spring as the following graph shows, which contains the evolution of the consumer price index at constant taxes, that is, without taking into consideration the impact of the different tax increases. Both one-time increases in June and September are caused by circumstantial factors like price increases related to the tourist season or academic fee increases.


Source: National Institute of Statistics (INE)

The main cause of this deflationary process is the great weakness of the internal demand, which forces enterprises to lower prices to be able to sell. This situation, however, entails two risks. The first one is that the price reduction implies lower entrepreneurial margins that can force labor cost cuts, mainly through wage reductions.

But these cuts take place in an environment where family debt still represents 79,9% of GDP and that of enterprises 128,3%, according to the Bank of Spain. Consequently, the debt burden over family and entrepreneurial income will increase causing further household and entrepreneurial insolvencies or, in the best case scenario, reducing even more their spending capacity.

This leads to a second risk, a deflationary spiral in the sense that the new lower family spending will be followed by more price cuts, lower margins and lower salaries that again will reduce household spending, and so forth. The danger is there and it should not be ruled out. That is why it is key to act reducing taxes that increase the income of families and enterprises so that they can compensate the deflationary pressure that the weak internal demand causes, something that will, of course, imply reducing public deficit through public spending.




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