This document discusses the feasibility of increasing taxes to restore fiscal solvency in the EU given rising debt levels. It argues that: 1) Dynamic "Laffer curves" show much lower potential for tax increases than previous studies, especially for capital income taxes. 2) Southern European countries have already made large fiscal adjustments through spending cuts and tax increases, yet deficits remain high due to the magnitude of the economic downturn. 3) Models of capital income taxation underestimate firms' ability to avoid taxes, so the potential for increases is even lower than estimated. Raising other taxes like VAT or cutting entitlements will be very difficult.

1. Comment on: Saving Europe? The unpleasant
arithmetic of fiscal austerity in integrated economies
Juan Carlos Conesa
Stony Brook University
Cambridge, September 2016

2. Are the countries in Southern Europe solvent?
Conesa Discussion on: Saving EU Cambridge, September 2016 2 / 17

3. Are the countries in Southern Europe solvent?
Is it feasible to increase taxes in order to restore fiscal solvency in the EU
given the increase in debt observed in the data?
This paper provides very little room for optimism
Conesa Discussion on: Saving EU Cambridge, September 2016 3 / 17

4. Are the countries in Southern Europe solvent?
Is it feasible to increase taxes in order to restore fiscal solvency in the EU
given the increase in debt observed in the data?
This paper provides very little room for optimism
I will argue in this discussion that things might be even worst than what
this paper implies
Conesa Discussion on: Saving EU Cambridge, September 2016 4 / 17

5. The economic environment
General equilibrium infinitely lived model with two twists:
Endogenous capacity utilization ⇒ capital income taxes are
distortionary
Limited depreciation allowance
Standard setup for the specification of capital ownership and its
taxation
Conesa Discussion on: Saving EU Cambridge, September 2016 5 / 17

6. Basic Experiment: Can southern countries pay for debt?
Dynamic Laffer curves substantially below the closed economy
scenario usually considered in the literature (Trabandt and Uhlig, and
others)
A lot lower for capital income taxes, maybe some hope with large
increases on labor income taxes
Tax competition (strategic interactions) makes things worse
Conesa Discussion on: Saving EU Cambridge, September 2016 6 / 17

7. Basic Experiment: Can southern countries pay for debt?
Dynamic Laffer curves substantially below the closed economy
scenario usually considered in the literature (Trabandt and Uhlig, and
others)
A lot lower for capital income taxes, maybe some hope with large
increases on labor income taxes
Tax competition (strategic interactions) make things worse
I think it is even worse
Conesa Discussion on: Saving EU Cambridge, September 2016 7 / 17

8. Why do I think it is worse?
1st: Mendoza, Razin, Tesar estimates of tax rates are too low
(indicating there is still room)
They are average tax rates, marginals are much higher
Still they do not seem to include social security taxes (?). My own
calculations using the same methodology yield much larger effective
marginal tax rates
If that were true, room for tax increases is not there (Trabandt-Uhlig
argue Europe near pick of Laffer curves)
2nd: Southern countries have already made huge effort
3rd: The “standard setup” used underestimates the ability of firms to
“escape” taxation
Conesa Discussion on: Saving EU Cambridge, September 2016 8 / 17

9. 1st: Our (Conesa-Kehoe) estimate of effective marginal
taxes in Spain
Conesa Discussion on: Saving EU Cambridge, September 2016 9 / 17

10. 2nd: Magnitude of recession (GDP)
Conesa Discussion on: Saving EU Cambridge, September 2016 10 / 17

11. 2nd: Magnitude of recession (fiscal revenues)
Conesa Discussion on: Saving EU Cambridge, September 2016 11 / 17

12. 2nd: Fiscal adjustment
GDP down by 10%
Fiscal revenues down by 15%
Government expenditures have gone down by 10%
Still large deficit remains
Tim was wrong: Huge effort done, yet more to do (deficit remains).
Higher interest rates won’t help
Conesa Discussion on: Saving EU Cambridge, September 2016 12 / 17

13. So...
This paper leaves only room for increases in labor income taxes
Yet, VAT revenues in Southern countries are lower than in Northern
countries
Bringing up revenues and further cutting expenditures will be extremely
difficult
Reforms to entitlement/welfare programs are unavoidable in Southern
Europe, more so given projected demographics
Precedent: Scandinavian experience after large crisis of early nineties
Conesa Discussion on: Saving EU Cambridge, September 2016 13 / 17

14. 3rd: No hope for capital income taxes. What do I mean by
the “standard setup”?
The standard budget constraint is: ct + kt+1 = wt + (1 + rt − δ) kt
This is equivalent to: ct + νt (st+1 − st) = wt + dtst, where st denotes
holdings of shares, νt denotes price of shares, and dt denotes dividend
payments
In this scenario, firms own capital and the objective function of the firm is
dynamic: max ∞
t=0 ptdt, where dt = f (kt, nt) − wtnt − xt
Easy to prove these two scenarios are equivalent, i.e.
ν0 = ∞
t=0 ptdt = (1 + r0 − δ) k0
Conesa Discussion on: Saving EU Cambridge, September 2016 14 / 17

15. Capital income taxation in practice
In the standard setup capital income taxes are levied as τ(r − δ)k
As in Strulig and Trimborn (2012) or Conesa and Dominguez (2013),
in practice
Dividend taxes
Corporate taxes
Capital gains taxes
In the data, firms find many ways to avoid taxation (Slemrod,
Chetty-Saez)
Conesa Discussion on: Saving EU Cambridge, September 2016 15 / 17

16. Why does that matter?
Trabandt and Uhlig report European countries close to top of Laffer curves
Strulig and Trimborn (2012) argue things are even worst in alternative
setup (nearly flat Laffer curves for ALL forms of capital income taxation)
Conesa and Dominguez (2013) solve for optimal policy and argue corporate
taxes should be zero, and dividend taxes should be set equal to labor taxes
Conesa Discussion on: Saving EU Cambridge, September 2016 16 / 17

17. Also related to literature on tax competition
Klein, Quadrini, Rios-Rull (Markov perfect equilibrium) study US vs
EU
Explains US higher reliance on capital taxes than EU
Main reason is smaller size of public sector
Soojin Kim (impact of migration) study UK vs rest-of-EU
Relative to only capital mobility, mobility of labor implies lower capital
taxes in UK and higher rest-of-EU capital taxes
Reason is higher productivity in UK (attractive for workers)
Conesa Discussion on: Saving EU Cambridge, September 2016 17 / 17