Europe Needs to Reduce Underground Economies, Fight Tax Evasion

April 30th, 2012

Larry Summers

World Economic Forum, Flickr*

This morning, Larry Summers, former U.S. Treasury Secretary under President Clinton and former top economic advisor to President Obama, wrote that European austerity is holding back economic growth, which is making their sovereign debt problem worse, both in individual countries passing austerity budgets and on a continent-wide basis. He argues,

The premise of European policymaking is that countries are overindebted and so unable to access markets on reasonable terms, and that the high interest rates associated with excessive debt hurt the financial system and inhibit growth. The strategy is to provide financing while insisting on austerity, in hopes that countries can rein in their excessive spending enough to restore credibility, bring down interest rates and restart economic growth. Models include successful International Monetary Fund programs in emerging markets and Germany’s adjustment after the expense and trauma of reintegrating East Germany.

Unfortunately, Europe has misdiagnosed its problems in important respects and set the wrong strategic course. Outside of Greece, which represents only 2 percent of the euro zone, profligacy is not the root cause of problems. Spain and Ireland stood out for their low ratios of debt to gross domestic product five years ago, with ratios well below Germany’s. Italy had a high debt ratio but a very favorable deficit position. Europe’s problem countries are in trouble because the financial crisis underway since 2008 has damaged their financial systems and led to a collapse in growth. High deficits are much more a symptom than a cause of their problems. And treating symptoms rather than underlying causes is usually a good way to make a patient worse.

Mr. Summers is quite right that Europe’s need of the hour is to stimulate economic growth rather than embrace ever-more austerity to cut debt. Misguided policies to reign in debt, an idea being touted around in this country in an election year, can only make matters worse by choking off an economic recovery and hamstringing the very means to pay down debt. In the United States, disagreements between Republicans and Democrats about the need for austerity versus more government spending to foster growth sound like couples quarreling over last month’s water bill as the house is burning down.  Clearly, we should douse the fire first and worry about the water bill later.

That said, policies to absorb more of the size-able underground economies into official GDP comprise an important tool at the disposal of European governments to recover from the crisis. For instance, tax evasion, which is a significant part of the large underground economies in Europe’s periphery, has severely reduced their governments’ capacity to service debt. Therefore, improving tax collection by plugging the holes in the tax net while ensuring equity in the onus of taxation is very much required.  Thus, while pro-growth policies are crucial, measures to absorb the underground economy into productive capacity are needed to ensure continued tax-payer support.

* Image License: Some rights reserved by World Economic Forum

Written by Dev Kar

Follow @FinTrCo