Budget 2012: Spanish Government Announces Deeper Fiscal Tightening

Finance Minister Cristobal Montoro has unveiled Spain's delayed 2012 Budget to be presented to parliament on 3 April, which is likely to be the toughest since the 1970s. The austere budget will contain fiscal tightening measures worth EUR27 billion (USD36 billion) or 2.5% of GDP to bring about a dramatic improvement in central government finances. This will be accompanied by estimated regional spending cuts totalling EUR15 billion, helping to reduce the overall public-sector budget deficit from 8.5% of GDP in 2011 to 5.3% in 2012, the biggest reduction since 1980. Another key and challenging assumption is that the social security system will move into surplus in 2012 after a posting a small deficit in 2011, even though the number of contributors continues to fall alongside rising pension obligations.

The Main 2012 Budget Spending Measures Include:

• Government departmental spending will be cut by 16.9% to EUR65.8 billion, with the axe falling mainly on the Foreign Office (planned reduction of 45%), Industry, Energy and Tourism (31.9%) and Public Works (34.6%).

• Central government investment will be squeezed by 19.6% to EUR4.7 billion. Some high-profile victims are the water fund (cut by EUR795 million), the Defence Ministry (EUR351 million), the housing access fund (EUR322 million) and motorways (EUR360 million).

• Civil servants' wages will be frozen. Therefore, central government personal costs are expected to rise by 1.3% in 2012, despite the wage freeze and falling employment levels.

• Development aid will be cut by EUR594 million.

• A further EUR1.6 billion-worth of savings will be found from government employment schemes.

• Unemployment benefits will be frozen, while pensions will be adjusted in line with inflation.

Revenue Measures Include:

• Overall non-financial revenues are expected to climb by 12.5% to EUR119.2 billion in 2012.

• Income tax changes were already announced at the end of 2011. They entail an increase for all employees from 1 January 2012 until 31 December 2013. This involves an increase of 0.75% for all wages below EUR17,707 a year, rising progressively to 7% for all incomes up to EUR300,000 a year. Overall income tax receipts are expected to rise by 1.9% in 2012.

• Corporation taxes are expected to increase by 22.2% or EUR12.3 billion by reducing deductions companies can make.

• The VAT rate will remain at 18.0%, one of the lowest rates in the Eurozone.

• There will be an amnesty on tax evasion in return for 10% fee, hoping to encourage individuals to repatriate "black money" from overseas.

• The government will hike electricity and gas tariffs by 7% and 5%, respectively in attempt to cut state electricity subsidies.

Budget Measures Should Be Implemented Despite Risk of More Demonstrations

Prime Minister Mariano Rajoy's Popular Party (PP) controls a comfortable majority in the Spanish national legislature, while the party also dominates a majority of regional governments. This means that the budget's approval and its subsequent implementation should be smooth. However, although most Spaniards acknowledge that the cuts are needed, the plans could spark some sectoral and even further general strikes and protests regardless. Last week (29 March), Spain held its first general strike since Rajoy's administration assumed power in December, and although minimal services were assured, the action was disruptive. Moreover, violence also erupted in some major cities, as protesters vandalised properties and clashed with police. Prior to the general strikes, some regions had already seen protests against spending cuts, particularly those affecting education. Although the intensity of Spanish industrial action is unlikely to reach that of Greece, further disruptions cannot be ruled out, especially when the announced measures take effect and start to bite. In addition, impending labour market reform is already stoking up the public's appetite for protest, with the unions already warning that they will stage more protests unless the government "fine tunes" its reforms—especially the labour reform. Nevertheless, Rajoy is adamant that the changes are needed and there is no room for compromise. This will play well with international investors, but the government might pay for it with falling public support and more industrial action taking place in the coming months than Spain is generally accustomed to.

Outlook and Implications

The overall impact of the fiscal tightening measures to be announced in the 2012 Budget is in line with expectations, and suggests that central government spending will bear the largest slice of the overall general government spending retrenchment. This is a less contentious move given the regions are already struggling to claw back the 2011 fiscal shortfalls, and are likely to need financial assistance from central government to meet their overdue credit liabilities. Furthermore, it is easier to control government spending at the central level than impose even more draconian spending cuts on the regions, which are responsible for provision of the key social services like education and health. Nevertheless, a projected cut in central government ministerial budgets of 16.9% is very challenging in the current economic climate.

The specific budget measures of the civil servants' wage freeze, higher electricity and gas prices from April and income tax changes spell bad news for the household economy, already struggling to cope with falling real incomes, a devastated labour market, shrinking housing wealth and diminishing but still uncomfortably high indebtedness.

The government could be forced to implement further austerity measures later this year, with lingering economic downturn set to place additional strains on an already perilous budget deficit reduction plan. The main risk is that the government's tax revenue projections for 2012 look too optimistic, and are at odds with the latest official projections of real GDP and consumer spending falling by 1.7% and 4.0% in 2012, respectively. Clearly, given this tough economic backdrop, the main supports of tax receipts, employment, retail and house sales will be under considerable pressure in 2012.

Finally, the continued commitment to lower the public-sector budget deficit target to 3.0% of GDP by 2013 is close to impossible given that both the economy and labour market are likely to remain in the doldrums next year. In addition, some of the 2012 deficit reduction measures are one-offs, increasing the pressure on the government to seek further cost cutting measures in 2013. The pace of fiscal tightening will need to be readdressed soon if the economy continues to stumble after slipping into recession in early 2011, or Spain will have face another dire and austerity-riddled year. Currently, we assume that the government will be willing to reinforce the budget deficit reduction plan to achieve the 3.0% deficit target, but this is likely to condemn the Spanish economy to a second successive full-year contraction in 2013, probably by 0.3% after projected 1.6% drop in 2012, according to our March forecast. Nevertheless, despite relentless fiscal endeavour, we still expect the government to fall short again in 2013, with deficit expected to narrow to just 3.6% of GDP.