Portugal: austerity budget with highest tax increase in history as prep for OMT

Mired in the worst recession since the 1970s, Portugal’s governing coalition is going to turn up the austerity dial even higher. The goal is to reduce the Portuguese deficit to 4.5% of GDP in 2013 in order to be in a position to switch out of the present 78 billion euro bailout facility that is expiring and access market funding in conjunction with the ECB’s new outright monetary transactions programme. Under the OMT, Portugal would move from its present Troika program to one in which Portugal would be able to issue debt to the public markets, with any shortfall at auction up to 3 years’ maturity bought by the ESM bailout facility. The ECB would buy Portuguese bonds in the secondary market in potentially unlimited quantities to ensure that yields remain low.

However, as I reiterated yesterday in my post on Spain, Portugal is now shut out of the market and the extension of bailout programmes for periphery countries is going to be particularly controversial in an election year in Germany. In fact, a rumour currently circulating about Spain is that the German government is trying to get the Spanish to hold off on its bailout in order to get a bailout trifecta of Cyprus, Greece and Spain through the German Bundestag at the same time. El Pais has said officials within the Spanish government poured scorn on the credibility of this story. Nonetheless, the rumour had gained currency simply because of the political nature of new bailouts and bailout extensions.

The issue I had focused on regarding Portugal was the mechanism through which the ECB would make a Portuguese OMT-style bailout viable. Portugal’s deficit cutting ambitions are too aggressive. The taxes they are set to impose will cause a tremendous loss in tax revenue due to lower domestic demand and so they will not hit that target in all likelihood. Therefore, I don’t think Portugal can leg into an OMT-style program without an explicit rate target from the ECB like the one Spain is reported to have requested. The story on Spain bolsters my view that this is something being actively considered.

As to the Portuguese government’s ambitions to cut the deficit enough to be market-funding, they will rely heavily on tax increases. The “massive tax increase” is so large that the Association of Judges has announced that it will look into whether the budget is unconstitutional based on violation of the principle of contributory capacity of the fiscal system as designated in the Portuguese constitution. That gives you a sense of how controversial this budget will be. The tax schedule will be simplified to start at 14.5% of earnings up to a top rate of 48%, which will have the net effect of increasing wage income tax. To this the government will add a special surtax of 4% of income that will be taken out of paychecks monthly. I would note that this is a maneuver similar to what led to the solidarity surtax that Germans paid after reunification to finance the reunification. High income earners over 80,000 euros a year will pay an additional ‘solidarity’ surtax of 2.5%. Pension cuts and property tax increases are also in the budget as well.

From opposition political parties there is already great resistance. They are calling this an “unacceptable attack on the middle class” and will heap yet more criticism on the ruling coalition whose standing among Portuguese has plummeted in a precipitous way in the last few months. Portuguese unions are already planning a day of protest for 31 October. Bottom line: this budget is aggressively austere in tax increases and will cause a deep downturn in demand. When the time comes for Portugal to roll over its debt, they will need the ECB to do some very heavy lifting. Otherwise Portugal will be stuck in a traditional bailout facility that can’t possibly be supported by the German ruling coalition in an election year. If the Spanish don’t get a spread target for their OMT program, I would expect the rhetoric regarding target spreads to increase as Portugal’s situation becomes clear.