Late in 2011, after realizing that Spain had run up an exceptionally large budget deficit for the year, exceeding 8.5% of the nation's entire GDP, the newly elected government of Mariano Rajoy set out to get Spain's fiscal situation under control.

To do that, Rajoy committed Spain to a program of spending cuts and tax hikes in 2012, as demanded by the European Commission (EC). A program that appears to have only succeeded in crashing Spain's troubled economy in 2012. (Refresh the image below to see Spain's quarterly GDP growth rates from 2010 through the end of 2012.)

But which aspect of Rajoy's austerity program is most responsible for sinking Spain's fortunes? Was it the spending cuts? Or was it the tax rate hikes?

Believe it or not, we can answer that question! And to do it, we'll use data from the United States for its fiscal multipliers!

What's a fiscal multiplier, you ask? A fiscal multiplier is a ratio that tells us how much a nation's income, or GDP, is affected by changes in its government's spending or taxation policies. They are typically used by economists to predict how much more or less economic activity there will be in an economy as a result of a change in the levels of government spending or taxation.

That's where the data from the U.S. comes into play, because we'll use the fiscal multipliers that have been calculated for both government spending and for taxes to apply to Spain's situation in 2012 to see if we can predict how much Spain's GDP was affected by the different parts of its so-called austerity program.

Let's start with the government spending multiplier. Research published by the Federal Reserve in January 2013 finds that the fiscal multiplier for government spending is somewhere between +0.6 and +0.7, which applies when unemployment rates are high (above 7.5%).

Here, having a fiscal multiplier with a value of less than 1 means that changes in government spending have a muted impact on a nation's GDP. For a fiscal multiplier of 0.6 to 0.7, if government spending were increased by 1 billion dollars, the nation's GDP would only rise by somewhere between 600 to 700 million dollars. Likewise, if government spending were cut by $1 billion, GDP would only fall by $600-$700 million.

By contrast, the tax multiplier has a much greater impact on GDP. Here, Christina Romer and David Romer (Christina Romer was formerly the chair of President Obama's Council of Economic Advisers, which is oddly omitted from her official academic biography) have found that the fiscal multiplier that applies for taxes is approximately -3.0, which as you notice, is both rather large in magnitude and negative.

What being large in magnitude means is that changes in tax levels will have an outsized effect upon GDP. What being negative means is that is changes in a nation's tax policy have an opposite effect upon its GDP. So, for example, if a nation were to cut its taxes by 1 billion dollars, it could expect to see its GDP grow by 3 billion dollars. Conversely, if a nation were to hike its taxes by $1 billion, it would expect to see its GDP fall by $3 billion.

Now let's apply these multipliers to Spain's situation in 2012. Starting with the spending cuts, we find in using data from Eurostat along with GDP reported in the World Economic Outlook for 2013 that Spain's spending was $668.8 billion (in terms of U.S. dollars) in 2011 and $635.5 billion in 2012, as Spain cut its spending from the previous year by $33.3 billion.

The tax data is more difficult to come by, because here, we must use the estimated amounts by which Spain's government expected to increase its revenue by increasing its tax rates and through other means. We do this because while a nation has full control over how much it spends, there is no guarantee that it will actually be able to collect as much revenue as it expects or plans, especially as those being taxed often make adjustments to avoid the full burden of new or higher taxes being imposed upon them.

Early in 2012, the Rajoy government imposed higher taxes on both wage and salary income as well as investment income, expecting to increase its tax collections by 4.3% over the $528.2 billion USD it collected in 2011, or rather, by approximately $22.71 billion USD. In addition, the Rajoy government also planned to crack down on Spain's tax evaders, expecting to collect an additional 8.2 billion euros ($10.67 billion USD) through their increased enforcement measures.

However, by September 2012, it was clear that these measures would not be sufficient to close Spain's budget gap as much as the European Commission demanded. As the EC threatened to end its bailout of the Spanish government as Spain's debt crisis escalated, Rajoy's government finally consented to also increase Spain's value added tax rate, which took effect after September. This measure was expected to increase Spain's tax collections by an annual amount of 7.5 billion euros ($9.8 billion USD), but for our purposes, this tax increase only applied in the final quarter of 2012, so the expected additional tax collections from this source in 2012 is one-fourth that amount, or $2.45 billion USD.

Adding all those government revenue increasing amounts that apply for 2012 together gives us a total of $35.82 billion, for which the tax multiplier of -3 will apply.

We'll take these values and enter them in our tool below, which will do the fiscal multiplier math!

In the tool above, we used the lower end of the range of possible values that would apply for the government spending multiplier in obtaining the result using our default data of a GDP decline of $127.5 billion for Spain, which would be predicted using the Spanish government's actual level of spending cuts and our static analysis-produced expected increase in Spain's revenues from the government's tax-hiking frenzy in 2012.

The actual value that Spain's GDP fell in 2012 from 2011's level was $127.5 billion. The fiscal multipliers that seem to apply in the United States would therefore appear to be very effective in predicting how much other nation's GDPs might change in response to changes in their government's fiscal policies.

We should note at this point that these figures are likely to be revised in the future, which means that the actual fiscal multipliers that apply in Spain may need to be tweaked from this preliminary analysis. Which is, of course, why we made it very easy to alter them in our tool above!

Consequently, we find that the Spanish government's attempt to increase its revenues, driven by the EC's demands to impose higher taxes on Spanish businesses and high income-earning individuals, is responsible for about 84% of the nation's decline in GDP, while its spending cuts were only responsible for 16% of the decline in Spain's national income from 2011 to 2012.

And that is a prime example of austerity done wrong.

References

Knoema. World Economic Outlook, April 2013. [Online Database]. Accessed 15 May 2013.

Knoema. World Economic Outlook, April 2013. GDP per Capita - Spain. Accessed 15 May 2013.

Knoema. World Economic Outlook, April 2013. GDP - Spain. Accessed 15 May 2013.

Eurostat. Government Finance Statistics. [Online Database]. Accessed 15 May 2013.

Owyang, Michael T., Ramey, Valerie A. and Zubairy, Sarah. Are Government Spending Multipliers Greater During Periods of Slack? Evidence from 20th Century Historical Data. [PDF Document]. Federal Reserve Bank of St. Louis, Economic Research Division. Working Paper 2013-004A. January 2013.

Romer, Christina and Romer, David. The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks. [PDF document]. March 2007.

LibreMercado. The government shuffle a new tax increase to reduce the deficit. [Google Translation]. 20 August 2012.

EuroNews. Spanish VAT Rise: A Backward Plunge. 6 September 2012. Accessed 15 May 2013.

Angloinfo. Tax Rises in Spain for 2012. January 2012. Accessed 15 May 2013.

Image Credits

Trading Economics. Spain GDP Growth Rates. Accessed 16 May 2013.

Ryan, Rebecca. The Multiplier Effect of Local Investing. Lion Investing. 20 February 2011.

Ammons, David. Income tax on high-wage earners? WA Secretary of State Blogs: From Our Corner. 21 April 2010.

Ammons, David. House D Budget: Cuts, delays, but no sales tax hike. WA Secretary of State Blogs: From Our Corner. 21 February 2012.