Madrid ups taxes, punts on pension reform. Will Europe be satisfied?

The Spanish government hopes that its measures will be enough to convince Europe to okay a two-year extension on its deficit-reduction goals.

The Spanish government on Friday announced new public deficit-cutting measures to convince Europe that it deserves a two-year extension on reaching its targets, as data this week suggested that the recession is slowing down and that growth could resume next year.

The government announced it is extending a 2012 income tax hike, which was due to expire next year, until 2015, and eliminating some tax deductions for big companies. It also announced that more targeted tax increases will follow, although it ruled out any that would affect fuels.

But Spain didn’t announce any reforms in the pension system nor did it further reform labor laws, as the European Union wanted. The government believes to do so would only worsen its already dire unemployment, which for the first time in history topped 6 million people according to data released this week by Spain's National Statistics Institute.

The new measures are part of Spain’s revised macroeconomic stability plans, which need to be presented to and ultimately sanctioned by the EU. The new deficit target for 2013, if approved, will be 6.3 percent of gross domestic product, almost a two-point hike from its current – and unreachable – 4.5 percent.

“There have been talks with European institutions,” Finance Minister Luis de Guindos said Friday, suggesting that the government's plans have preliminary European support. The EU will review member country plans, and if convinced, sanction them in late May, which is when Spain would be given two more years to meet its target.

“The new hypothesis are extremely conservative, very prudent, to add credibility to the government’s action,” Mr. De Guindos said.

Bottoming out?

But the EU is also justifiably concerned. Not only has Spain missed its targets year after year – albeit like most of Europe, which continues to face economic headwind – but its economic situation is dire. At 10.6 percent of GDP, Spain’s real deficit is the EU’s biggest, higher even than Greece’s 10 percent, according to Eurostat data released this week.

Although the government’s 2012 deficit was officially 7 percent, down from 9 percent in 2011, a European bailout of the Spanish financial sector – in the form of loans to private institutions, but underwritten by the government – raises the total government liability.

The worst might be over though, although the vast majority of Spaniards won’t feel respite. The Central Bank said this week that the recession had slowed down in the first quarter of 2013 to 0.5 percent, a severe contraction, but nonetheless smaller than the previous quarter, and will bottom out in the end of 2013. Home prices also continue to fall, but at a slower pace than before.

The cost of borrowing for Spain has also dropped to 2010 levels, allowing the government to continue financing its increased spending requirements needed to return to growth.

Increasing debt

That is why Spain says it needs more time. The government significantly revised its outlook for the year and now expects a 1.3 percent contraction, from the 0.5 percent previously estimated.

The revision was largely expected and is in line with other forecasts. The government now expects only slight growth of 0.5 percent in 2014. Unemployment, already topping 27 percent, will continue increasing throughout most of this year, but job creation thereafter will be excruciatingly slow, and joblessness will remain around 25 percent even in 2016, the government said in its new outlook.

Spain’s total debt has also ballooned during the crisis, alarming investors, even though it remains manageable. In 2011, it was equal to nearly 70 of the GDP, but it will continue swelling to more than 91 percent in 2013 and reach almost 100 percent by 2016.

Tax revenue, as a share of the GDP, is also one of the lowest in the EU, as a result of lower consumer spending and unemployment.