Analysis - Rajoy plans tax reform to revive Spanish economy and jobs

By Julien Toyer MADRID (Reuters) - Spain's economy is growing again and exports are flourishing, but with a quarter of the workforce unemployed, the government now hopes to revive the austerity-weary nation by a new means - a major tax reform. If it works, the overhaul will boost economic growth, create hundreds of thousands of new jobs and halt relentless downward pressure on Spaniards' wages. But Prime Minister Mariano Rajoy must still gamble with his chances of re-election, as the plan will probably also demand an early leap in tax on goods and services that won't be popular with voters. Rajoy's centre-right cabinet is expected to discuss the plan on Friday. The goal is to shift the tax burden from jobs to consumption, while ensuring enough tax revenue to cut one of the highest budget deficits in the European Union. Government sources have said value-added tax (VAT) on products and services is likely to rise to Spain's standard rate of 21 percent from reduced rates of 4 and 10 percent imposed now. Property and fuel levies are also expected to increase. Simultaneously, corporate tax and income tax for lower earners will be slashed and Rajoy has also announced a 75 percent average cut in the amount of social contributions - such as for health insurance and pensions - that companies pay on top of their employees' salaries. This last step, although due to expire at the end of the year and limited to new recruits, aims to lower Spain's labour costs further and make it cheaper for companies to hire. This mix of tax measures - known by economists as fiscal devaluation - is one of the latest examples of how southern European countries are trying to buoy their economies beyond the wage and price-cut recipe that the EU has been encouraging the region to adopt for several years. Spain, as a member of the euro zone monetary union, cannot rely on currency devaluation and the European Central Bank has shown no appetite for engineering a weaker euro. Thus the country has undergone an internal devaluation, pushing down wages and prices to become more competitive. But the move is now threatening to mutate into deflation, a more dangerous phase in which consumers put off buying goods as they expect prices to drop, bringing the economy to a halt. POLITICAL BET For Rajoy, the reform is a political bet. Support for his People's Party has plummeted over the last two years as he made tough spending cuts. A recent Metroscopia poll showed 76 percent of Spaniards disapprove of his policies and only 6 percent believe the economic situation will improve in the short term. While some of the new tax increases may prove unpopular in a country sick of austerity, the boost for business and hiring that the steps aim to deliver may eventually persuade voters that Rajoy deserves a new four-year term. According to business bodies' estimates, about 300,000 self-employed who are working in the black economy could be lured back into the tax system by the lower contributions. Tens of thousands of part-time employment contracts, which benefit from an additional discount on contributions, are also expected to be signed this year. In a research paper published last year, BBVA bank said a cut of 3.5 percentage points in social contributions coupled with a 2 percentage point increase in consumer taxes would add 0.74 percent to gross domestic product and create more than 200,000 jobs in two years. The effect would be equivalent to an exchange rate depreciation of about 10 percent, BBVA said. A similar study from the European Commission also pointed at the high short-term impact on both economic output and jobs that the Spanish premier is looking for. If implemented now, the steps could allow Rajoy to fulfil his promise of ending his term next year with less unemployment than when he took office in December 2011. Spain had 4.8 million registered jobless in February, an increase of 390,000 since Rajoy was elected, although other data show that a total of six million people, or 26 percent of the workforce, are actually unemployed. DEPRESSING CONSUMPTION The government, which raised its economic growth forecast for 2014 and hopes to reduce unemployment below 25 percent by the year-end, is hoping fiscal devaluation will have two economic effects, even in a watered down version. Firstly, cutting back social contributions would lower unit labour costs further, boosting Spain's competitiveness. As in other southern European economies, Spanish labour costs have fallen from a peak in 2009. However, this has been achieved largely by pushing down real wages, depressing consumption and internal demand, which accounts for two third of GDP. By relying instead on lower employers' taxes to continue the fall in labour costs, pressure on salaries would be eased, helping to offset a hit on consumption caused by the higher VAT. Labour costs rose 0.2 percent in the third quarter of 2013, the first quarterly increase since early 2012, as a 0.7 percent rise in social contributions offset a 0.2 percent drop in wages. Secondly, lower social contributions combined with higher consumer taxes favour Spanish producers over their foreign competitors, which have the same VAT applied to their products in Spain without benefiting from the reduced labour costs. Economists, however, warn that the impact of fiscal devaluation will depend on how far the government is willing to shift the tax burden and implement unpopular tax increases. "A full fiscal devaluation would need the cut in social contributions to target all contracts and become permanent," said Rafael Domenech, Chief Economist for Developed Economies at BBVA who co-signed the research. Ideally, the tax increases should also target a wide range of products and the overhaul would be more efficient if combined with structural reforms and measures to bolster internal devaluation, Domenech said. The effects would be reduced if companies increased their margins or staff salaries rather than cut prices as a result of lower labour costs, while foreign firms exporting to Spain slashed prices to remain competitive or similar policies were implemented in other euro zone countries. (Editing by Alessandra Galloni and David Stamp)