Essec Business School

President Hollande and his government have committed themselves to reducing the budget deficit in 2013 to 3% of gross domestic product (GDP). To this end, massive tax increases and spending cuts were included in the 2013 budget. This budget proposes that one third of the 30 billion euro the government says it needs would come from large companies, another third would come from the top 10 % richest households, and a reduction in government spending (in reality, a reduction in previously planned expenditures – Government expenditures would continue to grow but at a slower pace), would provide the last third of scheduled resources.

Although the term has been banned from official vocabulary, a good number of Socialist Party members in addition to the majority of environmentalists and nearly all of Jean-Luc Mélanchon’s supporters, are unhappy with this austerity plan. Nevertheless, it will have to be implemented, given its inescapable primary objective: to inspire market confidence. If the French government fails to attain this objective, the rates at which it will borrow the moneys necessary to finance its budget deficits, added to the renewal of its pre-existing debts, will rise dramatically. This will ultimately increase France’s future budget deficits to the point of becoming unsustainable.

President Hollande’s strategy is therefore to focus on deficit reduction as required by the European Stability Pact budget (the golden rule) so as to prevent the worsening of imbalances due to the mistrust of lenders. He has forged ahead on this strategy despite criticism from within his own party and government majority. But unfortunately, its implementation has been fouled from the start by serious errors of calculation and ideological presuppositions that prevail over economic rationality.

The first of these errors is an overestimation of the potential growth of the French economy.

Indeed, on August 27^th, before President Hollande’s austerity plan had been made public, Jean-Marc Ayrault announced a French 2013 growth forecast at 0.8%, identical to that of the IMF at the time. Most observers already agreed that this figure was too high. More recently, the IMF has reduced its growth forecast to 0.4% (and 0.1% for the year 2012) which still seems optimistic to many observers.

In fact, the forecast of 0.8% growth in 2013 was the figure that served as a basis for calculating the tax measures intended to reduce the budget deficit to 3% next year. And even if France would have attained 0.8% growth in 2013 (that is to say before recent tax hikes) this calculation would no longer hold true if we take into consideration new taxation levels. Ignoring the impact of tax hikes on the country’s growth leads the Hollande government into their second miscalculation.

The reform ultimately impacts individual spending (increase of excise duties on beer and taxes on cigarettes) and even the most modest incomes (taxation of overtime, freezing of income tax brackets, increasing TV license fees, taxation of pensions) can only reduce consumption.

Worse still, other measures will negatively impact investment and hinder the creation and development  of new business. Particularly detrimental will be the overtaxation of corporate profits, dividends and savings products and the rise in payroll taxes especially for the self employed. In addition, higher capital gains taxes, even marginally revised to appease the "pigeons", will still inevitably eat away at entrepreneurial activity and reduce the number of new businesses.

The result: less hiring, more layoffs and an economic growth well below targets. That is to say, a recession in 2013 and a budget deficit well above the 3% of the GDP announced. The inevitable consequence will be increase borrowing by the French Treasury, rising unemployment and all the social unrest that will follow. Given the failure of its austerity plan, the French government will have to choose between two economic policies:

• Continue on the current path of wanting to finance deficits by households (supposedly the wealthy and corporations). In this case, the government will use two tax instruments: VAT and CSG. In the short term, this could help reduce the deficite. However, in the long term, by aggravating already heavy and uneconomical taxation, such a measure would clearly be counter-productive. Growth will not restart and it is not even certain that the Country’s revenue will increase.
• Undertake structural reforms that should have been imposed long ago. To start with, by disengaging the State from a number of non-sovereign, industrial activities by privatizing its holdings and, therefore, renouncing its industrial policy (especially when financing obsolete industries). Then actually reduce spending along the lines proposed recently by the Cour des comptes and the Inspection générale des finances (in its recent report on state agencies, for example). Legislate a profound tax reform in order to decrease total taxes collected and simplify the most deterrent ones (as will soon be done in Germany and Italy). Improve the allocative role of the labor market by making it more flexible and adaptable and therefore allowing employers the right to fire, a prerequisite for increased hiring. Introducing a minimum wage for young people (which was attempted but abandoned by the Villepin government). Give, consumers more freedom by abolishing monopolies (such as taxis) or allowing the opening of shops on Sundays. 

If such a program has not yet been realized it is because it is held back by vested interests hiding behind ideological predisposition. Pretending to believe that defending the status quo is defending "social justice" is a purely bureaucratic mindset devoid of any economic sense.