Portugal braced for 'fiscal earthquake'

Higher earners will suffer what tax consultants describe as a "brutal" increase under a government policy.

Story highlights

  • The coalition is relying on increased state revenue to account for about 80 per cent of the adjustment
  • The highest income tax rate in Portugal is to be increased in January from 46.5 to 48 per cent
  • Total tax revenue has fallen considerably below target this year, forcing additional austerity measures

"A fiscal earthquake", "armed robbery", "tax napalm". Descriptions of the income tax increases facing Portuguese families from January 1 make the fiscal cliff looming in the US sound tame by comparison.

Lisbon plans to lift income tax revenue by more than 30 per cent, raising the effective average rate by more than a third from 9.8 to 13.2 per cent. Anyone receiving more than the minimum wage of €485 a month, including pensioners, will also pay an extraordinary tax of 3.5 per cent on their income.

The increases, which the centre-right government has itself described as "enormous", are designed to ensure Lisbon meets deficit-reduction targets agreed with international lenders as part of a €78bn bailout.

But the scale of the tax rises and uncertainties over whether they will produce the desired results have exposed Pedro Passos Coelho, the prime minister, to stinging criticism from both left-wing political opponents and senior figures close to the governing coalition parties.

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"This is a kind of armed robbery of the taxpayer. It will not just penalise the middle class, it will kill them off," Luís Marques Mendes, a former leader of Mr Passos Coelho's Social Democrat party (PSD), said in October when the 2013 budget was presented in parliament.

"The only doubt is whether this [fiscal earthquake] will be seven on the Richter scale, which is destructive, or eight, which is devastating," António Bagão Félix, a former finance minister who is close to the conservative Popular party, the junior coalition partner, told Portuguese television.

As Portugal passes the halfway mark of its three-year adjustment program, the steep tax increases facing many families have made the outlook for 2013 -- the third consecutive year of austerity, recession and rising unemployment -- the grimmest yet.

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Total tax revenue has fallen considerably below target this year, forcing the government to implement additional austerity measures to meet even the more relaxed budget deficit targets agreed with the EU and International Monetary Fund in September.

The coalition will be relying on increased state revenue to account for about 80 per cent of the fiscal adjustment required in 2013 -- a reversal of the original bailout plan, in which consolidation was to be achieved mainly through spending cuts.

Higher earners will suffer what tax consultants describe as a "brutal" increase under a government policy to distribute sacrifices more fairly. But in Portugal, where the average monthly wage is about €800, taxpayers described as "high earners" tend to be middle-class professionals rather than business tycoons.

Read more: Spain: Perils of being 'filthy stinking poor'

A couple in which each partner earns about €3,500 a month -- two senior university professors, for example -- could now find themselves in the top tax bracket, when previously they would have had to earn more than €6,000 a month each to pay the top rate.

The highest income tax rate is be increased in January from 46.5 to 48 per cent and will apply to couples earning more than €80,000 a year, compared with €153,000 previously (income tax in Portugal is levied on family units). They will also pay an additional 2.5 per cent "solidarity tax" on their income.

Read more: Is the eurozone crisis almost over?

People struggling to make ends meet on unemployment benefits or the minimum wage are unlikely to be distressed by the increases facing the middle class -- in tax terms, families earning above €30,000 to €40,000 a year. But, according to Mr Bagão Felix, the increases threaten to destroy aspiration, instilling the idea that "there's no point in investing in the future, in working to become more successful".

"Earning €80,000 a year is a good salary, but these people are hardly millionaires," says Mr Marques Mendes.

The latest increases have stretched the tax system to the limit, says Carlos Loureiro, a tax partner at Deloitte. "The current model is exhausted. We need to do something different," he says. "Any further increase in tax rates is unlikely to result in increased revenue."

Income from value added tax, the government's biggest source of tax revenue representing about 36 per cent of the total, has been falling since 2008, despite a sharp increase in the rate -- the main rate is now 23 per cent.

Both the government and the European Commission have acknowledged the risks of depending on increased tax revenue, which is more growth sensitive, to meet fiscal targets and contingency spending cuts amounting to 0.5 per cent of national output have prepared in case of another tax shortfall.

Mr Loureiro believes the way forward for Portugal is to focus on simplifying its corporate and income tax codes and bringing at least part of the non-taxpaying "black economy", estimated to account for more than 20 per cent of total output, into the system.

"A tax structure in which wage earners, pensioners and a small percentage of companies bear the overwhelming burden is not sustainable," he says. "If tax revenue is going to contribute more to fiscal consolidation, we have to change the system."

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