Report No. 3365-PO Portugal: Recent Economic Developments and the Medium-Term Perspective with Special Reference to Resource Mobilization Public Disclosure Authorized (In Two Volumes) Volume I: Recent Economic Developments and Prospects September 21, 1981 Europe, Middle East and North Africa Regional Office FILE CPY FOR OFFICIAL USE ONLY X >U Public Disclosure Authorized Public Disclosure Authorized

Public Disclosure Authorized Document of the %brid Bank

This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. CURRENCY EQUIVALENTS

(Until) 1971 1 US Dollar 28.323 Escudos I Escudo .037 US Dollar

1972 1 US Dollar 27.011 Escudos I Escudo .037 US Dollar

1973 1 US Dollar 24.673 Escudos 1 Escudo = .041 US Dollar

1974 1 US Dollar 25.408 Escudos 1 Escudo = .039 US Dollar

1975 1 US Dollar 25.553 Escudos I Escudo .039 US Dollar

1976 1 US Dollar 30.227 Escudos 1 Escudo .033 US Dollar

1977 1 US Dollar 38.227 Escudos 1 Escudo .026 US Dollar

1978 1 US Dollar = 43.940 Escudos 1 Escudo 0.023 US Dollar

1979 1 US Dollar 48.924 Escudos 1 Escudo 0.020 US Dollar

1980 1 US Dollar 50.062 Escudos 1 Escudo 0.020 US Dollar

FISCAL YEAR

January - December

This report is based on the findings of a mission which visited Portugal between June 23 and July 11, 1980. The mission comprised A. R. Roe (mission leader), P. J. Lazar (general economist), W. S. Kee (public finance specialist) and S. Mitra (IMF). The draft of this report was sent to the Portuguese Government in March, 1981, and was discussed in Lisbon in July 1981. FOR OFFICIAL USE ONLY

PORTUGAL: RECENT ECONOMIC DEVELOPMENTS AND THE MEDIUM-TERM PERSPECTIVE WITH SPECIAL REFERENCE TO RESOURCE MOBILIZATION.

(IN TWO VOLUMES)

VOLUME II

PROBLEMS OF DOMESTIC RESOURCE MOBILIZATION

Table of Contents

Page No.

PROBLEMS OF DOMESTIC RESOURCE MOBILIZATION ...... 1

A. An Overview ...... 1 B. bavings and the Flow of Funds ...... 5 C. Resource Mobilization and Public Enterprises.... 10 D. Public Finance ...... 16 E. The Private Sector: Households ...... 24 F. SQme Concluding Remarks ...... 30

ANNEX II THE PORTUGUESE TAX SYSTEM...... 33

APPENDIX II ...... 37

This document has a restricted distribution and may be used by recipients only in the performance of , their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

VOLUME II

PROBLEMS OF DOMESTIC RESOURCE MOBILIZATION

A. An Overview

3.1 In the ten years preceding the revolution, the conservative eco- nomic policies adopted in Portugal resulted in an extremely sound financial position in which domestic saving was consistently high relative to gross domestic investment. As Table 3.1 indicates, an important aspect of this was the high level of public sector saving.

3.2 After the revolution the position changed dramatically. Public saving was decimated by many factors including the boost to expenditure as- sociated with the expansion of public sector employment, the newly acquired burden of the nationalized industries and the costs of an expanded welfare system. Household saving was reduced as a consequence of the higher con- sumption levels associated with the colonial returnees, and the decline in income inequality, as well as by the slump in migrants' remittances. Corporate saving was reduced by the squeeze on profitability associated with the loss of conventional markets, labor problems and by the control on prices. It was also hit by the higher costs associated with new employment legislation, the rapid rise in wage rates and the higher cost of imported fuels, and other inputs. Whereas in 1973, domestic savings was adequate to finance 111 percent of gross investment, by 1976 it was only sufficient to finance 60 percent of the total. This was in spite of the fact that invest- ment grew by only 32 percent in nominal terms during this period and fell slightly in real terms. Savings in nominal terms fell by 28 percent over that same three-year period.

3.3 This situation imposed a very considerable strain on financial intermediaries as firms in both the public and private sectors attempted to make good their inadequate operating positions by higher levels of borrow- ing. In the absence of sufficient savings, this in turn obliged the Central Bank to finance a large proportion of credit through rediscounting opera- tions and money creation. Credits extended by the financial community to the productive sectors increased from Esc. 250 billion at the end-1973 to Esc. 348 billion by mid-1976. At the same time, the proportion of these credits granted by, or rediscounted with, the Central Bank rose from 5.6 percent to 27 percent of the total.

3.4 Another very important consequence of the deterioration in company finances was its effect on the composition of private savings. Throughout the sixties, corporate saving was the major element in saving and normally accounted for over 50 percent of the total. By 1975 the position had rad- ically changed and the share of company saving had fallen to 8 percent as - 2 -

Table 3.1: GROSS NATIONAL SAVINGS AND DOMESTIC INVESTMENT 1962-1979

Gross Domestic Gross National Public Investment Savings Savings Savings/ Public Savings/ Esc. Billion Esc. Billion Esc. bln Investment GNS

1963 15.7 12.7 2.0 0.80 0.15

1968 24.4 26.9 4.2 1.10 0.15

1970 41.8 45.3 8.4 1.08 0.18 1971 37.7 42.9 8.5 1.13 0.19 1972 46.7 59.7 7.7 1.27 0.12 1973 73.9 82.4 8.7 1.11 0.10 1974 84.3 63.4 1.3 0.75 0.02

1975 61.5 35.0 -9.2 0.56 -0.26 1976 97.3 58.0 -13.0 0.59 -0.22 1977 157.9 101.9 -12.6 0.64 -0.12 1978 180.5 147.3 -26.3 0.81 -0.17 1979 207.8 214.2 -37.9 1.03 -0.17

compared with a share for the household sector of over 70 percent.l/ Although there has been some recovery in company saving, it now accounts for only 40 percent of total saving, as compared with 77 percent for households. This large switch in the sectoral composition of saving has important implications for the institutional arrangements to allocate saving. It is not clear that the Portuguese institutional structure has yet made the necessary adjustment.

3.5 In the recovery phase of the economy since 1977, domestic resource mobilization has been strengthened in several important ways which together produced a near balancing of domestic savings and investment by 1979. As far as household saving is concerned, the most important contribution to this development has been the rejection of Portugal's traditional stance of stable but highly negative real interest rates and the adoption of interest rates which are radically higher than in the past. This development is discussed in more detail in Chapter I of this report. The evolution of interest rates in the past few years is described in Table 3.2. The increases in interest rates have contributed to an extremely rapid growth of deposits in the banking system and especially time and savings deposits which have been the subject of the largest interest rate increases (see Table 3.3). In an economy in which the banks are the dominant outlet for

1/ As Table 3.1 has already indicated, public saving became negative in 1975. The dependence of external saving was extremely high by then. -3-

Table 3.2; PORTUGAL - MAXIMUM INTEREST RATES

1972 c/ 1975 1976 1977 1978 From From From From Dec. Dec. 19 July 1 Feb. 28 Aug. 26 May 26 Onwards

Rediscount Rate 4.0 6.50 6.50 8.00-12.00 13.00-18.00 18.00-23.00

Deposit Rates Sight Deposits a/ 1.0-3.0 1.00-4.00 1.00-4.00 1.00-4.00 1.00-4.00 1.00-4.00 15-90 Days 3.25 4.50 4.50 5.00 6.00 8.00 19-180 Days 4.25 6.50 6.50 7.50 9.00 12.00 180 Days-1 Year 5.25 9.50 9.50 11.00 15.00 19.00 1-2 Years 5.75 10.50 10.50 12.00 16.00 20.00 Over 2 Years 6.75 10.50-11.50 10.50-11.50 12.00-13.00 16.00-17.00 20.00-21.00

Standard Lending Rates b/ Up to 90 Days 5.75 7.75 8.75 10.25 14.75 18.25 90-180 Days 5.75 8.25 9.25 10.75 15.25 18.75 180 Days-i Year 6.5 9.50 10.50 12.00 16.50 20.00 1-2 Years 7.25 10.75 11.25 12.75 17.00 20.50 2-5 Years 7.75 11.75 12.25 13.75 17.75 21.25 5-7 Years 8.00 12.25 12.75 14.25 18.75 22.25 Over 7 Years 8.25 12.75 13.25 14.75 18.75 22.25

Source: Bank of Portugal, Boletim Trimental, March 1980.

a/ Payable to individuals only. The precise rate depends partly on the level of the deposit. b/ Lower rates prevail for preferred types of credit, such as for agriculture, exports, housing, and labor-intensive and export-oriented investments. The types of projects which receive subsidies have changed through time. An interest rate surcharge is applied on loans for the purchase of consumer durables. The subsidies on interest rates were originally introduced in 1977 when interest rates began to rise and the investment climate was unfavorable. c/ Changes made between December 1972 and December 1975 are not shown in this table. - 4 - financial saving, the main source of rapid deposit growth has been a relative decline in real expenditures (consumption and investment), and inflows from abroad. As Table 3.3 indicates, the inflow of funds from migrants' has been a particularly important factor with an expansion for this item of well over 100 percent in each of the last two years.l/ The fact that deposits increased although interest rates remained negative in real terms reflects several factors. These include the fact that households fail to fully integrate inflationary expectations into their behavior and the scarcity of alternative financial outlets for saving.

Table 3.3: THE GROWTH OF CURRENCY AND BANK DEPOSITS, 1976-79

Escudos billion - end period Growth Rates (%) 1976 1977 1978 1979 1977 1978 1979

Currency Holdings 109.2 113.3 121.4 142.1 3.8 7.1 17.1 Demand Deposits 130.8 155.2 186.0 246.4 18.7 19.8 32.5 Time & Savings Deposits 214.5 292.6 411.7 595.3 36.4 40.7 44.6 Of which: Individuals .. 230.3 297.2 401.6 .. 29.0 35.1 Emigrants .. 34.0 80.2 133.4 .. 135.9 166.3

Not available. Source: Bank of Portugal

3.6 The second important factor in the recovery of domestic savings has been the recovery of corporate profitability after 1976. This has been made possible, in particular, by the expansion of old and the development of new export markets, and by the substantial gap between price and wage inflation which characterized the period up to 1979. The improvement in corporate saving is placed in context by Table 3.4 below. This clearly shows that while the growth of corporate saving (Esc. 18.8 billion and 26.4 billion in 1978 and 1979 respectively), has been considerable, it has in fact declined slightly as a proportion of the total of domestic saving while household saving has risen. The picture is confused, however, by the fact that the official figures for corporate savings, shown in Table 3.4 include public enterprise saving which in turn reflects the receipt of subsidies and other transfers from the Government.

3.7 The encouraging performance of household and corporate saving has had an offset in the continuing high levels of dissaving in the public sector which are also shown in Table 3.4. It has been the intention of

1/ For completeness, it should be noted that migrants' remittances which are held in foreign currency deposits in the banks attract interest at prevailing international levels rather than Portuguese rates. Although international interest rates can be lower, protection from further escudo devaluation is a compensating advantage of such deposits. - 5 - recent Governments to reverse the six-year trend of declining public saving. However, the pressures associated particularly with transfers and public sector employment have conspired to maintain that trend. In terms of its share of GDP at market prices, the current deficit rose from 2.8 percent in 1976 to 3.8 percent in 1979.

Table 3.4: SECTORAL SAVING, 1977-79

Esc. Amounts (Billion) ------Shares %------Growth Rates % 1977 1978 1979 1977 1978 1979 1978 1979

Households 71.5 111.6 166.5 71.1 76.6 77.3 56.1 49.2 Companies a/ 41.6 60.4 86.8 41.4 41.5 40.3 45.2 43.7 Public Admin. -12.6 -26.3 -37.9 -12.5 -18.1 -17.6 -108.7 -44.1 Total Domestic Savings 100.5 145.7 215.4 100.0 100.0 100.0 45.0 47.8

Domestic Investment 157.9 180.5 207.8 Saving/Invest- .636 .807 1.037 ment a! Including public enterprises. Source: Bank of Portugal

3.8 In spite of this, overall domestic savings has risen strongly since the drastic decline in 1974 and 1975. The overall growth rate of savings has averaged more than 40 percent in the past two years and by 1979 the total exceeded total domestic investment by over 3 percent. The problem of savings mobilization is analyzed on a detailed sector by sector basis in Sections C to F inclusive. First, in Section B, we analyze the relative importance of savings flows in the main sectors and the manner in which these are channelled for investment purposes.

B. Savings and the Flow of Funds

3.9 The manner in which the savings, identified above, are channelled for the use of investing sectors is documented in detail in Table 3.5 below. This table is an elaboration of an estimate of the flow of funds compiled by the Bank of Portugal. The table provides an estimate of savings in each sector arrived at by summing the identified financial and other uses of sav- ing and subtracting identified borrowing. To the extent that the savings estimates derived in this manner differ from the estimates in the national accounts, this suggest either that some sources and/or uses of funds have failed to be identified at the sectoral level or that the national accounts estimates of savings are wrong. In Table 3.5, the-discrepancies are -6-

recorded in row 20 and indicate, in our judgement, a possible underestima- tion of household saving and an overestimation of corporate saving in the national accounts.

3.10 Several important conclusions about Portugal's savings investment balance and financial system emerge from Table 3.5. First, an examination of line 4 indicates the relatively self-contained nature of Portugal's pri- vate corporate sector. In both 1978 and 1979, the private corporate sector shows a near balance between its own use of capital funds for investment and the funds it generates through its own savings. This is indicative both of the limited institutional arrangements for raising external finance in the Portuguese context, as well as the corporate sector's inability or unwillingness to further increase its indebtedness to the banking sector beyond the very high levels reached during the post-revolution crisis. At the same time, the obvious absence of a significant financial surplus in the corporate sector indicates that the sector has been unable to decumulate debt. On the basis of the 1978 and 1979 performance, it will take the corporate sector as a whole many years to restore equity/debt ratios to the levels experienced prior to 1974.

3.11 Second, the table indicates the extremely large net burden on capital financing represented by the public enterprises. The data in line 4 show that the financial deficit of these enterprises absorbed approxi- mately 40 percent of domestic saving in 1978 and 20 percent in 1979. In 1978, the public enterprises placed net demands on the capital markets only slightly below those of public administration, even though the latter figure is increased by the subsidies paid to the enterprises. In 1979, despite an improved savings performance from the public enterprises associated with more realistic pricing arrangements, the net capital demands remained at about Esc. 40 billion. Comparison with line 10 indicates that the major portion of these financial deficits have been met from bank credit. How- ever, beginning in 1979 the position changed in that the enterprises borrowed extensively from external sources (lines 14 and 15) and thereby limited their claims on domestic credit to about Esc. 35 billion. This switch in the sources of financing has been even more marked in 1980 and the public enterprise use of bank credit has consequently declined further. However, the external indebtedness of the enterprises, much of it short- term, has increased considerably.

3.12 Third, and in common with many developing countries, Portugal's savings effort now depends extremely heavily on household saving (see line 1). As noted earlier, this is a departure from the situation in the 1960s. In both 1978 and 1979, household saving contributed about 77 per- cent of total domestic saving. Because of its large contribution to saving, the household sector is also the only domestic sector which in the post-revolution period has been able to generate a significant financial surplus. This totalled Esc. 83 billion in 1978 (Esc. 126.8 billion if one calculates it by summing identified financial transactions) and Esc. 130 billion in 1979 (or Esc. 180 billion on the flow of funds basis). It is - 7-

important to. emphasize that the financing of the deficit sectors, and especially public administration and the public enterprises, is crucially dependent on this household surplus. Given that the public sectors are likely to continue in deficit in the next few years, institutional improve- ments which could enable the private corporate sector to rely less on retained earnings and bank credit, would also depend on the maintenance of a high level of household sector surplus. For these reasons policies to ensure the stability of the household financial surplus at an adequate level, and to ensure that its allocation to deficit sectors is handled efficiently, represent an important part of a medium-term strategy. They are discussed more fully in Section F below.

3.13 The fourth major perspective emerging from Table 3.5 concerns the extremely "thin" nature of Portugal's financial system. Comparison of the monetary, including quasi monetary, totals (lines 5 to 10) with all other domestic financial items (lines 11 to 13 and line 19), confirm that avail- able savings flow predominantly into monetary assets and that the financing of deficit sectors depends almost exclusively on monetary liabilities. For example, the net acquisition of monetary assets by the household sector in 1979 represented at least 130 percent of its financial surplus, as esti- mated from the national accounts, and well over 90 percent of its financial surplus as estimated from the flow of funds. Similarly, the net bank bor- rowing of the public enterprises and public administration represented 80 percent of those sectors' combined deficits in 1979. Even in the case of the private corporate sector which shows no significant net acquisition or net decumulation of financial assets in the two years under review, virtually all of the gross transactions in financial assets and liabilities are with the banking system.

3.14 There is nothing inherently wrong, or for that matter uncommon, about the banking system being placed at the center of the stage in capital market operations. What is worrying in the Portuguese context is that the powers of the banks to provide a balanced menu of financing have been sub- stantially reduced by the nationalization measures. At the same time, high interest rates combined with credit ceilings have presented them with a very rapid expansion of available funds much of which they are unable to on-lend. This has had two important consequences. First, the profitabil- ity of the banks has been seriously eroded as has the incentive to innovate in the provision of credit. Second, in an era when the banks have been unable to supply equity finance, but when the corporate sector has been generally undercapitalized, it has produced imbalances in the composition of the supply and demand for funds. The resolution of this imbalance seems to have resulted in an over-provision of loan finance, much of it short- term, and so to a worsening of debt/equity positions in some cases. The Government as a major alternative provider of equity capital has been unable to step into the gap because of its own serious budgetary problems. - 8-

Table 3.5a; THE FLOW OF FUNDS IN PORTUGAL, 1978

House- Private Public Public holds Corp. Corp. Admin. Monetary External Residual Total

1. Saving 111.6 60.8 -0.4 -26.3 - 34.8 - 180.5 2. Fixed Investments 28.2 45.2 44.0 39.1 - - - 156.5 3. Changes in Stocks - 12.0 12.0 - - - - 24.0 4. Financial Surplus/ Deficit 83.4 3.6 -56.4 -65.4 - 34.8 - 0

Accounted for by Changes In; 5. Currency Holding 4.2 3.2 1.0 - -8.4 - - 0 6. Demand Deposits 16.8 11.4 3.5 - -31.7 - - 0 7. Time Deposits 67.0 4.7 1.3 - -119.1 - - 0 of which Migrants 46.1 8. Deposits of Public Administration -6.2 6.2 - - 0 9. Bank Credit (Fin. Applications) - -4.7 - -38.0 42.7 - - 0 10. Other Bank Credit -13.4 -26.2 -46.3 -4.2 123.4 - -33.3 0

11. Non-Bank Credit: 12. (i) Public Bonds 2.3 2.3 - -4.6 - - - 0 13. (ii) Other Creditors - - -23.9 23.9 - - - 0

14. MLT External Debt ) -7.2 -12.0 -23.0 -2.2 34.1 0 15. ST External Debt ) 10.3 0 16. Liquid External Items; 17. (i) Banking System 14.6 -14.6 0 18. (ii) Public Treasury 2.8 -2.8 0

19. Other Assets/ Liabilities 3.8 15.0 15.0 -16.1 -25.5 7.8 0

20. Total -43.4 5.1 5.0 0 0 0 33.3 0

Notes: a) Arbitrary allocations of known totals to sectoral categories have been used in relation to the following items: Line 3; Between private companies and public enterprises. Line 5; Between households, private companies and public enterprises. Line 9; "Applicacoes Financeiras." Between private corporation and public enterprises. Line 19: Between households, private companies and public enterprises. b) In Line 2, the investment figure for households is the housing investment figure from the national accounts. This is the minimal figure for this item. - 9 -

Table 3.5b; THE FLOW OF FUNDS IN PORTUGAL, 1979

House- Private Public Public holds Corp. Corp. Admin. Monetary External Residual Total

1. Saving 166.5 59.8 27.0 -37.9 - -7.6 - 207.8 2. Fixed Investments 36.6 50.7 55.7 42.7 - - - 185.7 3. Changes in Stocks - 11.1 11.0 ,- - - - 22.1 4. Financial Surplus! Deficit 129.9 -2.0 -39.7 -80.6 - -7.6 - 0

Accounted for by Changes In: 5. Currency Holding 11.7 8.6 3.0 - -23.3 - - 0 6. Demand Deposits 21.4 25.7 11.2 - -58.3 - - 0 7. Time Deposits 104.3 23.9 2.1 - -183.6 - - 0 of which; Migrants 53.3 8. Deposits of Public Administration 26.4 -26.4 - - 9. Bank Credit (Fin. Applicaroes) - 2.9 - -99.7 96.8 - - 0 10. Other Bank Credit -18.1 -88.0 -34.7 -3.4 155.2 - -11.0 0

11. Non-Bank Credit: 12. (i) Public Bonds 3.4 3.4 - -6.8 - - - - 13. (ii) Other

Creditors - - -18.0 18.0 - - - 0

14. MLT External Debt ) -3.2 -28.0 -17.3 -9.3 40.0 0 15. ST External Debt ) 17.8 0 16. Liquid External items; 17. (i) Banking System 59.7 -59.7 0 18. (ii) Public Treasury 6.6 -6.6 0

19. Other Assets! Liabilities 4.3 5.0 5.0 -4.4 -10.8 0.9 0

20. Total -50.4 19.7 19.7 0 0 0 11.0 0

Notes (continued): c) In Line 10, the credit to households' figure is the housing loans' figure from Table 1.4 of the Boletim Trimestral of the Banco de Portugal. Again, this is a minimal figure. d) The residual figure in Line 10 is the change in bad debts, which the banking statistics do not allocate by sector. e) The non-zero figures shown in Line 20 are the amounts of additional financial asset (+) or liability (-) accumulation needed to reconcile the flow of funds accounts estimate with national accounts estimates of sectoral saving. They sum to the unallocated total of bad debts. They also represent a best guess at the potential errors in the sectoral savings estimate. - 10 -

C. Resource Mobilization and the Public Enterprises

3.15 The origin of the substantial financial deficits of the public enterprise sector 1/ which was largely created by the 1974 revolution, lies in several factors. These include excessive increases in employment and wage rates that followed the 1974 revolution (and also the return of the colonial emigrants with certain enterprises being obliged to employ some of these emigrants), price controls on the output of some of the enterprises (e.g., public utilities), delays in raising prices and tariffs, and lack of centralized control. Many of the enterprises have been in serious financial difficulties for several years and some have fallen in arrears with their loan payments to the banking system, particularly to the Banco de Fomento Nacional (BFN). 2/ The indebtedness as between different parts of the public enterprise sector (e.g., Petrogal and T.A.P.) is increasing and is creating serious problems. The accumulation of large and prolonged deficits has weakened the financial base and capitalization, increased debt service requirements, and reduced the creditworthiness of some of the public enter- prises. This is particularly evident in the transport enterprises where tariff controls and subsidy payments that have been inadequate to cover losses, incurred in providing services on social grounds, have seriously compounded the problems arising from low levels of operating efficiency. The lack of accountability to the Government has been a major problem as the enterprises tended to budget autonomously and unrealistically and to have ambitious investment plans which required large resort to either domestic or foreign borrowing or to transfers from the public sector budget. Even basically sound enterprises are having their investment and financing plans disrupted by the increasing volumes of unpaid accounts due from other enterprises. Solutions now need to be found which combine broadly based measures to raise the efficiency of the enterprises with steps to moderate the financial constraints under which they operate. 3/

1/ This sector now has about 400 members of which 125 are fully owned by the state. About 130 are in manufacturing, 40 in transportation and 70 in banking and insurance. They are estimated to account for 25 percent of GDP and 20 percent of the labor force.

2/ Aggregate estimates of the economic problems of the public enterprises are difficult to obtain, but some data are available for 26 of the largest enterprises. The absence of appropriate aggregate data is an indication that the monitoring of public enterprise activities is still imperfect despite the improvements initiated in the past two years.

3/ In the discussion which follows it is assumed that the dimensions of the public enterprise sector remains broadly unchanged. However, in practice, the Government is working actively to re-admit private capital to some of the productive areas presently monopolized by public companies. - 11 -

3.16 The financial policies applicable to the public enterprises were established by Decree Law No. 260, of April 1976, which provides for the setting of prices that cover operating costs and an adequate proportion of investment costs. In cases where for social reasons below-cost prices were to be applied, the enterprises would be eligible for compensation from the State. The application of policies provided for under this law ought to result in the generation of sufficient revenues by enterprises to fully cover all operating and financial costs and to self-finance a proportion of their investment. The prices set by the enterprises ought to reflect the resource costs to the economy for the provision of the goods and services by the enterprise and avoid distortions in the production and consumption of such services, except to the extent that certain activities were being subsidized on social grounds.

3.17 In practice, however, the enterprises have been widely used as a mechanism to promote equity, regional balance and empioyment. In partic- ular, the granting of inadequate price increases has meant that many enter- prises and especially those in the transport sector have had to face operating and financial losses which are larger than necessary. The deficits that have been incurred have been partly covered by subsidies and partly by resort to credit from the banking system, which in recent years has greatly increased the short-term indebtedness of these enterprises and led to heavy debt service costs. Inadequate revenues have also contributed to the debt burden of the enterprises with capital expenditures being financed from outside sources and, in certain cases, have led to inadequate working capital and provision for depreciation.

3.18 Table 3.6 shows the amount of subsidies and other Government sup- port broken down by sector. Subsidy payments grew by 180 percent between 1976 and 1979, but were frozen in nominal terms in'1980 and are expected to decline in nominal terms in 1981. Even in 1978, subsidy payments did not cover deficits and many enterprises were forced into heavy borrowings from the commercial banks. In fact, in that year, they accounted for over a quarter of total domestic credit expansion which, coming on top of the heavy demands from Government, resulted in a very restricted availability of credit for the private sector. In the last two years the healthier enterprises have been encouraged to borrow more extensively from abroad and this has moderated their claims on bank credit in spite of the freezing of subsidy payments. However, the volume of foreign borrowing has not been adequately monitored and controlled and is now becoming a cause for some concern. In particular, in 1980 there was an estimated increase of over $1.0 billion in short-term external debts till September, much of it attrib- utable to the public enterprises. This borrowing is indirectly helping to finance the less healthy enterprises by increasing the arrears of receiv- ables which the healthy companies are able to tolerate. One possible rationale for the freezing of subsidies to the enterprises, combined with control on output prices, is that this can encourage them to seek much needed improvements in productivity. So far this result has been achieved to only a limited extent as the outside funds which the enterprises have managed to generate have been substituted for subsidies. More specifically, - 12 -

subsidies have declined from 13 percent of the enterprises outside funds in 1978 to 8 percent in 1980. Over the same period the total of outside funds (subsidies, government capital transfers, bank credit and foreign borrowing) has risen from 11 percent of GDP to 12 percent. This is not to say that subsidies should have been higher; only that policies could have been followed which could have reduced the need for both subsidies and borrowing.

Table 3.6: GOVERNMENT ASSISTANCE TO PUBLIC ENTERPRISES BY SECTOR (In Billions of Escudos)

(a) Budgetary Subsidies

1976 1977 1978 1979 1980 June ------Outturn----- Budget Outturn Budget

Transport 3.5 6.1 8.2 5.3 8.2 8.2 Industry .. 1.2 1.4 0.9 1.4 1.4 Agriculture and Fisheries .. 0.5 0.7 0.5 0.8 0.4 Communications .. 0.2 0.5 0.4 0.6 0.8 Other 0.5 _ 0.1 0.2 0.2 0.2

Total 4.0 8.0 10.9 7.3 11.2 11.0

Source: Data supplied by the Portuguese authorities.

(b) Subsidies, Capital Transfers and Guarantees (1978)

Guarantees Sub- Capital External for Internal Special a/ sidies Transfers Guarantees Credit Guarantees

Total 10.9 5.4 40.3 b/ 7.8 n.a. Industrial Sector (1.4) (2.2) (19.2) (n.a.) (n.a.) Transport Sector (8.1) (2.7) (6.5) (6.2) (10.0) a/ Especially granted by the Ministries of Industry and Transport for either domestic or foreign loans. b/ Of which Esc. 14.7 billion was granted for the Banco de Fomento Nacional and Sines. In US dollars, the total external guarantee amounted to $842 million.

3.19 The position of the railway company (CP) illustrates the nature of the problem of public enterprises in its most extreme form. In brief, the problem is that between 1973 and 1979 CP's revenues increased by an average of 24 percent per annum, whereas expenditures rose by an average of 33 per- cent. Revenues declined as a percentage of expenditures from 64 percent in - 13 -

1973 to 43 percent in 1979 (see Table 3.7). Staff costs rose by 35 percent as a result of a 50 percent increase in staffing from 1973 to 1978 and im- provements in salaries and benefits quite unrelated to productivity. Wages and salaries peaked as a percentage of total expenditures at 68 percent in 1975, but declined thereafter as the growth of nominal wages slowed relative to that of other costs. In spite of quite inadequate allowances for depre- ciation and track maintenance, operating costs per traffic unit rose by 38 percent over the same period, just a little more than wage costs. Financial costs started to increase sharply after 1977 as interest rates increased. The debt service share of total expenditures rose from 14 per- cent in 1976 to 29 percent in 1978 and to 24 percent in 1979 (see Table 3.7). Tariff increases have been set in a manner which is related to many factors besides cost developments and has resulted in a general failure of price adjustments to match cost increases. The most recent increase has been one of about 15 percent for passenger traffic in April 1978 and a 20 percent increase in October 1979. No increase occurred in 1980 and the operating position has deteriorated sharply since 1977. The short-term indebtedness has risen alarmingly as a consequence, and the ratio of equity to fixed assets has declined to less than 9 percent. At the same time no real progress has been made in rationalizing services and in improving the general operating efficiency of the organization.

Table 3.7; SELECTED FINANCIAL INDICATORS FOR CP

As a % of Expenditures 1973 1974 1975 1976 1977 1978 1979

Revenues 64 53 42 44 42 44 43 Wages and Salaries 52 56 68 63 51 48 48 Debt Service 12 10 12 14 22 29 24 State Subsidies 31 34 44 46 37 52 41 Current Assets/ Current Liabilities 0.4 0.3 0.3 0.3 0.2 0.1 - Equity/Fixed Assets 33.6 41.2 34.3 30.8 24.2 8.9 -

3.20 One might wonder why the authorities did not raise tariffs as costs increased and why operating costs could not be contained. As for tariffs, it is obvious that social considerations prevailed over accounting princi- ples in order to maintain a large subsidy for the consumer; the passenger traffic accounts for 85 percent of CP's traffic volume and 75 percent of its revenues. Among the social factors which were considered, one must cite first the desire to keep the commuting costs low for the increasing number of workers who live in the suburbs of major cities. Their numbers grew as the large flows of returnees and workers leaving the agricultural sector settled in the suburbs and as new housing opportunities in the center and close surroundings of the cities diminished. The subsidizing of public transportation became one way of substituting for the provision of housing - 14 - facilities which would be closer to work. It also certainly had the effect of reducing the use of private vehicles in the center of the cities, thus reducing congestion and fuel usage. In addition, the rising cost of automobile transportation, caused by the increase in the price of car imports and in gasoline, made the ownership of a car out of reach for many. The size of the apparent subsidy has become so large over time, however, that an increase in tariffs of the order of 50 percent would be needed to enable CP to simply cover working expenses (excluding depreciation).

3.21 A large net absorption of funds for current operations by major public enterprises, such as CP, in the form of state subsidies and bank credit obviously preempts part of the total funds mobilized for investment purposes and is a serious misallocation of resources. Remedies, in the case of CP and several other companies, would require first and foremost, a major rationalization of operations to raise productivity. However, this would only be effective if accompanied by prompt and adequate increases in the price of services in the framework of a general relaxation of price controls and a rigid containment of costs, particularly of personnel. It should be clear that the users of the services should not pay for overmanning, that prices should be set for efficient operations, and that subsidies should be given on some predetermined and rational basis. Once for all, injections of Government equity, especially in the case of CP, seem vital to the rehabilitation of its financial structure. It would also be useful to adhere rigidly to the principal of full subsidization for the operation of uneconomic services justified by social considerations. In the absence of a reformed approach towards the pricing, subsidy and other policies of the public enterprises, they will continue to represent a large net drain on the economy's saving. Given also the distortions in the allocation of capital funds which the present situation generates, it is difficult to overstate the need for policy reform in this area.

3.22 In order to provide a counter-example to that of the major trans- port enterprises, it is also useful to briefly document the experiences of a major industrial enterprise, namely the cement company, CIMPOR, which is basically on a sound financial footing. In the case of CIMPOR, both the level and recent rise of wage costs have been overshadowed by fuel costs which have risen from 25 percent to 43 percent of the final cost of the product. A 40 percent price adjustment was implemented in 1978 to cover cost increases since the previous adjustment in 1975. In spite of a policy implemented at the same time to automatically pass on increases in fuel and electricity costs, no price increases took place in 1979 or in 1980. The operating surplus has suffered as a consequence and fell by nearly 6 percent of sales to 4.1 percent in 1979. The essentially sound financial structure also deteriorated. Although CIMPOR can certainly produce on a more cost effective basis, not least by switching to production methbds which econo- mize on energy use, it also requires a well-defined system for regular price adjustments. - 15 -

Conclusions and Policy Actions

3.23 The Government has not been blind to the problems of the public enterprises and has been working hard to effect some solutions. As far as administration is concerned the authorities have already implemented two schemes in 1979 designed to improve their control over the public enter- prises. The first was the Sistema de Planeamento das Empresas Publicas et Participadoes (SPEPP), which was due to become effective in 1980. SPEPP required all enterprises to provide, at the beginning of each year, an operating and a capital budget specifying sources of financing. The Minister of Finance and Planning would be responsible for ensuring that the aggregate public enterprises' budget was consistent with the public sector budget and the fiscal stance for the year. The system is not yet in operation.

3.24 The second measure consisted of an effort by the Ministry of Finance and Planning to require each ministry to assess the investment proposals of all the enterprises under its control and to submit a list of approved investments to the Minister of Finance for consideration. The enterprises were also required to specify sources of financing, including the extent of self-financing. Furthermore, all foreign loans and domestic loans of more than six years' maturity required the approval of the Secretary of State for the Treasury. In theory, this allowed the Ministry of Finanee and Planning to have greater control over, and better monitoring of, the investment activities of the public enterprises and to avoid the problem of having to finance investments already contracted into by the enterprises without any central clearing. The effectiveness of this system remains to be fully demonstrated.

3.25 As far as rehabilitation is concerned, the major mechanism has been the Economic and Financial Clearing Agreement (ASEF) which has operated with varying degrees of effectiveness. The ASEF signed with the bus company (RN) in 1978 has failed to generate the projected post-transfer rate of return of 9 percent. This is partly because the agreement fails to give the company much latitude to freely pursue a well defined pecuniary target subject to well defined contraints. In addition, the Government has not yet to honored its commitment to the company to compensate it fully for non-commercial operations. The 1980 agreement with TAP seems to represent an improvement in several respects. The Government is committed to compensating TAP for operating deficits resulting from the need to meet international competition and the operation of below-cost flights to the Azores and Madeira. In addi- tion, it is rather specific on measures to raise productivity, and contains explicit projections on a number of performance indicators. If these are achieved, the post-transfer rate of return should rise from minus 2 percent in 1980 to plus 7 percent in 1984. A more recent draft agreement concerning CP involves a new ingredient in which the Government would assume financial responsibility for investment in and maintenance of the company's infra- structure. In addition, the scheme provides for the transfer to Government - 16 - of certain of CP's liabilities. However, the measures to rationalize operations which should complement these essentially financial proposals are still to be defined.

3.26 Important as these developments are, it is clear that their long run effectiveness is dependent on improved arrangements in the area of pricing policy. In the case of manufacturing enterprises such as CIMPOR, there is almost no reason, economic or social, why productive enterprises should not be allowed to adjust prices to cover increases in costs. Intervention to prevent this has transferred a part of the burden of the costs of productive services from the users of these services to the tax- payer and has, thereby, distorted other costs and prices. As an interim solution, we would suggest that enterprises be allowed to pass on a certain proportion of cost increases (perhaps 80 percent) as an automatic right and to apply for Government approval only for cost increases greater than this. Such an arrangement would provide some stimulus to productivity improve- ments, but would not leave the financial viability of enterprises dependent on such improvements. These proposals should not, however, be seen as an alternative to measures to improve efficiency in the enterprises. In order to avoid the risks of this new policy giving rise to explosive wage increases, the Government could announce a norm rate of increase for each 6-month or 12-month period. Wage increases in excess of this should not be allowable as a cost increase which can automatically be passed on. In addi- tion, further attempts should be made to reduce over-manning where this is a problem and to develop appropriate incentives within enterprises to stimulate efficiency.

3.27 In the case of the transport enterprises, the position is more difficult because of the sensitive social issues which impinge on pricing. Here, a thorough financial restructuring operation is often needed in addi- tion to price adjustments and measures to improve productivity. Nonethe- less, and again as an interim solution, it can be agreed that the present subsidy from the taxpayer to the users of the services is generally too high and ought not to be increased further. Such an agreement would suggest the need for a pricing policy similar to that defined for productive enter- prises. Thereafter, and once the necessary financial restructuring has been agreed, it would be appropriate to make additional tariff adjustments to catch up on the short-falls of tariff increases of the recent past. Evi- dently, this adjustment might need to be spread through time since in many cases it will be large, but it should result in a progressive reduction in the enterprise's deficits, and so could complement productivity-improving measures. Precisely how large it should be cannot be determined without a detailed study of the manner in which the transport enterprises generate a social, as opposed to a commercial, service. The mounting of such a study is a matter of some urgency. It is possible that the Commission of Public Enterprises, recently established by the Government, will address this question as well as the efficiency questions which are its main concern. - 17 -

E. Public Finance 1/

3.28 As was noted in Chapter I of this report, the Government authorities have been facing increasing difficulties in reconciling the slow growth of revenues from an outmoded tax system with social and political pressures for continued growtn in wages and social outlays. During the 1974-1979 period, total expenditures in the public sector rose at an average annual rate of over 32 percent (31.5 percent for current and 35.0 percent for capital outlay), as compared to a revenue increase of 26.5 percent. As a result, tne overall deficit of the budget rose from an average of 5.2 percent of GDP in 1974-75 to 10.8 percent in 1978-79, while the current deficit has risen from 0.4 percent of GDP in 1974 to 3.8 percent of GDP in 1979. By 1981 the current deficit is projected to be well over 4 percent of GDP. Much of the increase in current outlay has been attrib- utable to the rising costs of Government consumption (mostly wages), but subsidies and interest payments rose sharply as a percentage of total expenditures (see Table 3.8). At the same time, there has been a steady shift in the composition of current revenues towards more direct taxes (see Table 3.8).

Table 3.8: STRUCTURE OF CURRENT REVENUES AND EXPENDITURES 1974-1979

Absolute - Structure - Index, 1979 Increase 1974 1979 (1974=100) (Esc. billion)

Revenues Current Revenues 282.0 100.0 100.0 332.0 Direct Taxes - Social Security Contributions 141.0 46.3 46.9 343.6 Indirect Taxes 124.0 47.5 46.1 329.7 Other 17.0 6.2 6.9 381.3 Central Government as % of Total 67.0 64.4

Expenditures Total 324.0 100.0 100.0 395.3 Goods and Services 131.0 64.1 48.8 300.3 Subsidies 52.0 9.9 15.4 613.5 Transfers 24.0 26.3 432.9 Of which: Social Security 101.0 - 21.4 Interest 39.0 2.0 9.5 1,900.0

1/ Defined to include the finances of the central Government, the social security system, the autonomous funds and services, and the local authorities. It excludes the finances of the public enterprise or parastatal sector. The central Government represents about two-thirds of total revenues and expenditures of the public sector. This is followed, in order of importance, by the social security funds and the autonomous funds and services and notably the supply fund. - 18 -

3.29 Although there are undoubted weaknesses in the Portuguese tax sys- tem, it is fairly clear that it is the lack of control on the expenditure side which carries most of the responsibility for the overall budgetary deterioration. This can be confirmed in a crude fashion by some inter- national comparisons of tax and expenditure performance which are presented in Table 3.9.

Table 3.9: COMPARISON OF TAX AND EXPENDITURE STRUCTURES IN SELECTED COUNTRIES

Portugal Brazil Greece Mexico Spain Turkey

1977 Per Capita GNP (US$) 1,840 1,410 2,950 1,160 3,260 1,110

Taxes: (percentage of GDP) a/ Personal Income Taxes 1.9 1.3 2.8 2.4 2.5 8.9 Corporate Income Taxes 1.2 1.8 1.7 2.7 1.9 0.9 Total Direct Taxes 4.7 3.2 5.6 5.1 5.3 9.8 Taxes on Foreign Trade 2.0 0.9 1.4 1.3 2.4 3.8

Domestic Taxes on Goods and Services 6.1 5.9 10.5 4.1 3.0 5.8 Total Indirect Taxes 9.7 6.8 14.5 5.4 5.4 9.6

Total Tax Revenues 14.4 10.0 20.1 10.4 10.7 19.4

Expenditures: b/ Current Expenditures as % of GDP 17.8 9.6 16.4 9.7 9.2 13.1 Current Expenditures as % of Current Revenues 121.6 90.7 72.5 87.0 85.0 87.7 a/ 1976/77 Average share of tax revenue in GDP excluding social security contributions. b/ Excludes social security and other budgetary accounts.

3.30 The revenue comparison in Table 3.9 suggests that Portugal is performing at almost exactly the average of a group of comparator countries in terms of the ratio of overall tax revenues to GDP. However, Portugal is slightly below average in terms of direct tax revenues and slightly above average in terms of indirect taxes. By sharp contrast, when we look at the expenditure comparison in Table 3.9, we see that Portugal is weli above average in terms of expenditures expressed as a ratio of both GDP and current revenues. To dramatise the comparison, it can be noted that a reduction of 1980 budgeted expenditures of the order of 25 percent would be required to bring Portugal to the average of the group of comparator countries. - 19 -

Expenditures

3.31 Having established this much, we can look more closely at the major components of recent expenditure increases before turning to a consideration of the tax system. It is important to look in particular at wages and salaries, transfers, subsidies and interest payments (see Table 3.8). On the question of wages and salaries, estimates from the National Institute of Statistics indicate that the size of public sector employment increased from 254,000 in 1974 to 386,000 in 1979 as the Government accepted the main responsibility for absorbing the colonial returnees. This increase repre- sents an average annual growth of nearly 9 percent. The impact of this on the wage bill was intensified by the fact that from 1974 to 1977 the aver- age Government worker received annual increments in earnings significantly greater than the rise in the consumer price index of about 22 percent. However, this additional boost to the Government's wage bill was reversed beginning in 1978, as wage controls began to bite. Also, beginning in 1978, the Government introduced strict limits on the growth of personnel and changes in the grade structure. This appears to have had only a modest effect in 1979 when the number of civil servants rose by a further 8,000 (or 3 percent). However, the preliminary evidence for 1980 does show a marked slowdown in Government employment as controls have become more effective.

3.32 The Government has certainly made serious and strenuous efforts to moderate the rise in the costs of its own civil service. However, the political feasibility of actually reducing the number of civil servants is questionable so long as the unemployment rate remains so high. For this reason, continued moderation of this element of the budget will depend heavily upon the policies which are followed for the control of public sector wage settlements. Given the losses of real wages which have been sustained during the past three years, it realistically has to be expected that wages will rise at least as fast as prices during the immediate future.

3.33 The subsidies and transfers required to operate various Government agencies constitute a rapidly increasing portion of the budget (see Table 3.8). In 1979 the bulk of these subsidies and transfers took the form of subsidies to the transport industry, transfer payments through the Social Security Fund, to local authorities and the Supply Fund.

3.34 Easily, the most important element of Government transfers is the transfer paid through the Social Security Fund, for pensions and other bene- fits which, in 1979, accounted for 80 percent of transfers. As a result of the shift of medical services out of Social Security, the financing burden of the Social Security Fund itself was temporarily alleviated after 1978; the deficit, Esc. 6.1 billion in 1977, was transformed into a surplus of Esc. 2.6 billion in 1978. However, this surplus was substantially eroded in 1979. The 1980 budget provided for a further large increase of 48 per- cent in old age pensions and social security benefits as a whole. Even after taking account of the broadening of the scope of benefits and an increasing number of recipents, the recent increases in social security - 20 - payments have been extremely high. In recent years the rise in the rate of most benefits has significantly exceeded the rate of inflation. Notwith- standing, the enormity of social needs in Portugal, the budgetary position is simply not sound enough to support the continuation of such rates of increase in the future and some moderation is clearly called for. The problem is compounded by the fact that the shift of medical and hospital services away from the social security budget has not prevented expend- itures on these services from increasing rapidly, and requiring an increased transfer from the central Government. The rise in expenditure (Esc. 23.2 billion in 1]978 to Esc. 33.8 billion in 1979) has been mainly due to wider use of medical and hospital services and an improvement in benefits.

3.35 Rising subsidy payments to public enterprises and the Supply Fund have resulted mainly from the Government's attempt to insulate consumer prices of food, fertilizer and some petroleum products as well as transport and other public services from rises in local production and distribution costs and in prices of imported products. As was noted earlier, subsidies to public enterprises have been rigidly controlled in the recent past and are expected to decline in nominal terms in 1981. Subsidy payments from the Supply Fund now account for over 80 percent of total subsidy payments.

3.36 The Supply Fund derives its revenues from taxation on petroleum and oil products and its major expenditure is the cost of subsidizing a selected group of commodities. Among this group the most important com- modities are cereals and flour, milk products, vegetable oil, fertilizer, heating fuels, diesel, heavy fuel and industrial oil. Total commodity subsidies have doubled since 1978 largely because of the Government's failure to fully pass on import price increases to the consumer (see Table 3.10). In the case of agricultural products, there is an urgent need to reform the existing system of price supports and agricultural subsidies. Tentative proposals for 1981 suggest the intention to sub- stantially reduce food subsidies. This is certainly the direction in which policy can be expected to move in the medium-term as membership into the EEC gets closer. In both 1978 and 1979 oil taxes were increased in order to promote conservation and raise additional revenues. The average oil tax was increased by approximately 50 percent and the oil subsidy accounted for 37 percent of total subsidies in 1979 and 6 percent of total current expend- itures. The fertilizer subsidy is relatively small and the oil product subsidy is mainly a cross-subsidization from gasoline products and other fuels, so that there exists considerable scope for reducing subsidies on these other oil products, such as heating fuels, town gas and diesel. Overall, there is no reason to expect the subsidy component of the budget to rise particularly fast in the future.

3.37 Unfortunately, the same cannot be said of interest payments on Government debt and two factors are conspiring to push this up rapidly. First, as the Government's overall deficit has progressively risen to about 10 percent of GDP, the accumulated public debt has inevitably been signifi- cantly inflated. Second, the Government has recently, and correctly, taken - 21 - steps to increase the interest payments on its own borrowing to bring them more closely into line with other interest rates. In relation to non- monetary borrowing, the higher interest rates are seen as a necessary

Table 3.10: SUBSIDY EXPENDITURES OF FUNDO DE ABASTECIMENTO (in billions of escudos)

(Estimate) (Estimate) 1975 1976 1977 1978 1979 1980

Foodstuffs 2.0 6.5 6.2 12.1 13.3 22.2 Fertilizers .. 1.2 0.9 2.3 1.8 4.9 Oil Products 2.6 3.0 6.1 8.3 18.2 21.4

Total 4.6 10.7 13.2 22.7 33.3 48.5

Source: Ministry of Finance and Planning and data provided by Fundo de Abastecimento. measure to limit the monetary implications of the Government's own bor- rowing. In relation to Government borrowing from the the banking system, the higher interest rates are seen as an important step to limit the profit squeeze on banks associated with their strong liquidity positions. Given that this policy stance will continue, there is no immediate prospect for any slowing down in the growth rate of the Government's interest payment burden.

3.38 The overall position on the expenditure side is that the Government can expect some further moderation in the burden which it has to face in relation to subsidy payments (currently 15 percent of the budget). By contrast it can only look forward to sharp increases in the budgetary changes for interest payments (10 percent of the budget). In relation to the two major components of its own expenditure namely wages and salaries and social security transfers, it will need to exercise considerable restraint in the face of.strong political pressure, if it is to avoid these payments rising significantly faster than the rate of inflation.

Revenues

3.39 The major sources of central Government tax revenues are, in order of importance, transaction tax, income-taxes, stamp duties, import duties, and other miscellaneous taxes. Based on actual revenue collections in 1979, the four major taxes together accounted for 70 percent of total tax or 57 percent of total revenue. The tax structure is also characterized by a dependence on a schedular income tax, some ear-marking of taxes to particular classes of expenditures and an unusually large revenue from stamp duties and a substantial role for social security contributions. - 22 -

3.40 The income tax, which makes up the bulk of direct tax revenues, has become increasingly important in revenue raising. This was particu- larly due to a rapid growth in professional tax. The share of income taxes in total tax revenue rose from 25.9 percent in 1974 to 29.9 percent in 1979. The share of stamp duties also rose from 10.2 percent in 1974 to 11.7 per- cent of total tax revenue in 1979, whereas the share of import duties (including surcharges) declined from 11.9 percent to 7.5 percent during the same period. Non-tax revenues, which are mainly incomes from Government- owned property and profits from credit institutions--especially the Bank of Portugal--have not changed much, as a percentage of total revenue, during the past five years.

3.41 A broad indication of the effectiveness of the Government's tax effort is already available from the international comparisons presented earlier (see Table 3.9). A further indication is available from the summary of the elasticities and buoyancies of taxes presented in Table 3.11. The "buoyancy" of each tax refers to the growth in revenues coming from a broad range of sources including increased tax rates, improved administration and changes in the tax base. By contrast, "elasticity" shows the response of tax revenues net of discretionary changes and so can be interpreted as measuring the quality of performance of tax administration and tax design. As one would expect, the buoyancy of most taxes in Portugal is much greater than unity. However, the elasticities are generally low.

Table 3.11: ELASTICITIES AND BUOYANCIES OF CENTRAL GOVERNMENT TAXES

(1974-1978)

Elasticity Tax Buoyancy Tax Category (Tax Base) Coefficients Ratios

Total Direct Taxes (National Income) 0.81 1.19 Total Indirect Taxes (Private Consumption) 0.84 1.11 Professional Tax (Labor Income) 2.32 2.72 Industrial Tax (Non-Labor Income) 0.38 0.71 Complementary Tax (Labor plus Personal Income) 0.72 4.30 Other Direct Taxes (Non-Labor Income) 0.54 0.70 Transactions Tax (Private Consumption) 0.88 1.46 Import Duties (Import Values) 0.53 0.47 Other Indirect Taxes (Private) Consumption 1.09 1.18

Source: Based on data provided by the Ministry of Finance and Planning. - 23 -

3.42 In relation to income taxes, the low elasticities are thought to be associated with widespread evasion particularly among self-employed professionals and businessmen. For example, in a recent study,l/ it was shown that about 35 percent of potential revenues from the complementary tax were lost to evasion in 1977-1978. Another important factor is the time lags between assessment and final collection. In the case of the complementary tax for example, tax payments are often on income earned over 12 months earlier. Because of this, the actual burden on taxpayers is considerably smaller than the nominal burden especially in periods of rapid inflation. The main exception to the low elasticity of Portuguese taxes is the professional tax. This tax avoids some of the problem of both evasion and delayed collection by virtue of the fact that it is collected at source.

3.43 In 1980 the Government mounted a strenuous campaign against tax evasion and fraud centered upon an amnesty on tax arrears. This has con- tributed to an overall outturn for tax revenues which is about 3 percent higher than was budgeted. However, the improvements which can come from the further reform in tax arrangements will take time and cannot be expected to contribute much to the growth of revenues in the immediate future. Some of the specific problems which arise is the context of the main Portuguese tax system are discussed in detail in Annex II. The main conclusions and proposals for reform are as follows. The industrial tax suffers, in particular, from excessive deductions in the taxation of business incomes and the under-reporting of income. Furthermore, the tax base is substantially eroded by Portugal's complex tax incentive arrange- ments, which seem to be administered with inadequate regard to their revenue consequences. The complementary tax should exhibit a far higher elasticity than has been witnessed in recent years. The explanation is that there has been a severe erosion of the tax base due to administrative inefficiency and tax evasion, especially by small businessmen and profes- sional people. There is also strong reason to believe that the excessive progressivity of the tax has been a major encouragement to substantial tax fraud and evasion. In relation to direct taxes in general, the moves which are being made to establish a global basis of taxation are welcome.

3.44 The major single issue in the field of indirect taxation concerns the speed and the manner in which the value-added tax (TVA) should be adopted in relation to EEC membership. In particular, the question of which existing taxes should be repealed is a crucial one. The transactions tax is a most productive source of revenue, but the high tax rates and poor administration, nevertheless, result in some loss of potential revenue. It is, therefore, the most likely tax to be repealed. In the absence of repeal, various measures to improve the administration of the tax are essential. They include heavier penalties for failure to declare

1/ A. Cavaco Silva, "Portugal's Budget Policy in 1974-1978," Second International Conference on the Portuguese Economy, Lisbon, September 1979. - 24 - and for under-reporting of production, especially by companies and large individual taxpayers. The stamp tax is an extremely complicated tax and some simplification would be desirable as a minimal reform. In addition, the stamp taxes, which are essentially payments to the Government for services performed (e.g., the fiscal stamp), might be placed on a cost-of- service fee basis. Other stamp taxes, which have a high nuisance value, could be abolished with the revenue losses being made good by higher rates elsewhere. All these conclusions relate to the composition of Portugal's tax arrangements. Together, they suggest that there is considerable scope for improving the efficiency of the tax system and, to a lesser extent, the total receipts of tax revenues. However, insofar as an impact on crucial macro questions such as the size of the public deficit is concerned, action on the expenditures side is likely to be more important.

F. The Private Sector: Households

3.45 As was noted earlier, the only domestic sector which has shown a significant financial surplus in the recent past is the household sector. Even allowing for significant improvements in the current account position of other domestic sectors, it is implausible to imagine that any of these can acquire the same importance as an ultimate source of capital funds in the medium-term future. Consequently, the allocation of household saving to different uses will continue to be the major aspect of the savings allocation process.

3.46 In considering this process, the first point to note is that a significant and rising proportion of household saving has been generated through migrants' remittances. The position in the last few years is summarized in Table 3.12. The figures indicate that migrants now account for approximately 48 percent of personal saving as compared with 34 percent in 1976.

3.47 Obviously the resurgence of migrants' remittances is a cause for congratulation since it clearly arises from policy measures such as the interest rate changes and the establishment of special forms of bank ac- counts designed for the needs of migrants. However, if the 1979 level of migrants' savings is seen as the base from which further growth is expected (and this is the approach of the macro projections presented earlier), then future Government policy is inevitably constrained. In particular, in a liberalized environment, migrants' saving is certain to be sensitive to interest differentials as between Portugal and the countries in which the migrants currently reside, and Portuguese interest rate policy needs to be set accordingly. Similarly devaluation may encourage remittances, while the commitment to future devaluation through a crawling peg arrangement may discourage or delay them. This is not to say that the Government has not been successful in maintaining a good degree of insulation between its general economic policies and those that affect migrants' savings.l/

1/ For example, through the foreign currency deposits (which protect the deposits from devaluation of the escudo and earn interest at rates related to these in the source country). - 25 -

Table 3.12: DISPOSABLE INCOME AND SAVING IN THE PERSONAL SECTOR

1976 1977 1978 1979

Levels (escudo billion) Disposable incomes 428.4 541.7 690.0 903.7 Less; Consumption 367.2 470.2 578.3 725.7

Personal Saving 61.2 71.5 112.6 178.0 Less: Migrants Saving - Identified Time Deposits 20.9 ) 30.5 46.1 53.3 - Other ) ) 4.7 31.4

Savings of Domestic Persons 40.3 41.0 61.8 93.3

Shares Personal Saving 100.0 100.0 100.0 100.0 Migrants Saving 34.2 42.7 45.1 47.6

Source; Bank of Portugal estimates. Migrants' saving is based on an assumed savings rate of 0.7.

However, the possibilities of such insulation are clearly limited in the absence of subsidies to the banking system which, in effect, would buy migrants' saving at the cost of lower public saving. In the long run, this constraint on policy can only be lifted by raising the proportion of household saving coming from domestic residents.

3.48 A second and more tractable problem for household saving concerns the manner in which it is channelled into the financial system. As the data in Table 3.5 makes abundantly clear, the intermediation of household saving depends very heavily upon the commercial banking system. It is not unusual for the commercial banks to be the major channel for household saving but the extent of their pre-eminence in this respect in Portugal is rather extreme. Certainly there are far poorer countries in the world where savers have a wider choice of outlets for their saving than they do here.l/ Why is this a problem? Because it almost certainly results in a lower quantity of institutionally channelled saving and to a poorer allocation of that saving.

1/ For example, in Sri Lanka (with a per capita income of $250) 20 percent of households saving gets channelled through non-bank financial institutions. - 26 -

3.49 The most important aspect of the allocation issue relates to the mix between long- and short-term lending. The legal position after 1974 was that the commercial banks were not allowed to lend for terms exceeding one year except under special conditions. Thus, in the period from nation- alization until 1977, less than 5 percent of credit granted was for more than one year. The introduction of the limitation was associated with the perception of the banks as symbols of the family-based, conglomerate capitalism of the pre-revolutionary period. However, it was obviously inefficent 1/ and was amended in August 1977. From that point on, the banks were permitted to carry out lending operations for periods of up to ten years. The same legislation stipulated that the banks should devote a proportion of the annual increase in their time deposits of over 181 days to medium- and long-term purposes; in July 1978, for example, the propor- tion was set at 35 percent. These measures have contributed to a slight increase in the medium- and long-term lending of the banks but this is still modest (see Table 3.13). At the same time, the other banks which are classified under the broad heading of savings and investment banks have increased the maturity structure of their lending in the manner indicated in Table 3.14.

Table 3.13: THE MATURITY STRUCTURE OF OUTSTANDING COMMERCIAL BANK LENDING

Jan. Dec. Dec. 1978 1978 1979 (%) (%) (%)

Up to One Year 88.9 88.4 86.0 One-to-Five Years 10.4 10.4 11.3 More than Five Years 0.7 1.2 2.7

100.0 100.0 100.0

Source: Banco de Portugal, Boletim Trimestral, March 1980, Table 1.4.

1/ Not least because it forced the banks to meet medium-term credit needs by rolling over short-term credits. This introduced a good deal of uncertainty for users of credit, and imposed unnecessary transaction costs on the banks. - 27 -

Table 3.14: MATURITY STRUCTURE OF OUTSTANDING LOANS FROM SAVINGS AND INVESTMENT BANKS

Jan. Dec. Dec. 1978 1978 1979

Up to One Year 21.9 20.6 18.0 One-to-Five Years 20.7 20.5 19.3 More than Five Years 57.4 58.9 62.7

100.0 100.0 100.0

Source: Banco de Portugal, Boletim Trimestral, March 1980, Table 1.4.

3.50 Unfortunately, in the past few years the relative importance of the savings and investment banks in the total of outstanding bank deposits has declined relative to the commercial banks. More specifically, the share of the commercial banks has risen to 74 percent of the total as compared with less than 72 percent in 1976. This is largely because of the far greater importance of migrants' deposits in the total of bank deposits (15 percent in 1979 as against 2 percent in 1976) and the far greater suc- cess of commercial, as opposed to savings and investment banks, in mobilizing such deposits.l/

3.51 Combining this fact with the information shown in the earlier tables, it can be concluded that the proportion of bank deposits channelled into medium- and long-term loans is virtually unchanged since end-1977 at about 31 percent (although the absolute total is significantly larger). Since the proportion of time and savings deposits in the total of deposits has risen rapidly and is now approximately 68 percent, there is at least a suspicion that the banks are engaged in a negative maturity transformation. Funds which savers are prepared to tie up for relatively long periods of time are being onlent for shorter periods. As at the end of 1979, for example, the quasi-monetary liabilities of the commercial and savings banks together totalled Esc. 600 billion while their outstanding loans of more than one-year maturity amounted to only Esc. 290 billion. While it is true that a part of the quasi-monetary liabilities may have maturities of less than one year, this, nonetheless, gives the overall lending policy of the banks an excessively short-run orientation.

3.52 Evidently, the banks do not carry the responsibility for this alone. Given the severely undercapitalized state of so much of Portuguese

1/ Though it is thought that some of. the more important of the savings and investment banks under-report the volume of migrant deposits., - 28 -

industry, it would be unrealistic to expect the banks to use long-term loan finance to replace what would formerly have been equity finance on a one- to-one basis. This would be true even assuming an unlimited demand for long-term finance. However, the demand is far from unlimited, both because of the prevailing high interest rates and also because some corporate borrowers are just as worried about debt/equity ratios as are the banks.

3.53 The other aspect of the quality of saving channelled through the banking system relates to the very large allocation of bank credit to public enterprises. The causes of this have already been discussed at length in Section C above. The only additional point that needs to be made is that public enterprise borrowing invariably carries some form of impli- cit or explicit Government guarantee. In these circumstances, the banks cannot be blamed for favoring credit to public enterprises and thereby denying funds to some productive investments in the private sector. This distortion, which reflects the excessive size of public and public enter- prise deficits, is clearly undesirable but is not readily eliminated.

3.54 The quantity effect arises from the fact that people save for various motives only a few of which can be catered for by commercial banks. The banks provide a ready means of using saving for transaction purposes (i.e., current accounts), various degrees of interest rewards depending on the terms of particular deposits and a high degree of security. What they do not do explicitly is cater to savings motives such as ultimate house- ownership or provision for old age. Nor do they have the capability of linking the aspirations of particular savers to the uses to which savings are ultimately put. It is clearly inefficient to combine savings, which arise from widely different preferences for maturity, security and return, into one single pool of loanable funds. These inefficiencies manifest themselves in a (probably unarticulated but nonetheless real), dissatis- faction of some potential savers in what the system can offer them, and so in lower financial saving.

3.55 The elimination of these inefficiencies in financially advanced countries has invariably involved the development of new institutions to cater to specialized financial needs and savings motives. Portugal is at a stage of economic development where the return to an enlargement and diver- sification of the financial system could be quite considerable not only in terms of the quantity of saving but also in terms of the provision of a better standard of life. Two obvious examples spring to mind; a strength- ening of institutional arrangements to cater for life insurance and pensions, and improved arrangements to provide housing finance.

3.56 Assuming that the obvious constitutional and other legal problems could be overcome, there is considerable merit in attempting to establish more active institutional arrangements for both life insurance., and pension provision than those which currently exist. Whether this is done in the context of state-run or privately-owned institutions is unimportant. The improvement in saving performance would come by allowing the institutions a - 29 -

relatively free hand as regards portfolio selection, subject to standard prudential limits, and not tying them to Government bond issues. Assuming competent mangement, this could provide for a return to savers higher than that available from the banks. Together with active marketing and judicious tax incentives, this ought to generate a strong flow of funds into the strengthened institutions. The pool of investable funds which this development could create would have the merit first, of originating from the household sector where financial surpluses currently reside, and second, of being available for long periods of time because of the motiva- tion which generates it. Thus, a major part of the funds could be onlent for long-term purposes without risk to the institution.

3.57 -A second obvious example of possible improvement in the financial institutional structure is in the general area of housing finance. Portugal faces a serious housing deficit which forces several hundred thousand house- hold units to live in overcrowded, unsafe and unhygenic structures. The remedy for this involves better policies in many dimensions and the finan- cial dimension is only one of these but it is an important one. Even in the presence of multifarious controls, house ownership has manifestly shown itself to be a highly desirable aim of large numbers of Portuguese. 1/ With reforms in the housing market in the form of relaxation of rent controls, the provision of more and better serviced sites for new housing development to so on, this could become increasingly true. The role of an improvement in arrangements for housing finance would be to help ensure that the existing, and future growth of, demand is not frustrated by inadequate financing arrangements.

3.58 For the moment, housing which is not built through direct public investment is financed either through the major savings and investment banks, notably Caixa Geral, or through self-finance. In 1979, housing loans represented about one fifth of the medium- and long-term lending of the saving and investment banks and less than 2 percent of total bank credit. The lending is highly subsidized in the range of 4.5 to 12.0 per- cent depending on family income and the value of the dwelling being constructed. The precise extent of the self-financing of housing is unknown but must be considerable given a figure for housing investment which is at least twice the amount of bank credit for that purpose.

3.59 In order to lend for housing purposes, the banks need to make a maturity transformation of their deposit funds which are available on average, for periods far shorter than the typical housing loan. The extent to which they can do this is limited given prudential considerations and the needs of other forms of long-term credit. There is no guarantee that the amount of lending for housing purposes is adequate given these con-

1/ The estimate of the number of clandestine housing units is well over 100,000. These units are often built id a way which involves considerable personal difficulty for the owners. - 30 - straints.l/ Additional and specialized arrangements for housing finance could certainly improve the situation. Above all and as with life insurance policies, mortgage repayment contracts can produce a component in total saving which is characterized by its stability through time. As was noted earlier, stability is a characteristic which is largely absent from present arrangements for mobilizing houshold saving.

3.60 Taking account of both the quality and quantity effects just described, there is a strong case for establishing channels for household saving which can compete with the banks. For the moment, the actions which have been considered in this area have emphasized new and attractive forms of Government debt designed to reduce the monetary financing of Government deficits.2/ The difficult dilemma which the Government has to face is that broader institutional developments of the type we have discussed are likely to increase the volume of financial saving but, at the same time, may reduce the part of that volume which can readily be channelled for the use of the Government. This being the case, these developments will be easier to implement once the Government's own demands for capital funds begin to be moderated. At the same time, the macroeconomic importance of an improved menu of savings outlets should not be understated. The per- sonal savings rate has risen sharply in recent years, to almost 20 percent, as a result of higher interest rates and improved political stability. The further increases which are needed to meet the investment targets of our macroeconomic projections are likely to need additional policy action especially in the face of pressures to reduce interest rates.

G. Some Concluding Remarks

3.61 In this chapter, we have provided an analysis of the resource mobilization problem in three of the major sectors of the economy. A number of main issues need to be emphasized. First, the large magnitude-of the Government's own deficit is a serious impediment to both the volume and the allocation of investment resources. In particular, it forces the con- tinuation of relatively high interest rates which help to deter private investment. These high interest rates are associated with a particular pattern in the use of saving which is less than optimal. In particular, the policies made necessary by the deficit have given rise to a largely unprofitable banking sector with little incentive to innovate. At the same time, the emergence of new financial institutions are discouraged because

1/ Though it should be noted that the operation of credit ceilings has probably worked in favor of housing and other credit having high social priority. It is difficult to demonstrate an actual shortage of funds given the disequilibrium state of the housing market caused by non-financial factors.

2/ For example, in 1980 a new instrument having a one-year maturity and 18 percent tax-free yield was made available to the non-bank public. - 31 - the Government's own appetite for funds is so large and the extent to which the Government can allow available saving to be diverted for alternative uses is necessarily limited. Perhaps the most disturbing aspect of the situation is that in the past two years the Government has made genuine and stringent efforts to restricts its expenditures and raise revenues, but the deficit has continued to rise. It is our conclusion that the Government will do well in the next few years if it can restrict its dissaving to about 3 or 4 percent of GDP. This can be done through a more stringent policy of subsidies and other transfers, through the continuation of present policies on public employment and through progressive improvements in the tax system. However, a deficit remaining at 3 or 4 percent of GDP will still constrain the remedies for the problems in the financial sector that we currently perceive.

3.62 Second, the finantial difficulties of the public enterprises repre- sent an increasingly serious problem in terms of the allocation of capital resources, and resource allocation in general. The solutions which have been attempted in the recent past seem to have been largely cosmetic. The Government has not been prepared to give the enterprises the freedom in pricing and other policies which could have limited their deficits. For some enterprises such freedom, in any event, would have been quite inade- quate to eliminate their financial difficulties because of the chronic inadequacy of their balance sheet positions arising from the accumulation of deficits over a long period of time. Ultimately this problem has to be overcome through far reaching programs to eliminate operating inefficien- cies. In the interim, financial solutions involving further commitment of Government funds will also be required. Subsidies have to be adequate to cover operating deficits to the extent that they persist and are associated solely with the enforcement of price controls. Capital injections for the enterprises in most serious trouble have to be adequate to bring these enterprises to the point where they can be self-sufficient given improved productivity and appropriate pricing and subsidy policies. Evidently, this policy has not been fully accepted in the past and is unlikely to be readily acepted in the future because of the severe budgetary constraints which the Government itself faces. There seem-to be three avenues which the Government could explore to reconcile this severe conflict of policy objectives. It would sell off some of the stronger public enterprises to supplement the resources available to rehabilitate the rest. The Government could define a clear long-term rehabilitation exercise but spread its implementation through time so as to restrict the budgetary impact in any one year. Finally, it might seek some supplement to its budgetary resources for this explicit purpose, possibly from external sources. However, whatever is done, the problem has to be seen as an integrated whole: the attempt to solve it on a piece-meal basis carries the danger that it will merely move the problem from one place to another. For this reason the Government's comprehensive study of the financial problems of the enterprises is urgently needed. - 32 -

3.63 Finally, the large volume of personal saving which is now avail- able makes it important to ensure that such saving is allocated efficiently. In particular, the weakness of balance sheet positions in the private corporate sector and especially high debt equity ratios and excessive short-term debt, is directly associated with the present inadequacy of arrangements for channelling personal saving. A few tentative solutions have been made for effecting improvements in this area but these all need careful scrutiny and further development. However, the returns to an enlargement and diversification of the financial system could be large and ought to be seriously explored. - 33 -

ANNEX II

THE PORTUGUESE TAX SYSTEM: SOME ISSUES AND PROPOSALS FOR REFORM

A. Income Taxes fI.l. In Portugal the income tax applies separate rates to various cate- gories of income. It is thus of the "schedular" type. It differs from the "global" type, where all income received from various sources by any one taxpayer is combined into a single income. There would be little difference between the two approaches if the rate schedule was proportional. But with progressive rates the global tax produces a more obviously equitable outcome. This suggests that eventually the income tax should be placed on a global basis. At present there are four major separate income taxes; the professional tax, the industrial tax, the complementary tax, and the tax on capital income. In 1979 these four taxes accounted for 80.5 percent of revenue from taxes on incomes and profits.

II.2. The professional tax is levied on incomes from labor, including those of professionals who are not required to report income below legally established minimum levels. Civil servants are exempt from this tax. At present, annual salaries below Esc. 105,000 were also exempt. The rates at which this income tax is levied range from 2 to 22 percent. The minimum rate applies to wages up to Esc. 105,000 while the maximum applies to wages above Esc. 1,350,000. In 1979 there were 1.1 million or about 12 percent of the population who were subject to the professional tax. Of these, 27,000 had independent activities, and the rest worked for others. Since high exemptions are granted to the recipients of earned income, the burden of this tax is not very high on the average. However, the professional tax is progressive for those taxpayers who derive all of their income from wages and salary. In addition, and unlike other taxes, the withholding of the tax at source has been one of the major reasons for its rapid growth.

II.3. The industrial tax is levied on the profits of enterprises. Taxpayers pay taxes according to three classifications. Group A includes taxpayers that are assessed on actual profits, while group B and C include those that are assessed on presumed rather than actual income. Taxable income is determined by reference to the profits and gains shown in the accounts for the business year preceding the tax year. The rates at which these profits are subject to tax range from 30 percent to 40 percent. The minimum rate applies to profits up to Esc. 1 million, while the maximum applies to business profits above Esc. 5 million. In 1978 a total of 309,357 tax returns were filed, of which only 179,370 returns had taxable income. Of these 114,209 returns are from general trade and commerce activities. The excessive deductions allowed for expenses in the taxation of business income and the underreporting of taxable income (or even outright evasion) constitute the major deficiencies in the industrial tax. - 34 -

II.4. Another aspect of the industrial tax worth noting is that Portugal has an extensive program of incentives for industrial development. The tax incentive schemes which were nominally intended to induce investment can serve instead to erode the tax base, and to make effective tax administration more difficult. As was indicated earlier, this is a matter which should be kept under close review as experience with the new incentive scheme is accumulated.

II.5. The complementary tax is a progressive surtax on total income from all sources. It is divided into two parts; income of individuals (under Section A) and income of enterprises (under Section B). The maximum marginal rate reaches 70 percent for a married couple (on incomes above Esc. 1.4 million) and 12 percent for enterprises (on income above Esc. 6 million). The rates that currently apply to modest taxable incomes are relatively low. For example, up to incomes of Esc. 350,000 the marginal rate is only 8 percent, and up to Esc. 650,000 it is only 20 percent. At middle and high income levels the marginal rates are possibly too high.

II.6. With the present progressive rates the complementary tax should have exhibited a high income elasticity. But the actual elasticity estimated for recent years is far less than unity. A severe erosion of the tax base due to the administrative inefficiency and prevalent tax evasion especially by small business and professionals are among the major factors responsible for low elasticity. Given the Government's preference not to extend the presumptive basis of taxation, the remedy for this problem must lie with improved administration and better tax design.

II.7. Contrary to expectations the policy changes on deductions and rate schedules have in the past tended not to offset, but rather to reinforce the effects of inflation on the average tax rates. More recently there has been some adjustment of the level of exemptions and deductions, among which the most important are an earned income allowance of 20 percent of gross wages and salaries up to a maximum of Esc. 30,000 (up from Esc. 25,000 in 1978) and a personal exemption of Esc. 120,000 for a married couple (Esc. 100,000'in 1978) and between Esc. 20,000 and Esc. 10,000 for each dependent child (Esc. 16,000 and Esc 8,000 in 1978). In 1978 a total gross income of Esc. 140.2 million was reported by 548,000 taxpayers of which the exemptions, allowances and deductions claimed Esc. 82.7 million. Further- more, the actual tax receipts of Esc. 5.4 million amounted to less than 10 percent of total taxable income (Esc. 57.5 million). In addition, according to the 1978 tax returns, no more than 4 percent of tax returns were subject to the complementary tax at a rate exceeding 20 percent.

II.8. The low revenue yield of the tax can be linked to its progres- sivity. The high degree of progressivity of the current rate structure constitutes a significant disincentive to individuals' work effort, savings and investment. There is a strong reason to believe that the extreme progressivity has been one of the major factors responsible for the existence of substantial tax fraud and evasion. This aggravates tax equity. Experience from other countries suggests that, as a rough guide, - 35 -

the top marginal rate should not greatly exceed 50 percent for a married couple (or 60 percent for a single person).

II.9. The capital income tax is levied on incomes from financial capital. All capital income is divided into two sections, A and B. Section A includes imputed interest on loans and credit openings while Section B includes all other capital income. Taxpayers under Section B have the tax withheld at the source. At present the tax is levied with a normal rate of 30 percent, but there are several special cases for which the rates are lower (e.g., 15 percent for interest on time deposits and 12 percent for interest on bonds). In 1978 tax on capital income was collected from only 56,000 taxpayers. Although the number of taxpayers under Section B constituted a little more than half of total returns they accounted for most of revenues from this source especially interest income on bank deposits. This indicates the advantages of deduction at source.

B. Indirect Taxes

II.10. The single most important fiscal policy issue, currently facing Portugal concerns the move towards a value-added tax (TVA), and when it is introduced, the question what existing taxes should be repealed. Allied with this is the question of how rapidly such a change should be adopted. There are a series of related issues which have to be sorted out before its implementation.l/ The obvious reasons for adopting TVA in Portugal include the harmonization of its indirect tax system with those of the EEC member countries (which is also part of the requirement for full membership) and the presence of a number of indirect taxes that are inefficient compared with TVA. Furthermore, Portugal needs to raise its total tax revenue beyond what can be expected from the present system even with improved enforcements. In addition, Portugal is facing a revenue loss from import duties, as it adapts its tariff structure to accord with the harmonization requirements of the EEC. TVA is one way of making good these revenue losses. The following section deals with some of the existing indirect taxes.

II.11. The transaction tax is a single-stage wholesale tax that is applied to both domestic production and imports. It covers about one-third of per- sonal consumption, exempting basic necessities, such as food, medicine, educational materials, tools, and other capital equipment. Recently the full range of services, including hotel and telephone services, has become subject to the tax. It is the most productive source of revenue and yielded Esc. 37.6 billion in 1979 or 26.7 percent of total tax revenue. However, the growth in revenues has been mainly due to a rapid increase in the tax rates. The effective tax rates in 1974 were the normal 7 percent while higher rates of 12 percent and 20 percent were applicable to products in the list appended to the tax code. The rates have risen rapidly in the

1/ There are many technical aspects of a TVA that are beyond the scope of this report and are not analyzed here. - 36 - past few years and in 1979 the normal rate was raised to 15 percent and the higher rates were increased to 30, 45 and 75 percent. The later rates are applicable to different categories of luxury products. The special rate for beer was also raised to Esc. 12.0 per liter.

II.12. During the 1975-79 period the normal tax rate was doubled and the luxury tax rates rose by 125 percent and 150 percent. Nevertheless, the ratio of tax revenue collected to total private consumption increased by only 52.9 percent, from 3.4 percent to 5.2 percent. The high nominal rate needed to raise a given amount of revenue resulted in an increased pressure to evade the tax. The current structure of high tax rates and inefficiency in the tax administration are among the major factors responsible for the substantial loss of potential revenue.

11.13. Various measures to improve the administration of the transactions tax are essential, and they are similar to those required to strengthen the administration of income taxes. Heavy penalties for failure to declare and for underreporting, especially for companies and large individual taxpayers, are called for. Although substantial improvement in assessing the larger taxpayers should be possible, the task is much more difficult for the large number of small taxpayers. Progress can be made through strict licensing and by establishing presumptive standards for sales.

1I.14. The stamp tax is the second most productive source of revenue. It consists of a large number of levies on various types of transactions evidenced by documents or other papers; certificates, licenses, permits, bills of exchange, bonds and documents related to court proceedings. In 1979 it yielded Esc. 16.5 billion or 11.7 percent of total tax revenue. Although the normal rate is low (0.5 percent), various other rates exist for different types of documents. The rates are either specific or ad valorem. Like the stamp taxes of other countries they seem to have been motivated by administrative convenience. But the existing system of stamp taxes is one of the most complicated areas of taxation in Portugal. Not only are tne majority of stamp taxes business-obstructory nuisance levies, but also they are usually regressive and characterized by high administra- tive and compliance costs.

II.15. There are two important categories of stamp taxes which should be retained, while those which are objectionable on many accounts and produce infinitesimally low yields should be abolished. The stamp taxes which are essentially payments to the government for services performed for the public (e.g., fiscal stamp) should be improved by placing them on a cost-of-service fee basis. Some of the present charges would be revised upward considerably, and much of the revenue loss that could arise from the abolition of nuisance stamp taxes could be made up in this way. Other stamp taxes which should be retained include those which actually represent taxes unrelated to services rendered by the government but which have some merit as elements in the tax structure (e.g., travel stamp tax, stamp tax on imports, automotive stamp tax). Appendix II: Summary of Portugal's Tax System, 1980

(Amounts in escudos)

Nature of tax Exemptions and Deductions Rates

1.Taxes on income and profits Taxable income Marginal rates

1.1 Industrial tax Annual tax levied on the profits All taxpayers are allowed the Up to 1,000,000 Esc. 30% attributable to commerical or in- ordinary trading expenditures. 1,000,000 to 5,000,000 36% (Contribuicao industrial) dustrial activity, including that depreciation costs, contribu- Over 5,000,000 Esc. 4C% of self-employed individuals not tions to some legal reserves, falling within the scope of the etc. The investment incentivc tax on wages and salaries. Only legislation also exempts some incomes resulting from activities incomes from taxation and may performed in Portugal are taxed. allow a special deduction for Realized capital gains are not reinvested profits. Individual included in the tax base but are taxpayers are allowed personal taxed separately. The tobacco exemptions: 280,000 for the in- industry is subjected to a special dividual and the same amount for tax regime that reflects its mono- some members of his family. Agri- poly position. cultural income is exempt, unless the generating activity is an in- tegral part of an industrial or commercial activity.

1.2 Professional tax Annual tax on(a) wages, salaries Civil.servants of all levels of Taxable income Tax rate (Imposto Profissional) and other forms of remuneration government and personnel of foreign (in per cent) from employment (whether in cash or international organizations to uipto 105,000 0% (chargable at or in kind), (b) professional in- which Portugal is a signatory power. 105,000 to 150,0)0 2 a single rate come of persons working on their Professionals are allowed to deduct 150,001 to 225,00 4 on the whole own, and (c) sums entered in own business expenses. 225,001 to 300,0)0 6 taxable account by proprietors of one-man 300,001 to 450,0)00 8 income). businesses as remuneration for A personal exempiton of 105,000 is 450,001 to 600,0)0 10 own work. Professionals cannot provided. 600,001 to 750,000 12 declare less than a minimum taxable 750,001 to 900,0)0 14 income, which varies with profes- 900,001 to 1,050,000 16 sion and district. 1,050,001 to 1,200,000 18 1,200,001 to 1,350,000 20 1.3 Rental income tax Annual tax on income arising or State and local authorities, public over 1,350,000 22 (Contribuicao predial) deemed to arise from rural or urban utilities, and religious and chari- (A local government property in Portugal. Payable by table institutions. Urban Property 18 percent tax since 1979) the preson entitled to the income. Taxpayers are exempt if (1) their Rural property: assessable income rural and urban rents in that dis- Rural Property 14 percent is the return of productive utili- trict do not exceed 100 or zation of the land and anv improve- (2) if they own, in that district Rates of 25 to 50 percent may be used ments. Such income is normally only the house in which they live when the Secretary of State for Agriculture given in a cadastral register. and if the rental value of this judges that particular properties are under- Urban property: assessable income house (together with the rent ob- utilized. is the rent actually received if tained from any land let out in any the property is rented or the pro- district) does not exceed 1,000. fit which could be obtained if the property is not rented. Summary of Tax System (Continued)

Tax Nature of Tax Emenptions and Deductions Rates

1.4 Capital Income tax Levied on income arising from the State and any of its services, local Several rates exist. The normal one (Imposto de capitais) use of financial capital. All authorities and approved public utili- is 30%. capital income is subdivided into ties, and social security institutions. 15% on interest paid to time deposits two groups. __ction A: imputed. 12% on interest paid to bonds. interest on loans and credit open- ings; interest is assumed to be at least 6 per cent. Section B: all other capital income. Payers of income taxed under Section B must withhold the tax at the source.

1.5 Capital gains tax A tax charged on certain gains Sale by state or local authorities. 24 percent on gains made on sale of (Imposto de maisevalias) made by individuals and companies: urban building land. All other gains (a) sale of urban land acquired are taxed at 12 percent. after June 9, 1965 or of premises' for professional use. If land was held for less than two years then the gains are taxed as business profits: (b) sale by businesses of fixed or movable assets; (c) capitalization of reserves. Married Single

1.6 Complementary tax A progressive surtax on combined _ndividuals:k The income of civil Individuals Margiaal rates (Imposto complementar) income from all sources. Indivi- servants is included only for the Taxable Income (in percent) duals and businesses are subject purpose of determining the rate of Up to 100,000 4 4.8 to this tax, each according to tax on the taxpayerss' other income. 1, to 200,000 6 7.2 special provisions. A personal allowance of 120,000 for 200,000 to 350,000 9667 6 Individuals: Taxable income is the married taxpayers is allowed and ' t sum of income from rural and urban 80,000 allowed for-single taxpayers 350,000 to 500,000 14 16.8 property, commercial and industrial and between 20,000 and 10,000 for 500,000 to 650,000 20 24 activity, wages and salaries, capital dependent children (11 years or less) 650,000 to 800,000 26 31.2 income, and pensions and annuities. depending on their age. An earned '00,000to 950,000 34 40.8 The income of all members of the income allowance of 20 percent is 950,000 to 1,100,000 42 50.4 family is aggregated. Income from granted with a maximum of 30,000. 1,100,000 to 1,250,000 50 60.0 bearer shares is taxed at 24 per Schedular taxes, obligatory employee 1,250,000to1,400,000 760 80.0 cent and withheld at source. Share- contributions, charitable contribu- o 1 7 holders can resister their shares if tions and interest paid are allowed they choose to do so. as deductions. Summary of Tax System (Continued)

Tax Nature of tax Exemptions and Deductions Rates

Businesses: Taxable income is the Businesses: Distributed profits, in- Companies Marginal rates sum of all industrial or commercial come from bearer shares, and all sched- Taxable income (in percent) profits, real estate income, capital ular taxes. Income of the state and income, and income taxed under the local authorities, public utilities. Up to 120,000 6 public entertainment tax. churches, and charitable organiations. 100,000 to 1,000,000 8 1,200,000 to 6,000,000 10 2. Social Security tax The social security sytem is or- There are no ceil:ggs to the income Over 6,000,000 12 ganized along four lines: on which contributions are paid. a. Providencia Social: Covers under different suborganizations, the Contributions Percent commercial and industrial workers, farm laborers, fishermen, and profes- Employer 20.0 sionals. It covers old age, inval- Employee 8.5 idity and death benefits. b. Providencia do Estado: Covers the civil servants. Employer 7 Employee - c. Various minor Social Security Institutions. - C d. Employment Fund: Finances certain unemployment benefits. If the employee is not covered by Social Security: Employer 3 percent 3. Property tax Employee 3 percent If the employee is covered by Social 3.1 Gift and death tax Payable by the person who receives All transfers of less than 1,000 per Security: (Imposto sobre as the gift or inheritance. All mov- beneficiary. Transfers to descendants Employer 3 percent sucessoes e doacues) able and immovable property is in- if the accumulated value of all trans- Employee 2.5 percent cluded in the tax base. fers made over time is less than 200,000. Transfers to ascendants or The rates are set progressively according spouse if the accumulated vlaue of all to the amounts transferred and the family the transfers made over time is less relation between donor and donee. They than 100,000. range from 4 to 75 percent.

3.2 Transfer tax A Tax upon the transfer, against Transfers to the State, social secu- The normal rate is S per cent. (SISA) payment of real estate assets. rity organizations, and educational Transfer of urban real estate and Even when no sale is involved, some charitable, and religious institutions. building land - 10%. acts are, for the purpose of this The acquisition of cheap housing Purchase of house for permanent use: tax, defined as real estate trans- units. Special provisions exempt up to 2,000,000 - exempt fers and thus taxable--e.g., the from the tax the acquisition of some 2,000,000 to 2,600,000 - 47 transfer of concessions made by the building plots to be used for housing State for the operation of industrial development or for the construction firms of any nature and promises of industrial establishments. to buy or sell property. The tax must be paid by the recipient of the transfer and is'levied on the value for which the goods are trans- ferred. sumaanr of -Tax-Sys-ta C,o-ntinued)

Tax Nature of Tax Exemptions and Deductions

4. Tas on goods and services

4.1 General sales tax A single-stage wholesale tax that All services and many products of The normal rate is 15 per cent (Inposto de transaccoes) is applied to both domestic produc- basic necessities such as foodstuffs, Specific lists of products are drawn up tion and imports. This legtslation medicines, tools and capital equip- that specify which products are to be also provides for the taxation of ment, transport material and didac- taxed at higher rates. These higher beer, wine, and other alcoholic bever- tic material. rates s2e 30, 4S, and 75 per cent. ages. These last taxes are, strictly Beer: 12 per liter (1979) speaking. excise taxes. Fortified wines and vermouth: 90 to 112 speaking, excise taxes. ~~~~~~~~~~~~percent. Whisky, gin, etc.: 110 per cent

4.2 Excise taxes

4.21 Fuels These products are taxed under import National Salvation tax duties; in addition there is a levy Gasoline 3.52 per liter earmarked for the Supply Fund (rondo Oil 0.112 per liter de Abastecimento) Some of the levies levy for the Supply Fund for the Supply Fund can_be anegative (S',bsidies). National Salvation tax olies to_ regular 22 per liter _gpplies to some fuels.- some fuels. ~~ ~ ~ ~~~~~~~Oil3.8 per liter

4.22 Tobacco A tobacco tax is levied first on imports; xlports are exempt from the manu- Import duty (inciusive of the tapor- second an consumption. facturing duty. ary 30 per cent surtax presently exis- ting): 234 per kg. for cigarettes 240 per kg. for cigars Consumption tax: on cigarettes from 4.00 to 11.00 per pack of 20 cigarette

4.31 Vehicle tax A tax levied on the users of Automobiles, State and local authorities and Automobiles: from 240 to 22,560 (Impostn sobre veiculos) airplanes, and pleasure boats. Its level some public utility organizations Airplanes: from 2,880 to 600,000 depends on the size of the cylinders cf the Pleasure boats: 432 per ton, plus engine (automobiles), age (automobiles and 156 per 1 h.p. pleasure boats), weight (airplanes) value if in excess of (auitomobiles) or some combination of these 25 h.p. for boats that characteristics of the vehicle. are lees than 15 years

available for older boats.

4.32 Vehicle sales tax Tax on imported automobiles. 3 Up to 1,400 cm T - 0.03 x CC (Toposto sobre a venda de 1,401 to 1,700 501 (of sales aut.movois) 1,701 to 2,000 751 price) over 2,000 100% Summary of Tax System (Continued)

Tax Nature of Tax Exemptions and Deductions

5. Taxes on international trade to product and Levied on all imported products. Rates Varies widely from product 5.1 liport duties Rate structure differ according to the origin of the by origin of the imports. of processing imports. The lowest rates apply to imports graduates with the degree products. from EFTA countries; the highest apply to of the imported is presently imports from countries vith which no most A temporary 10 per cent surtax for some luxury favored nation clauses are in force. - in effect, and a 60% surtax Rates are ad valorem. goods is presently in effect. The flint "e.oluments" levy is 9 per A special "emoluments" levy is applied thousand to all products so as to compensate the custom authorities for the use of re- sources involved in levying the custom duties. In addition, some compensation for weighting and counting Imports may be assessed.

Various rates on different types of duties Obligatory use of stamped paper for many 6. Stamp documents. Rates are either specific (Imposto de selo) legal documents, such as contracts or papers in court proceedings: requirements or ad valores. that stamp be affixed to other documents, such as bills of exchange, bonds, and many licenses and permits.

Sources: Ministry of Finance and Planning, The Portuguese Tax Syster (Lisbon, 1979) and many changes have been made recently and were obtained from the appropriate officials in the Ministry of Finance.