Fiscal Deficits
Financial intermediation

During the 1970s, Spain and Portugal responded to the first oil shock and their political democratization by increasing public expenditure with no corresponding increases in tax revenues. Both governments financed the resulting budget deficits largely through their access to central bank credit at zero or very low interest rates, but the central banks' responses were very different. Broadly speaking, the Banco de España used reserve requirements to freeze the excess liquidity generated by the monetization of the budget deficits; while the Banco de Portugal set up a system of credit ceilings to control the growth of private borrowing and used the banks' excess liquidity to place public debt at very favourable interest rates. Both policy instruments amount to implicit taxes on financial intermediation and have similar effects on interest rates to borrowers; but interest rates on the public debt increase with the level of reserve requirements and decrease as credit ceilings tighten.
In Discussion Paper No. 583, Research Fellow Rafael Repullo uses a simple partial equilibrium model of the banking sector to evaluate the combined contribution of seigniorage and this type of implicit taxation to the financing of the Spanish and Portuguese budget deficits in the 1980s. For Spain, the implicit tax revenue from the reserve requirement is the volume of reserves multiplied by the difference between the average interest rate on the public debt and the average remuneration of bank reserves. For Portugal, the corresponding figure is the public debt multiplied by the difference between the average actual interest rate on the domestic public debt and the growth rate of nominal GDP, taken as a proxy for the (unobservable) interest rate that would have prevailed without credit ceilings.
Repullo finds that the average combined contributions of seigniorage and implicit taxation to the financing of budget deficits during the 1980s amounted to 1.7% and 4.0% of GDP for Spain and Portugal respectively. These sources of revenue are likely to decline, however, as nominal interest rates (and inflation) fall with progress towards EMU and as Europe's financial integration deepens. He also derives medium-run estimates of the losses this will entail. For a ratio of high-powered money to GDP of around 10% and a nominal interest rate on the public debt of 9%, if bank reserves are not remunerated, he finds seigniorage revenues of approximately 0.8 percentage points of GDP for both countries. This suggests that the fiscal adjustment required to offset the reduction in implicit tax revenues will be not too large for Spain but quite substantial for Portugal.

Financing Budget Deficits by Seigniorage and Implicit Taxation: The Cases of Spain and Portugal
Rafael Repullo

Discussion Paper No. 583, October 1991 (IM)