Tax deferral and relief schemes employed by European countries during the COVID-19 crisis have helped households and businesses weather declines in cash flow and eased liquidity difficulties, a financial watchdog report found.
According to a February 16 report from the European Systemic Risk Board (ESRB), support measures such as tax relief and deferrals, direct grants, and public guarantees on loans stabilized lending and have allowed the financial system to function during the coronavirus crisis. However, the ESRB cautioned that the risk of losses in the nonfinancial sector spilling over to the financial sector increases the longer the crisis lasts, especially if there is a weak economic recovery.
If the shock of the COVID-19 crisis cannot be absorbed by nonfinancial firms and households or be mitigated by policy measures, the financial sector could become unable or unwilling to provide credit, liquidity, and financial services, the report says. "In this situation, the financial sector could exacerbate liquidity and solvency problems in the real economy, eventually creating a doom loop between the real economy and the financial system," it says.
The ESRB recommended that European authorities maintain a balance between continuing fiscal support for financial stability and balancing budgets. “Withdrawing fiscal support too soon could exacerbate the effects of the economic crisis and put financial stability at risk. Maintaining fiscal support for too long would increase budgetary pressures and could delay structural change,” it said in a February 16 release.
While tax relief and tax deferrals have had a positive effect on short-term financial stability during the crisis, the report found that loan and insurance premium moratoria decreased liquidity in the financial sector as a consequence of reduced cash inflows. It also found that public and subsidized loans — while supporting nonfinancial corporation solvency — have led to excessive risk-taking because of mispricing of risks. There is a risk that these loans could keep unviable NFCs in business.
Fiscal measures, including public guarantees on loans, public loans, direct grants, and tax measures, saw a €700 billion uptake by September 2020, around 4 percent of ESRB member countries' combined gross domestic product, according to the report. Total uptake of tax deferrals and tax relief among the 31 member countries was €90 billion out of a total package of €245 billion as of September 2020.
Tax relief also presents significant fiscal cost to governments, which should be taken into consideration during the recovery phase, the report says. As deferred taxes come due, governments could see increased cash outflows, it says.
All but two ESRB member countries applied tax deferrals at least once, while over half applied tax relief as part of their COVID-19 fiscal programs, says the report. Countries with high public deficits before the crisis — including Cyprus, Greece, and Spain — used fewer direct grants and tax measures and more public loans and guarantees on loans. Germany offered the largest tax relief program as a percentage of GDP, followed by Italy and the Czech Republic.
The report recommends that governments study the risk of cliff effects in phasing out fiscal programs and recovery mechanisms, warning that there could be more immediate effects from the phaseout of direct grants or tax deferrals. Governments should be mindful of simultaneous phaseouts, particularly of public guarantees and loan moratoria, which could lead to cliff effects, the report says.
EU institutions are still exploring options to fund the bloc's €750 billion coronavirus recovery package. The EU Council presidency will reopen talks on a proposal for a financial transactions tax during a meeting of its Working Party on Tax Questions February 24.