Why Tax Pressure Matters As Much As GDP When Assessing A Sovereign's Debt Sustainability

Primary Credit Analyst: Frank Gill, London (44) 20-7176-7129; frank.gill@standardandpoors.com

Table Of Contents
Comparison Of Leverage Ratios Reveals Differing Governmental Priorities No Easy Route For Eurozone Sovereigns To Stabilize Their Debt Note Related Criteria And Research

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Why Tax Pressure Matters As Much As GDP When Assessing A Sovereign's Debt Sustainability
The use of nominal GDP as the denominator for assessing the capacity of sovereigns to pay debt is the cornerstone of most debt sustainability studies--including those published by the International Monetary Fund and the academic community. Standard & Poor's Ratings Services concurs that debt to GDP is an important metric for assessing government creditworthiness. But it's not the only one. A second, sometimes overlooked, measure is the stock of general government debt as a percentage of annual general government revenues. In our view, this latter ratio is useful in that it measures a central government's institutional capacity, while also connecting the government's balance sheet to its own income statement, rather than to the income of the entire economy. Governments pay their debt out of their own revenues, not out of GDP. A third ratio, general government interest expenditures as a percentage of revenues, goes even further by connecting a government's financing costs to its revenue base. Overview Debt to GDP is not the only, or necessarily the best, measure for assessing a government's debt sustainability, in our view. Debt to revenues connects the government's balance sheet to its income, while interest expense to revenues gives a more refined view of debt sustainability. Results from using these latter two ratios indicates that euro area sovereigns are less heavily indebted than might appear from a debt-to-GDP standpoint.

Comparison Of Leverage Ratios Reveals Differing Governmental Priorities

In the table below, we rank the top 10 most indebted sovereigns according to the ratio of gross general government debt to GDP (see list 1 on the left hand side). In list 2, we rank the top 10 most indebted sovereigns according to general government debt as a percentage of revenues. And in list 3, we rank the most fiscally challenged sovereigns according to general government interest expenditure to revenues. Next to these alternative measures of leverage, we compare how many places sovereigns rise or fall (in parentheses) in the alternative ratio rankings when compared to their debt-to-GDP ratios. Ranking Of Highly Indebted Sovereigns Against GDP , Revenues, And Interest Expense

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Why Tax Pressure Matters As Much As GDP When Assessing A Sovereign's Debt Sustainability

Ranking Of Highly Indebted Sovereigns Against GDP , Revenues, And Interest Expense (cont.)
As Of Year-End 2012 1: Debt to GDP 2: Debt to revenues 3: Interest expense to revenues General government interest expenditures No. of (as a % of places revenues) rise/(fall)* 47 42 39 35 30 25 15 15 15 14 2 16 3 27 16 16 62 56 51 (1)

Ranking Country 1 Japan 2 Greece 3 Lebanon 4 Ireland 5 Italy 6 Jamaica 7 Portugal 8 Singapore 9 Iceland 10 Belgium

Gross general government debt (as a % of GDP) Ranking Country 235 179 145 131 124 119 119 108 104 99 1 Japan 2 Lebanon 3 Sri Lanka 4 Pakistan 5 Jamaica 6 Greece 7 Grenada 8 Egypt 9 Ireland 10 India

General government debt (as a No. of % of places revenues) rise/(fall)* Ranking Country 745 603 571 475 455 413 405 392 381 352 0 1 15 27 1 (4) 4 13 (5) 12 1 Lebanon 2 Sri Lanka 3 Jamaica 4 Pakistan 5 Egypt 6 India 7 Bangladesh 8 Dominican Republic 9 Ghana 10 Iceland

*Compared to debt-to-GDP position. Source: Standard & Poor's.

Japan, Lebanon, Jamaica, Greece, and also Ireland (see note) feature on both the debt-to-GDP and debt-to-revenues lists. However, Italy, Portugal, Singapore, Iceland, and Belgium, which rank in the top 10 most leveraged sovereigns as a percentage of GDP, fall out of the top 10 completely when we assess their leverage as a percentage of revenues. Taking their place are five lower-income countries that perform poorly in taxing national income--Sri Lanka, Pakistan, Grenada, Egypt, and India. So while eurozone (European Economic and Monetary Union) sovereigns make up 50% of those ranked according to debt to GDP, their presence in list 2 declines to 20%. A similar trend continues in list 3, which ranks the most leveraged sovereigns according to interest expenditure to revenues. No sovereigns in the euro area or other advanced economy are on this third list, due to their superior administrative capacity and deeper local currency capital markets. Indeed, with the exception of Lebanon, Jamaica, and Iceland, none of the most highly indebted sovereigns as a percentage of GDP are among those countries that need to divert the highest percentage of revenues to interest payments.

No Easy Route For Eurozone Sovereigns To Stabilize Their Debt

One key point is that both denominators--GDP (for the first ratio) and general government revenues (for the other two ratios)--are nominal concepts. They are annual flows that rise and fall with a country's GDP deflator (the metric that accounts for inflation by converting output at current prices into constant dollar GDP) and real GDP growth. These inflation and growth-indexed flows (the denominators) are used to service a fixed stock of historical debt (the numerator) that does not increase along with nominal GDP, except--partially--for a usually small part of inflation-indexed sovereign debt. This can be to the debtor's advantage if it leads to a sustained reduction in effective real interest rates paid by the sovereign. But in the euro area, where monetary policy is conducted with a view to the

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Why Tax Pressure Matters As Much As GDP When Assessing A Sovereign's Debt Sustainability

whole of the monetary zone, a surprise inflation to benefit individual debtors is not an easily accessible option--neither for private or public debtors. This lower level of effective country-specific monetary flexibility may in our opinion continue to make it tougher for eurozone member states to stabilize and eventually reverse their rising debt ratios, regardless of which denominator you choose.

Note
Standard & Poor's estimate of Irish general government debt includes National Asset Management Agency obligations as stipulated under our criteria for measuring the liabilities of sovereigns that guarantee asset management corporations.

Related Criteria And Research

The following article is available on RatingsDirect. Sovereign Government Rating Methodology And Assumptions, June 30, 2011
Additional Contact: SovereignEurope; SovereignEurope@standardandpoors.com

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