Footing the COVID-19 bill:

As a result, countries are running massive deficits. The soaring public spending, together with the adverse effect of the looming recession on future tax receipts, are leading to unprecedented levels of budget deficit worldwide. As the world is trying to adapt to the new normal, the question starts to emerge — how are countries going to pay for the pandemic?

Although we are still immersed in an unprecedented level of uncertainties forced upon the world by the virus, one thing seems beyond dispute — at some point, taxes will have to rise. The question is, when, which and by how much?

This brings us to a more general question – is this the only way out? What can countries do both in the short and long term to pay for the pandemic? And how can these measures be implemented not to hinder, but to encourage business activity and economic recovery the world desperately needs?

Broadly speaking, countries have two different strategies to tackle the problem of funding the public-finance shortfall caused by the pandemic: they can borrow through the crisis and they can increase taxes. Although different, they are not mutually exclusive.

In fight against the virus, use war measures: War-time finance

The magnitude of the economic shock forced upon the world economy by the pandemic is so immense that some argue that paying for COVID-19 will have to be like war debt – spread over generations. Governments can resort to issuing debt with very long maturities such as 50 or 100 years, or even debt that never matures – so-called perpetuities or consols – a long-known part of the war-time finance toolbox. 

These instruments are actually not that rare. For example, in 2014, the UK government repaid part of the country’s First World War debt – 100 years since the start of the war –in addition to some of the debt that dates as far back as the eighteenth century. Britain also financed the Napoleonic wars by issuing “consols" or bonds that promised payments in perpetuity and could not be redeemed. This type of debt instrument is now gaining traction again as a means to manage the escalating costs of the pandemic.

But for how long is it possible to borrow through the crisis? Debt can be rolled into the future and it can be done so for some time — potentially forever or at least as long as investors are willing to buy newly-issued bonds that governments can use to pay back the old debt that is coming due.

The risk is that, at some point, although now it seems inconceivable, the increased debt burden will start to have inflationary effects. This means that interest rates will need to rise to fend off the inflationary impact and at that point, the government will be faced with high debt that they need to pay off at higher rates.

What comes after buying some breathing space: Tax rise

There is no rush to close these gaping fiscal deficits, but they cannot continue indefinitely. Countries can leverage the current low cost of borrowing to cover much of the shortfall in the short term and buy some breathing space. Still, at some point, some tax raise is inevitable to put the public finances on a sustainable footing. The question is – which ones?

As the saying goes, never waste a good crisis. This time, countries can use this crisis of unprecedented magnitude as a platform for a profound rethinking of the tax systems and implementation of broader tax reforms that have long been avoided. As with many other things, the pandemic has accelerated what was meant to come anyway – we are just going to deal with those things much sooner than expected.

The change in thinking is already emerging. The UK has already started a review into capital gains tax, following its probe into inheritance tax last year. Calls for review of pension tax relief and more robust measures to address tax avoidance schemes are gaining traction and even the expectation of the two-year suspension of "triple lock," a rule that regulates the state pension increase, is growing.

Other countries are considering limits on the use of net operating loss carry-forwards, higher tax rates applicable to foreign-earned income, and even higher tax rates on capital gain for certain high-income taxpayers. Even digital services taxes are gaining momentum around the world, especially since the OECD’s BEPS initiative released Action 1: Addressing the Tax Challenges of the Digital Economy. These taxes include both direct taxes such as withholding and digital services/advertising taxes, and indirect, input taxes like the value added tax (VAT) or goods and services tax (GST).

The silver lining of the pandemic

The public spending spree is necessary to prevent long-term damage to the economy and borrowing is one way to fund the shortfall. For most countries, the stock of debt is high and rising as they face a funding squeeze with revenue dwindling while spending soared. But the cost of servicing it is at a record low level, providing some comfort for the burdened public purse.

Still, although borrowing does provide some breathing space for governments to soften the blow of the shock and for businesses to adjust to new normal, tax increases nonetheless appear inevitable. Rising taxes do not have to hinder businesses. If they approach this issue from the right angle, countries can tweak taxes to encourage economic recovery.

This can be an opportunity for countries to rethink and update their fiscal regimes to make them fit for the new world that is emerging from the pandemic. The silver lining of the pandemic could be the tax reforms that will determine how the financial pain inflicted by COVID-19 is shared between different parts of the economy and even across different generations, resulting in a new tax system for the new normal and the changed world.

By Daniel Mayo, HLB USA