Something’s rotten in Paris

July 6, 2012, 1:00 PM UTC

By Cyrus Sanati, contributor

Not-so-gay Paris.

FORTUNE — The French government’s new budget and agenda could destabilize the nation’s already shaky economy, setting the stage for a vicious chain of events that could end up pummeling its weak banks on Wall Street, while shattering the eurozone for good. While some elements of the budget are laudable, there are still too many that risk pushing France into a deeper economic sleep. Hard reforms are needed in the country’s bloated bureaucracy and overly generous health and pension schemes if it ever hopes to balance its budget and move forward, but that is much easier said than done.

Nevertheless, France’s new government, led by the Socialist Party, has the political capital and connections to get things done in a speedy and positive manner. But as long as party ideology trumps reason, France could eventually find itself in the same boat as its fellow eurozone counterparts, struggling to cope with impossibly high borrowing rates and anemic economic growth.

Jean-Marc Ayrault, France’s new Prime Minister, on Wednesday, released the specifics of his party’s plan to lift France out of its economic malaise. With the Socialist Party now in power of both the executive and legislative branches of the French government, whatever Mr. Ayrault wants will probably become law. Working in close conjunction with the nation’s new President, Francois Hollande, Mr. Ayrault has endorsed a number of controversial measures aimed at raising revenue to plug the massive hole in the country’s budget.

Running a budget deficit is frowned upon in the 17-member eurozone as one nation’s debts can impact the value of the common currency for all members. As such, countries in the eurozone are only allowed to have an annual budget shortfall equal to around 3% of their yearly income. France has had a hard time complying with the rule, running large budget deficits since the 1970s.

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On Monday, an independent audit of the French economy, ordered by the new government, spooked the markets as it showed that France was on course to run a budget deficit equivalent to around 5.2% of its output, up sharply from earlier estimates. The budget gap grew after the new government announced plans to roll back a number unpopular austerity measures passed by the former conservative government. The deficit also expanded as the government finally got real about its economic situation, forcing it to adjust its overoptimistic economic growth forecasts. The government now projects the French economy will grow at 0.3% in 2012, down from the rosier 0.7%. They also lowered their 2013 forecast, projecting a 1.2% growth, down from 1.75%.

The Socialist Party ran on a platform that envisioned lowering France’s budget deficit to zero by 2017. To do that, it would need to achieve a budget deficit equivalent of 4.5% of GDP in 2012 and 3% in 2013. Achieving those targets now with the revised data means that the government will need to cut spending or raise revenue in 2012 by an additional 6 billion to 10 billion euros than what they had originally anticipated. The gap is then expected to explode to as much as 33 billion euros in 2013.

To close the chasm in the budget, the government is focusing on the revenue side of the equation by imposing a number of one-time and permanent tax hikes. The new taxes will focus mainly on investors, large businesses and the wealthy. In its revised budget, the government is aiming to raise an additional 7.2 billion euros in taxes for 2012. This massive tax hike comes through a number of sources, including controversial plans to raise the national tax rate for the wealthy French citizens, which according to the French government is anyone pulling over 1 million euros a year, to an astounding 75%.

The government projects its new wealth tax will bring in an additional $2.3 billion to the nation’s coffers. That is, of course, assuming that many “wealthy” Frenchman and businesses simply won’t flee France to a more friendly tax jurisdiction. The European Union’s law of free movement of peoples makes it easy to pack up and establish residency in a neighboring country to avoid higher taxation in their own country. It is unclear how many of Frenchmen will make an effort to avoid the new tax, but the French government was livid last month when David Cameron, the United Kingdom’s Prime Minister, said he would, “roll out the red carpet,” for French businesses seeking to essentially dodge the tax hike.

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But for all the commotion over the 75% tax rate, it will only, at best, close a quarter of the budget gap for this year. So the government is now targeting investors, pushing for a 3% tax on company dividends, which is projected to bring in an estimated 300 million euros. There is also a plan to increase the financial transaction tax from 0.1%. to 0.2%, which will bring in an estimated 350 million euros.

Both taxes will weigh heavy on French financial companies as it will discourage investment, trading, brokering and deal making activities. Investors will be looking for ways to avoid the tax, so many might choose to do business with a firm that is not domiciled in France. Furthermore, French multinationals will now be more hesitant to repatriate their earning back to France amid fear the government will snatch up most of it.

Absent from the proposals are any major cuts in spending, as that would not jive with the Socialist Party’s “pro-growth” versus “anti-austerity” theme. But they will eventually need to slash spending in a significant way if they are to close the 33 billion euro shortfall projected for 2013. There isn’t much taxing left they can do without severely hampering the nation’s already anemic economic growth. The French were able to get its eurozone partners to agree to a 120 billion euro economic stimulus package at last week’s conference in Brussels to help jumpstart economies across the eurozone. While that is a good idea, its impact won’t be felt for a while, as it takes time it takes years, even decades for a big project to get off the ground in Europe. Furthermore, 120 billion euros spread out over several years isn’t that much stimulus considering that it is around a tenth of the eurozone’s total combined GDP. And it is doubtful France will see much, if any, of that cash as it is earmarked for the weakest eurozone members, not for a supposedly “core” member like France.

There is no doubt that France will be in need of some serious austerity in the next year. But spending cuts of the size France needs to move into compliance with eurozone debt caps will most likely have a negative impact on its economic growth, further exacerbating the nation’s pain. Soon, France will start to look more like Italy with its high debt and weak economic output.

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But France may also have to deal with a Spanish-like banking crisis, as well, if does not support its crippled financial sector. The Socialist Party has a strained relationship with France’s Megabanks like Société Générale and BNP Paribas. In addition to slapping the banks with a higher tax bill to the tune of 500 million euros, there now seems to be discussion around splitting the banks up. In his budget speech to the National Assembly Tuesday, Mr. Ayrault said that he was in favor of hiving a bank’s lending operations away from their more “speculative” trading operations. How such a split could be done remains up in the air. It could be as harsh as forcing commercial banks to spin-off their entire investment banking unit, a la Glass-Steagall, or somewhat lighter by forcing to spin-off only those units that were deemed to be excessively speculative, similar to the Volcker rule.

The European Union has already rejected the Volcker rule when it refused to work with the US in harmonizing banking structures. It could be that they wanted to either tweak the rule or totally change things up and go for a complete split of commercial and investment banking. Either way, French banks will take a pummeling. Implementing a Volcker-like rule could wipe a collective 500 million euros in profits for French banks, according to an analysis by Citibank, which also said that a Glass-Stegall-like split could cost the banks 1.5 billion euros in potential profit. A split would have a profound impact on the French megabank’s sizable presence on Wall Street. It is unclear if their trading operations in New York and in London can survive without the mothership back in Paris.

This kind of split would come at a bad time for the French banks as they are still carrying billions of euros of bad loans, ranging from Greek credit card debt to Spanish mortgages. Changes to their structure could reveal massive holes in their balance sheet, which could in turn cause the market to potentially overact and chew them apart like a school of hungry piranhas.

It is now game time for the Socialist Party. The decision has been made to raise taxes to fill the hole in their national budget. But next year, taxes won’t suffice. Forcing banks to break up this early in the recessionary cycle will probably cause more trouble than it’s worth. Signs of weakness at a megabank will force France to intervene to stave off a panic, which would probably cost the government more money. The next few weeks will be critical with all the credit rating agencies, which all have a negative outlook on France, watching the situation intently. If the government eases its debt shedding timeline to accommodate further empty spending, then it wouldn’t be surprising to see a major downgrade in French sovereign debt, setting the country up to become the next major victim of the European financial crisis.