Bringing Macroeconomics into the EU Budget Debate: Why and How?
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The EMU has been designed without an instrument for automatic fiscal stabilization on the European level. This article highlights the seriousness of this lacuna by new empirical data, which suggest that fiscal stabilization at the national level has also worked insufficiently. This situation will hamper the EU's efforts to achieve the targets set by the Lisbon Agenda: recent theoretical contributions suggest that a positive macroeconomic environment is a prerequisite for productivity growth and structural reform which form the centrepiece of the Agenda. There are thus strong economic arguments for rethinking the set-up for fiscal stabilization policies in the EMU. We suggest three remedies for the underperformance of the automatic stabilizers: making EU expenditure sensitive to the cyclical situation of the recipient country, introducing an EU corporate tax upon the upcoming revision of the EU budget before 2013 and/or setting up a European unemployment scheme.
This article examines whether fiscal stabilization in the EU works satisfactorily. As our econometric analysis suggests it does not, we discuss the consequences and conclude that stabilization elements have to be introduced at the EU level. With its empirical analysis and the specific proposal for better adjustment mechanisms, our article contributes to the literature on the budgetary performance of the Member States, the EU budget reform debate and on EMU governance as well as linking older literature on possible fiscal stabilization schemes with more recent macroeconomic contributions.
The current academic debate about budgetary policy in the EU and EMU has several strands, three of which are principally relevant for our analysis:
- 1The first focuses on the reform of the EU budget, coupling this question of reform in particular to the success of the Lisbon goals. This strand of analysis describes a debate that has arisen each time a new budgetary preview has been negotiated. Indeed, this debate intensified in 2005 due to the tensions that emerged after the EU Constitutional Treaty had been rejected and before a compromise for the 2007–13 budget was found. The ‘rendez-vous clause’ included in the Conclusions of the European Council of December 2005 was key to this compromise. It prescribes a profound reform debate on the EU public finances, including on previous taboos such as the British rebate. The European Commission has already launched the review with a consultation paper and a public and expert consultation process, and will deliver conclusions in spring 2009 at the latest. Yet, the fact that the 2005 compromise could only be reached with the perspective of fundamental reform fathomed by the rendez-vous clause has led many analysts to conclude that the decision-making process requires change due to the growing number and heterogeneity of participants and the increasing salience of national preferences. The reform debate focuses on three related issues.1 Firstly, as regards the expenditure side, the question is how to reform the relevant EU policies given the shortcomings on the national and Union levels. On the national level, the room for allocative policies is constrained by the Stability and Growth Pact (SGP); the allocative expenditure of the EU budget is meanwhile generally judged to be completely out of step with the tasks the EU has assigned itself (Buti and Nava, 2003; Sapir, 2003). Secondly, as regards the income side, analysts want to replace the horse-trading culture between net contributors and net recipients with a transparent system of EU public finances, possibly including an increased amount of the EU's own resources, in order to allow for more forward-looking budgetary decisions. The third issue comprises the twin questions of how a new EU budgetary system can be afforded legitimacy and subjected to scrutiny, and how the management of the EU budget might be improved.
- 2The debate on national fiscal policies under E(M)U institutions has developed relatively independently from that on the EU budget. It mostly focuses on the adequacy of the EU rules (notably the SGP and the Excessive Deficit Process) for national budgets. Many economic contributions deal with the question of whether the targets for budgetary policy are conducive to certain objectives such as sound public finances and long-term sustainability. The political economy view studies the application of rules, the functioning of soft co-ordination, the chance to implement sanctions and so on. Recently, the quality of public finances has also gained importance in the academic debate on national fiscal policy co-ordination in the EMU. In addition to the objective of reaching the nominal targets defined in the excessive deficit procedure, the debate now focuses on the question of how to improve the perspectives for growth-enhancing policies in line with the Lisbon Agenda as well as on how to ensure the long-term sustainability of national public finances.
- 3The debate surrounding the need for macroeconomic stabilization mainly concerns the functioning of stabilization mechanisms in the EU under certain given constraints (the existence of a single monetary policy for 13 Member States, the limits on national fiscal autonomy imposed on all EU countries through Art. 104 TEC and the SGP, and the incomplete functioning of markets). It strongly interrelates with the second discussion mentioned above, notably when analysts of the SGP turn to the question of whether the rules are likely to promote anti- or pro-cyclical fiscal policies. Notably, this debate is gaining attention among economists: the political economy of structural reforms and the interaction between a positive macroeconomic environment and productivity growth are increasingly well understood and clearly highlight the importance of a stable macroeconomic environment for microeconomic policies (see Galíet al., 2005; Mabbett and Schelkle, 2007; Aghion and Howitt, 2006).
Our article links these three debates. Section I argues that the issue of macroeconomic stabilization, and in particular the role of fiscal policy, should be taken into account more strongly in the debate on EU and EMU budgetary reform in order to contribute to the development of a coherent and efficient budgetary system. We argue that there are growing indications that a better management of economic fluctuations helps to increase the long-term growth potential and that thus a better fiscal management is a necessary complement of the Lisbon Agenda. In section II we show that, under the current set-up, national stabilization policies have underperformed considerably. We provide new evidence that budgetary policy, for instance in Germany and Portugal, became pro-cyclical when automatic stabilizers were less evident. The empirical data presented here support one important conclusion reached by theorists of fiscal federalism, namely that economic stabilization should occur on the highest possible level in a monetary union, and not in its sub-units. Against this background, the third section assesses the major weaknesses of the current EU and EMU budgetary systems and suggests a way to include the stabilizing function: by making EU-expenditure more sensitive to the cyclical situation in the recipient country, by introducing a European corporate tax to fund a substantial part of the EU budget and/or by setting up an EU or EMU-wide unemployment scheme. This final section includes a discussion of the institutional and legitimatory requirements of these new budgetary mechanisms.
I. The Importance of Fiscal Stabilization
Interdependencies and Spillovers: Fiscal Backing for the Lisbon Agenda
While macroeconomic stabilization policies have long been regarded as substitutes for policies to promote microeconomic productivity and efficiency, there is new evidence – both from a political economy perspective as well as from an economic point of view – that they should be seen as complementary. From the political economy side, it is increasingly argued that a long period of low economic growth and high unemployment in spite of painful economic reforms might undermine the population's support for further reforms. This argument has even been picked up by the OECD which usually focuses on supply-side policies. In its Economic Outlook (2005, p. viii) it concludes that ‘more robust domestic demand may also help avert a stalling of economic reforms, in a context where their potential deflationary impact raises apprehensions in many segments of public opinion’ (2005, p. viii). Hence, a better management of short-run macroeconomic fluctuation might help to improve public support for microeconomic reforms.
From an economic point of view, it is well known from the theory of monetary integration that Europe might need a stronger centralization of fiscal policy (Baldwin and Wyplosz, 2006, p. 358). According to the textbook arguments, handing over autonomy in monetary policy requires alternative adjustment mechanisms for asymmetric shocks. If a high degree of labour mobility or wage flexibility cannot be attained to bolster shocks, alternative mechanisms might be necessary. One possibility is fiscal policy which can bolster regional demand by increased expenditure, transfers or indeed by lower taxes. According to this argument, fiscal stabilization requirements in EMU are actually bigger than in other federal entities such as the USA, as labour mobility in Europe is lower and wages are less flexible.
While this argument has been widely discussed in the early debate on how to structure economic governance for a monetary union,2 it fell into disregard afterwards. Belief in the effectiveness of fiscal policy faded with the ascent of New Classical Economics in the late 1980s. Meanwhile, the political realities of the early 1990s made any closer political union with a larger budget unthinkable.3 That said, the view on this issue has again turned. One central proposition of the New Classical Economists was ‘Ricardian Equivalence’, the notion that an increase in budget deficits would be without effect as economic subjects would rationally expect higher taxes as a pay-back in the future and would accordingly already cut their private expenditure. Since then, a number of empirical indications have emerged to support the argument that Ricardian equivalence does not hold in its absolute form (Ricciuti, 2003). In addition, extensions of modern micro-founded models have provided a new rationale for improving the effectiveness of fiscal policies. A number of models now show that fiscal stabilization policy can be effective if households are liquidity-constrained and have limited access to unsecured loans or if individuals use rules-of-thumb for their consumption decisions.4
In addition, recent economic research has presented fundamentally new arguments to strengthen the case for counter-cyclical fiscal policy, Galíet al. (2005) finding that business cycle fluctuations distort the efficiency of an economy if price rigidities or other market frictions exist – the cost of which can be quite substantial. According to these scholars, major recessionary episodes in the US have been related to welfare losses of up to 8 per cent of annual consumption – a figure well above that quoted by Lucas (2003) in his critique of stabilization policies. In a further paper, Galí (2005, p. 7) argues that these results reinstate the old Keynesian proposition that it might be ‘require[d] that appropriate fiscal and monetary policies are undertaken to guarantee that a higher level of activity is attained’.
In a New Growth Theory framework, Aghion and Howitt (2006) go even further, arguing that macroeconomic fluctuation might hinder companies from conducting an optimum level of research and development, especially if financial markets are underdeveloped and firms may thus be unable to bridge periods of low earnings with fresh credit. Aghion and Marinescu (2006) show econometrically that this effect is significant at a macroeconomic level. Since the approaches adopted by both Galíet al. as well as Aghion and Howitt showthat the benefits from stabilization policies grow with market imperfections, the two approaches would lead us to the conclusion that Europe needs more macroeconomic stabilization than the US.
The Case for Automatic Stabilizers
It is now well established that this stabilization should not be attempted through discretionary policy, but rather through automatic stabilizers.5 One of the criticisms regularly made against discretionary fiscal-stabilization policy is that it involves long time lags from the initial economic slow-down until a change in the policy stance actually leads to changes in output and employment. First, in order to enact appropriate expansionary policies, a macroeconomic shock needs to be detected early and the type of shock analysed accordingly. As most economic data are only available with a significant time lag (in most European countries, GDP data are only published six weeks after the end of a quarter) and are subject to large volatility and revisions, there is a danger that fluctuations are only detected with a significant delay (detection lag). In addition, budgetary processes in most industrialized countries result in a long lag between the first idea and the implementation of fiscal policy measures (decision lag). Finally, economic agents have to adjust to fiscal policy measures (such as tax cuts) and might take time to adjust their expenditure (policy lag). Automatic stabilizers get around this problem as their pay-outs are usually linked to some directly observable high-frequency data such as unemployment and as they are automatic, they are not subject to a decision lag.
Moreover, economic considerations in modern models hint that stabilization policy is most effective when it is limited to a short period of time (Andersen, 2005). A permanent increase in deficits leads to an adjustment of the public sector towards the expected higher tax rates, while a temporary increase might just provide additional income to households, of which a share is liquidity-constrained. If fiscal policy is set in a discretionary manner, there might be reluctance to cut back public spending or increase taxes again even after the need for stabilization has ceased. Thus, there is a broad consensus that fiscal stabilization works best via automatic stabilizers, and not through discretionary spending.
II. Stabilization Policy: The Experience of the First Years of EMU
In principle, one should think that western Europe's welfare states are well positioned to use their fiscal policy as a stabilizing tool. With a relatively high government-revenue-to-GDP ratio and a progressive tax system as well as a rather generous social security system, automatic stabilizers should be strong. In an analysis of tax and welfare systems, Van den Noord (2000) finds that in most EMU countries, a change in GDP by 1 per cent actually changes the general government's budget balance by 0.5 per cent of GDP, compared to only 0.25 per cent for the US. In a simulation with the cyclical fluctuation of the 1990s, he finds that these automatic stabilizers have thus erased roughly 25 per cent of the fluctuations in GDP in the larger EMU countries.
However, as Van den Noord also notes, for the overall stabilization outcome, it is important to look beyond automatic stabilizers. After all, it is possible for one country to manage to counteract cyclical fluctuations through a discretionary fiscal policy, even if automatic stabilizers are rather small. Similarly, it is possible for a government to counteract automatic stabilizers with a pro-cyclical discretionary fiscal policy, thus dampening or even eliminating their positive effects completely. This was exactly what some critics of the SGP had warned about: if countries with a budget deficit close to the limit of 3 per cent of GDP were hit by a recession, they would be forced to cut back spending or increase taxes in the downturn, thus eliminating the stabilization effect exerted by the automatic stabilizers.
So far, most authors who had attempted to model the effect of EMU in empirical terms concluded that overall fiscal policy has not become more pro-cyclical after the beginning of European Monetary Union, but rather that it was acyclical to pro-cyclical even before the start of EMU (Galí and Perotti, 2003). This is in contrast to the US where it has been counter-cyclical.6 However, previous studies do not always include the time after 2002 when the excessive deficit procedure was applied to Portugal and Germany7 or the long period of very slow growth after 2001 which has brought many EMU countries into conflict with the SGP. To overcome this deficiency, we have conducted a new analysis in the spirit of Galí and Perotti, but using additional data-points.8
The results for the time before EMU mirror those of Galí and Perotti. Overall, discretionary fiscal policy in the run-up to EMU seems to have been slightly pro-cyclical, especially in Belgium and Italy, but also in France and Spain (albeit to a degree which is not statistically significant).9 This probably reflects the governments' resolve to reduce their budget deficits to meet the Maastricht criteria for joining EMU.
Since the beginning of EMU, discretionary fiscal policy seems overall to have been acyclical – as Galí and Perotti too have found. However, our conclusions differ in an important manner from theirs: in the two countries which were first subject to the excessive deficit procedure, Germany and Portugal, fiscal policy turned strongly pro-cyclical after the introduction of the euro (although in the case of Portugal the coefficient is not statistically significant, sitting, as it does, at the 10 per cent level). This shows that the concerns of those who warned that the SGP might hinder the working of the automatic stabilizers and might thus have prolonged the economic downturn were right. In fact, in Germany, the Schröder government with its Hartz labour market reforms cut unemployment benefit duration and benefit levels for the long-term unemployed during this time, thus actively reducing the possible effect of the automatic stabilizers. In Portugal, VAT was increased amidst an economic slump.
The results for EMU are even more interesting if one compares them with those of other major OECD economies – the US and Japan. Of the actors included in this international comparison, the euro area shows the least evidence of a counter-cyclical discretionary fiscal policy both prior to and after 1999. In the US, discretionary fiscal policy has always been strongly counter-cyclical, and this period was no exception. Japan ran a strongly counter-cyclical fiscal policy prior to 1999, but no subsequent systematic reaction to the cycle can be detected.
Yet, even though discretionary fiscal policy has been pro-cyclical in some EMU countries, this does not necessarily imply that overall fiscal policy cannot be counter-cyclical. In order to ascertain whether the overall policy stance has been counter-cyclical, we have thus run a number of additional regressions of the actual (headline, not cyclically adjusted) deficit on the output gap. On the basis of an analysis of both discretionary fiscal policy and automatic stabilizers, over the whole period from 1991 to 2006, but for two small EMU countries alone (Austria and Finland), a statistically significant reaction of fiscal policy towards the output gap can be detected. In all the other EMU countries, the coefficients are mostly small and none are statistically significant. Thus, discretionary fiscal policy in EMU obviously counteracted the automatic stabilizers to the degree that no significant stabilizing effect of overall fiscal policy remained.
Again, this contrasts with the US and Japan:10 In these countries, fiscal policy reacts in a strongly counter-cyclical manner towards the output gap, with coefficients as high as 0.9 in the US and 0.6 in Japan, meaning that an increase in the output gap by one percentage point causes the overall deficit to widen almost by one per cent of GDP in the US and by more than half a per cent in Japan.
Explaining Europe's Failure to Stabilize
Against this background, the question arises why Europe fails to use fiscal policy to stabilize even though economic theory tells us that it has more need to do so than the US. A possible explanation might be that the national governments in EMU responsible for stabilization policies have reasons to avoid them. As Goodhart and Smith (1993, p. 423ff) note, the smaller and the more open a country, the fewer incentives a government will have to use fiscal stabilization policies. If a country is very open as is the case with the individual members of the single market, a large part of the stabilization effort can be expected to result in higher imports and thus beneficial effects for the trading partners, and not for the home economy. Thus, fiscal stabilization policy has positive external effects. The costs of stabilization policy in the form of higher government debt, however, have to be completely borne by the national government which undertakes it. If a single government weighs its own benefits from stabilization against its own costs for such a policy, it will rationally decide for a degree of stabilization which is significantly lower than would be optimal for the currency union as a whole.11 As stabilization policy thus has a public-goods character for a currency union, fiscal stabilization should take place on the highest possible level of government in a currency union.12
Deducing the Requirements of a Coherent System
Against the background of these findings as well as, of course, the economic goals outlined in the preamble of the Treaty on the European Union (‘to achieve the strengthening and the convergence of their economies’ as well as ‘to promote economic and social progress for their peoples, taking into account the principle of sustainable development’) there is an argument for a significant shift in the way the EU both raises revenue as well as spends the money, especially under the conditions of a single currency. Three main principles are apparent:
- 1Expenditure should enhance the productivity of the European economy and thereby work towards the Lisbon targets. After all, total factor productivity is the single most important determinant for incomes and thereby for ‘economic progress’. Moreover, by spending money for productivity enhancement both at the EU level as well as in individual countries which lag behind in productivity (and hence have lower per capita incomes than the average), convergence in incomes across the EU is fostered.
- 2Both EU revenue and expenditure should be raised and spent in a way that does not contribute to boom and bust periods in the business cycle. Today, EU expenditure in infrastructure is paid and spent even if a national economy is overheating, thus aggravating the cycle and increasing the risk of a sharp downturn later. As the stability of the business cycle is a supplement to structural reforms in the process of increasing productivity, this leads to a sub-optimal outcome.
- 3An explicit mechanism to stabilize the business cycle at the EMU- or even EU-wide level should be introduced to complement stabilization policies at the national level. As the structure of the EMU leads to a sub-optimal degree of stabilization when the decision is left to national governments, the EU budget should have an explicit stabilization target and additional mechanisms for EMU should be considered.
The following sections analyse the revenue and expenditure side of the current EU budget and suggest changes to come closer to fulfilling these efficiency criteria.
III. The Structure of a New Budgetary System
With regard to the principles defined above for a coherent budgetary system which enhances the growth potential of the European economies, the EU budget broadly fails. Neither the way in which revenue is raised nor the means of its dispersal do anything to stabilize regional and EU-wide business cycles. Indeed, at worst, they even amplify existing fluctuations and misalignments.
The Income Side
The EU budget is currently funded through four kinds of ‘own resources’: agricultural levies, customs duties, value-added tax and the GNP-based own resource which covers the difference between planned expenditure and the amount yielded from the other three resources. This latter source of finance contributes more than 50 per cent of the revenue, as agricultural and other import duties have considerably decreased in the last decades.
The question of whether the EU needs a new system of own resources has been up for debate since the European Commission launched its 2007 consultation paper (Commission, 2007). From an economic point of view, this new system would be one which better takes into account the wealth in the Member States than the current system does (and which is additionally distorted by various factors including the UK rebate). This debate had already raged during the European Convention, where France, Germany, Austria, Belgium, Luxembourg and Portugal identified such a system as being in their interest.
Tax-based own resources are usually defended with the following arguments: increased transparency, increased EU autonomy, a more direct link to EU citizens and more scrutiny of EU public finances, the need for an increased democratic legitimization and justification of public expenditure in the EU.13 To this, from the EMU experience, we would add the cyclical stabilization function of a trans-European tax.
Unlike the tax systems of most modern countries, the EU revenue process is geared to have no stabilization effect whatsoever. National budgets usually finance themselves from a combination of different taxes, some of which, such as capital gains taxes, progressive income taxes or profit taxes, are, cyclically, highly sensitive. If there is an unexpected shortfall of revenues, the gap is filled by increased government borrowing in most countries.
In principle, the VAT and the tariff part of EU revenue could work in a similar manner. However, VAT and tariffs are amongst the least sensitive sources of revenue in cyclical terms, as consumption is relatively smooth over the business cycle. Moreover, as any shortfall in VAT revenue is automatically filled via ‘own resources’ which are extracted from the Member States, this small effect can be completely counteracted by the logic of the EU budget. Without the possibility of going into debt or at least drawing upon reserves accumulated earlier, the EU budget cannot act as an overall stabilizer for the European business cycle.
The Expenditure Side
The EU's expenditure is currently concentrated on two major areas: the common agricultural policy (almost €680 billion) and structural and cohesion policy (€308 billion). Both areas together make up 70 per cent of the budgetary outline 2007–13.14 The bulk of EU public expenditure hence goes into redistribution, and large parts of the budget actually support the status quo and hinder change, as e.g. the expenditure for agriculture provides a permanent transfer to certain rural regions without bringing any advantages with regard to social or economic progress or development.15Allocative expenditure is comparatively minor, totalling up to €74 billion for the Lisbon Agenda (improvement of competitiveness), the financing of the EU's citizenship policies and co-operation in justice and home affairs (€10.7 billion), the EU's international role (€49.4 billion) and administrative costs of €49.8 billion.
There is currently no expenditure devoted to stabilization purposes. The structure of the EU budget as such prevents any money flowing into automatic macroeconomic stabilization. The main reasons are the structure of the income and expenditure sides coupled with the organization of the EU budget process in six-year programmes which leave no room for reaction to cyclical developments. All expenditure is distributed or allocated along multi-annual programmes which follow objectives other than cyclical stabilization (e.g. redistribution to underdeveloped regions or uncompetitive market segments, allocation of means to create infrastructure, to finance research etc.).
From the country-by-country perspective, the situation is even worse, because for some of the countries, transfers from Brussels are much more important relative to GDP and affect a much smaller sector of the economy than the revenue side. For example, structural funds alone amounted on average to almost €10 billion for Spain each year from 2000 to 2006 (more than 1 per cent of GDP), with most of this money going into an already overheating construction sector, the now excessive size of which is considered to be one of the main vulnerabilities of the Spanish economy. One problem is that the money is spent at a predetermined speed without any consideration of the situation of the national business cycle. It is thus more than possible that the structural funds will first amplify a national boom and then expire exactly at a moment when the economy slumps.
In order to solve these problems, one could condition the speed of disbursement for investment-spending around the position of the business cycle. Under such a regime, work on infrastructure projects would be delayed when the national economy in question is growing above trend and expedited when growth falls below trend. The idea is not to suddenly reduce funding without prior notice, but rather to extend or speed up the funding period if need be. In most cases, this should be a measure appreciated by the contractors in the projects (and could even be negotiated in agreement with them). In a period of overheating in the construction sector, contractors may be happy to delay certain projects to a time when their order books are less packed and they have spare capacities to do the job.16 Without additional costs, the existing structural funds could thus be brought to a secondary use of stabilizing national business cycles. This principle could also be applied when some of the expenditure is shifted from traditional cohesion and structural-fund expenditure towards areas which are more compatible with the Lisbon Agenda such as research and development or higher education, with higher disbursement in times of economic slump and lower disbursement in times of rapid growth. While for the capital expenditure part of R&D (construction of laboratories or buildings) the mechanism described above could be applied, for large parts of R&D, such as the hiring of personnel, one would need a different approach as it is not feasible to delay a project once it has started. One possibility would be to start certain subsidized R&D projects at the beginning of a downturn when unemployment among scientists and engineers too is rising.
A shift towards a more cyclically sensitive tax than VAT would likewise improve its stabilization properties. A progressive personal income tax would probably provide the best stabilization properties (Goodhart and Smith, 1993). However, as introducing such a tax on the European level would be extremely complicated given the huge differences in the national preferences and tax bases for personal income taxes, a European Union corporate tax seems to be the second best solution. Introducing a common EU corporate tax would not only have the advantage of shifting from an acyclical to a more cyclical revenue source, but would in addition allow for the introduction of a minimum level of taxation which would limit the excesses of harmful tax competition. As is the case with the federal states in the US, introducing an EU corporate tax would not impair the single countries' power to levy an additional corporate tax on profits in their jurisdiction, thus still allowing for a certain degree of tax competition.
In principle, the whole EU budget beyond the revenue from tariffs could be financed with a Union-wide corporate income tax without increasing the overall tax burden for corporations. On average, taxes on corporate income amounted to 3.2 per cent of GDP in 2004, with corporate income taxes in all single EU countries exceeding 1.5 per cent of GDP (see OECD, 2006, p. 76). The whole EU budget of 1.27 per cent of GDP could thus be financed by a common corporate tax, leaving all countries ample room for an additional national corporate income tax. Shifting taxation to this new source would be neutral for national budgets as well as for taxpayers. Since the EU would be financed with corporate income taxes, the revenue now allocated to the EU budget from VAT and the national budgets would be available for national expenditure, allowing the countries to lower their own corporate income taxes by the amount of the new EU-wide tax.
In order to allow for the stabilization of the business cycle not only across regions, but also across time, the EU would need to be allowed to build up reserves in an economic upswing and draw upon them in a downswing – a stark change from the current practice. If the new budget system were to be phased in at a favourable point of the business cycle (and thus at a point of high tax revenue), this could work without allowing the European Union to go into debt. The EU would thus first build up reserves from which it could draw afterwards, thereby avoiding the politically sensitive debate on whether the European level should be allowed to issue debt titles of its own.
Introducing an Explicit Pillar for Stabilization in the EMU or EU
All the same, as the primary goal of most of the current expenditure as well as any additional expenditure aimed at reaching the Lisbon targets is to improve the structure of the economy, not to stabilize the cycle, the effects from these changes might be limited. In order to reach a stabilization closer to those of other advanced countries, an explicit pillar for stabilization policies in the EU would be desirable. In the early 1990s, there was a lively debate on possible stabilization schemes (Goodhart and Smith, 1993; Majocchi and Rey, 1993; Italianer and Vanheukelen, 1993; Pisani-Ferry et al., 1993). More recently, Dullien and Schwarzer (2005 and 2006) and Nevin (2007) have picked up the argument. Perhaps the most interesting result from this discussion has been that expenditure need not be large in order to provide significant effects. According to Italianer and Vanheukelen, a quarter of all country-specific GDP fluctuation could have been stabilized with an average cost of only 0.2 per cent of GDP. In their model, single countries would be paid a variable amount should national unemployment rise significantly faster than unemployment in the rest of the Union.
However, these proposals do not address the political economy problems of stabilization policies in very open economies such as those in the EMU. Even if national governments were given money in a downturn, it is not clear whether they would use it right away for expenditure increases or tax cuts. In particular, countries constrained by very high deficits might use the additional funds for budget consolidation to have room for additional spending or tax cuts just before the next elections, which would not stabilize the cycle.
An alternative solution would be the introduction of basic unemployment insurance on the European level. This could conceivably be applied to all EU or EMU countries just as well as it could to only a group of countries. For all employees in participating countries, a certain payroll tax (back-of-the-envelope calculations propose that roughly 2 per cent would suffice) on wages paid up to a certain limit (possibly the national median wage) would be collected. From this money, employees who have paid contributions for more than a year would be allowed to draw benefits of half their last salary up to a limit (possibly half the median wage) for a period of six to 12 months. This basic unemployment insurance would replace only part of the national system. Each nation would still have its own national unemployment insurance. This would reflect the national choice for social security since it would top up the payments from Europe (either in the monthly benefit amount or in the duration of benefits)17 without raising the overall burden on employers and employees. Importantly, it would not threaten to eliminate national specificities because national governments would still define the level and duration of benefits and bear the costs for very ambitious schemes.
Such a system would fit very neatly with existing unemployment insurance schemes, as all EMU countries (with the exception of Ireland and Greece) have unemployment insurance systems which are financed by payroll taxes and which pay benefits relative to past earnings. By retaining the overall benefits paid to the single unemployed, changing the source of funding alone, there would be no deterioration in the incentives to look for new work.
Such a scheme would stabilize the business cycle by draining purchasing power from countries in which the economy booms as unemployment in these countries falls. If a country goes into crisis, purchasing power and thus domestic demand would automatically be shored up. By funnelling the money directly to the unemployed, it is guaranteed that the money is actually spent. The system would only explicitly compensate for cyclical unemployment and not therefore for structural unemployment as only those who have been regularly employed for a certain period prior to unemployment can receive payments. Short-term unemployment is an excellent indicator for the output gap: those who have recently become unemployed are by definition unused potential of the national economy in question. In addition, by reacting to unemployment, the mechanism would not induce transfers caused by quarter-to-quarter fluctuations in GDP growth figures, but only if an economy experiences a protracted upturn or downturn of the kind that could be expected to have effects on the long-term growth path.
As the need for a common stabilization policy is larger inside the EMU than in the rest of the European Union (since EMU countries have no national monetary policy left), an option would be to introduce this kind of basic unemployment insurance at first only for the EMU (or even only part of the EMU), with a voluntary option for other EU countries to join. This might be politically more feasible than trying to get all EU members to agree to such a scheme, given the position of the British in particular (but also some central and eastern European countries' preferences) not to strengthen the social dimension of European integration. The overall amount of money required to achieve meaningful stabilization effects via unemployment insurance need not be large. According to Chimerine et al. (1999), US unemployment insurance has roughly stabilized 15 per cent of fluctuations in GDP, even though it only moves about 0.4 per cent of GDP each year.
Of course, as these proposed measures only use instruments designed for purposes different from macroeconomic stabilization (poverty alleviation for the case of the unemployment insurance and productivity enhancement for the case of R&D and infrastructure expenditure), there will be no perfect stabilization of the business cycle. However, this approach would allow using the instruments in question for partial stabilization without jeopardizing their primary purpose, bringing the economy closer to its optimum.18
Institutional and Legitimatory Requirements
The introduction of an EU tax would raise the procedural requirements for deciding on a democratically legitimate EU budget. Moreover, the European unemployment scheme would need a transparent and efficient governance system, which, if not all EU members participate, would have to have its own mechanisms either as part of or outside the EU budget.
As has been pointed out by Enderlein et al. (2005) in an ECB Discussion Paper, a further development of the EU's public finances has to go hand in hand with the development of the EU as a political entity. Today, the main source of legitimacy runs through the national governments. As these governments find it difficult to justify the benefits of EU integration and of the policies financed through the EU budget (at least for the net contributors) to their electorates, the basis of legitimacy for the current EU budget is comparatively low.
Even if the budget as such were not fundamentally changed, budgetary compromise in the EU-27 would remain extremely difficult to achieve. As the negotiations on the Financial Framework 2007–13 have shown, this can be traced to the sheer number of negotiators and the heterogeneity of their preferences. The lack of trans-European legitimization mechanisms provides a bias against reasoning in terms of European public goods. Collective action problems and temptations for free-riding prevent coherent action with the EU's resources. Log-rolling is a problem in this context as Member States are more likely to find a compromise if they trade different policies and financial flows against each other (Collignon, 2003). Meanwhile, the ‘no-taxation-without-representation’ rule remains valid for the EU. If EU taxes are raised, their imposition has to be based on a democratically legitimate and transparent process, giving voters the chance to sanction those who have imposed the taxes, and giving newly elected majorities the chance to change the direction of socio-economic policies reflected both in the income and expenditure side of the EU budget.
A modern approach based on individualistic/liberal principles would recommend redistribution to citizens as reflected in a tax system which is based on the individual's ability to pay for the provisions of public goods (such as the European corporate tax or a common progressive income tax system) – as well as in the European unemployment scheme suggested in this article. Regional policies should continue to supplement the distribution policies on the individual level (Collignon, 2003).
Assuming that the guiding principle of any future EU budgetary system should be the added value generated by EU expenditure in terms of European public goods, our proposals are in line with political economy considerations of national governments' incentives. Their implementation would not only improve the functioning of the EMU, but would also be a quantum leap in EU budgetary policy and in European integration as such, given the need for the new mechanism to enjoy democratic legitimacy.
Our starting point was the analysis of the newly identified efficiency requirements that budgetary policies would have to meet if stabilization were to be achieved – and which they do not meet under the current design of the EMU. Since the introduction of the euro, not only have problems with the implementation of the Lisbon Agenda surfaced, but economic tensions within the EMU have also grown with excessively prolonged boom and bust cycles in individual countries leading to dangerous imbalances (see Dullien and Schwarzer, 2005; 2006). These problems are likely to aggravate as EMU is being enlarged. Both problems could be at least mitigated by a more intelligent use of funds. Combining a relocation of expenditure towards productivity-enhancing goals such as research and development with stability-enhancing revenue and spending and an additional explicit stabilization pillar in European Union finances could provide a triple benefit. As the solutions proposed in this article are aimed at providing additional stabilization without reducing the funds' impact on productivity, productivity growth could be boosted, bringing the EU closer to its target of becoming more competitive. The economic workings of the euro area would be improved. Together, these moves can reduce the risk of political backlash against European integration.
Appendix: Econometric Estimates
In order to evaluate how far fiscal policy in the euro area and in other important industrialized countries has reacted to the business cycle over past years, we have broadly followed the approach chosen by Galí and Perotti (2006). However, unlike this original work which only uses data up to 2002, we have used time-series which include all years until 2006. In contrast to Galí and Perotti, we do not differentiate the time periods before and after the signature of the Maastricht Treaty in 1992, distinguishing instead the period from the early 1990s until the actual start of EMU in 1999 from the subsequent period.
Table A1 shows the results from a number of estimated equations of the form:
with dt* denoting the cyclically adjusted primary government balance, dt−1* denoting the lagged deficit, xt denoting the output gap and b denoting the debt to GDP level. The two coefficients φEMU and φBEMU allow for different reactions for the time before EMU and in EMU, with the first one being applied for the years until 1998 and the second one for the period starting in 1999. The idea behind this analysis is as follows: the cyclically adjusted primary deficit is the current deficit adjusted for the workings of the automatic stabilizers and the debt service. As the deficit beyond the automatic stabilizers and beyond the interest service can be seen as the discretionary fiscal policy variable, its reaction to the output gap shows how far policy-makers are reacting to the business cycle. Including the debt level into the equation simply mirrors the assumption that policy-makers are nevertheless concerned about the overall level of public debt and aim at attaining a certain debt-to-GDP-ratio. As there is the problem of endogeneity between the cyclically adjusted budget deficit and the output gap, the equations have been estimated by a two-stage-least-square procedure with the use of instruments following Galí and Perotti (in addition to the lagged deficit and the debt level, the output gaps of other countries have been used as instruments).19
Table A1. Reaction of Structural Primary Deficit on the Output Gap
In a second step, an additional analysis is run in order to evaluate whether overall fiscal policy has reacted systematically to a change in output gap. To this end, for all of the countries, an estimation of the following form has been estimated (without differentiating between pre- and post-1999 periods):
with dt denoting the headline deficit and all other variables defined as above. The results are presented in Table A2.
Table A2. Reaction of Total Deficit on Changes in the Output Gap
The data for the econometric estimations have been taken from the EU Commission's AMECO database (autumnFall 2006) for all EU countries and from the OECD Economic Outlook (autumnFall 2006) for Japan, the US, Canada and Switzerland.20 Budget deficits for EU countries are corrected for proceeds of the sale of UMTS mobile phone network licences as they can be seen as one-off-events that did not figure in the general consideration for discretionary fiscal policy (in fact, the EU finance ministers had agreed in advance to pay back public debt with the windfall revenue) and can also be assumed to have rather limited immediate effects on the business cycle. For most countries, the time-series runs from 1991 to 2006. However, for a small number of countries (i.e. Spain, Euro-12), the time-series only starts in 1996.
See for instance Sapir et al. (2004), Buti and Nava (2003), Becker (2007), Begg (2005), Enderlein et al. (2005), Collignon (2003) and the contributions in Lefebvre (2004).
See the special Reports and Studies Issue No. 5/1993 of the European Economy. The issue was also raised before and during the Maastricht negotiations, e.g. by then Bundesbank President Hans Tietmeyer who insisted a currency union should be complemented by a political union.
Note for instance the failure of the Intergovernmental Conference on the political union to accompany the EMU-project.
See for a survey Andersen (2005).
See also Lane (2003) and Aghion and Marinescu (2006).
The Commission started the Excessive Deficit Procedure against Portugal with its report in September 2002 and against Germany in November 2002.
For the econometric analysis, see Tables A1 and A2 in the Appendix.
Note that negative coefficients denote pro-cyclical fiscal policies while positive coefficients show counter-cyclical fiscal policies.
It should be noted here, however, that the Durbin-Watson test statistics for the US as well as for some EMU countries point towards misspecifications in the equation. However, as re-specifying the equation for each country would lead to a loss in comparability, they are reported nevertheless. For EMU as a whole as well as for Japan and Great Britain, the equation seems well specified in the form reported.
This is nothing other than Samuelson's (1954) seminal analysis, that the private provision of goods with positive externalities leads to an under-provision of these goods.
See the literature on fiscal federalism, as well as recently Collignon (2004), Begg (2005) and Buti and Nava (2003) for their ways to integrate this argument in the current debate on budgetary policies in the EU.
One interesting contribution with references to the most important positions in the debate is Le Cacheux (2007).
The figures are taken from the interinstitutional agreement with the European parliament of 4 April, 2006 which is based on the Council decision of 17 December 2005.
See for instance Becker (2007), Begg (2005), Buti and Nava (2003).
Another idea, which would be yet more complicated to implement, is to vary national co-payments according to the cyclical condition of the economy (yet again, not altering the overall amount of money the country receives, but only the time span in which the sum is paid out).
Dullien (2007) provides an overview.
According to the Tinbergen principle, one needs at least as many independent economic policy instruments as one has economic policy variables that one wants to target exactly. However, if one allows for inexact targeting, one can do so with fewer instruments. A real-world example would be the use of combined heat-and-power production for heating the housing in a power plant's vicinity. In these cases, there might not be perfect temperature control of the houses by adjusting the level of energy production alone. However, using the waste heat in this way improves the energy efficiency greatly. Hence, one would have two targets (the electricity production and the heating of the houses), but would use only one instrument (the production level). In the absence of additional heating in the house, this would greatly improve the comfort of the house, even if one cannot control temperature perfectly.
Details on the instruments used can be obtained from the authors on request.
While data for 2006 still have been estimates, they can be considered to be already reasonably accurate as final data for the first half of the year have already been available to the institutions at the time of the forecasts.