European Affairs

The main reason for our confidence is the enormous change taking place among Europe's political leaders. Last year we visited Oswald Metzger, a German parliamentarian, and a young leader of the Green party and its budget spokesperson. We were surprised and delighted to hear Mr. Metzger speak with enormous passion and conviction about unleashing the productive potential of German labor and entrepreneurs by aggressively cutting taxes and deregulating.

Here was a leading member of the supposedly Big Government, far-left Green party speaking about the power of tax cuts and deregulation in ways that would make a Jack Kemp Republican envious.

Last year, France's Socialist government cut taxes in response to public pressure from its own parliamentarians after tax revenues proved higher than expected. Just recently, the French government announced new income tax cuts. And in the first week of February, the Socialist head of the national assembly called for even further cuts in income, payroll and housing taxes.

Even France's notorious 35-hour workweek legislation is being implemented in ways to allow companies to recover flexibility. In fact, some unions are resisting a shorter workweek for their members precisely because of the concessions on working hours and management they must give to companies in return. It is not an exaggeration to say France is talking left, but governing right.

France's senior representative at the European Central Bank, Christian Noyer, constantly stresses the need for structural reform. In an October speech, Mr. Noyer said that only comprehensive reform could remove the underlying impediments to higher employment.

"In particular, further reforms of the tax and welfare systems are required in many EU countries in order to increase the incentives to create new jobs and to accept them. Wage moderation can also have a significant beneficial impact," he said.

Mr. Noyer concedes that such reforms may require difficult political decisions, especially since necessary changes are felt directly, while the benefits only become apparent over time. But the success of past structural reforms is already visible in countries that have adopted the right measures and kept wage growth moderate.

Clearly, there is a new, pragmatic, market-oriented consensus growing among Europe's young leaders. When it comes to creating growth and jobs, young business and political leaders in Europe are freeing themselves from yesterday's ideological debates and embracing market incentives.

Another important way of looking at the issue is through "generational accounting," a new way of measuring fiscal health, which can provide valuable insights about the amount of economic restructuring European countries still need to do.

Conventional recommendations for restructuring usually involve divesting state-owned companies, liberalizing labor markets, deregulating business practices and eliminating special market protections. But these factors tend to overlook the enormous challenges posed by aging, one of Europe's biggest problems.

The size of a country's pension, healthcare, unemployment and other benefits are crucial in this regard. More critical, however, is the degree to which they are sustainable or "funded" (that is, the degree to which the taxes of younger generations are not going to have to be increased to meet commitments to older generations).

A clear sign of the need for economic restructuring emerges when a country's government is no longer able to meet its public commitments without raising taxes significantly. The degree to which a country's fiscal situation is "unsustainable" is an effective indicator of the amount of needed real sector restructuring. Generational accounting, a new approach to measuring fiscal health, can provide valuable insights about the amount of restructuring a country has to do.

Generational accounting focuses on a country's fiscal balance in terms of benefit commitments less required taxes and measures the net burdens facing current and future generations. The method involves calculating the present value of each generation's government benefits and tax payments and subtracting one from the other to yield the net implicit lifetime tax payment.

A country's policy is said to be "sustainable" if the present value of each generation's already legislated tax payments covers the present value of the benefits the government has committed to. Despite the criticisms that have been leveled at it, generational accounting provides the most comprehensive methodology available to assess a nation's long-term fiscal health.

Alan Auerbach, Jagheesh Gokhale, and Laurence Kotlikoff developed the basic methodology and presented the early findings in 1991. Their most recent analysis and that of numerous other researchers is presented in a book, Generational Accounting Around the World, recently published by the University of Chicago Press. We highly recommend it.

Private corporate and individual decision-makers take a country's long-term tax outlook into consideration when allocating capital. Countries whose benefit commitments do not exceed the capacities of current tax policies are at a competitive advantage in attracting capital.

We have argued in papers for the Council on Foreign Relations and the Center for Strategic and International Studies, that national unfunded pension and medical care commitments and tax levels are powerfully affecting current international capital flows. Other things equal, countries with low lifecycle net tax costs are more attractive.

We call the long-term benefit/tax advantages some countries have achieved, "generational competitiveness." It is actually heartwarming, and maybe not surprising, that capital favors countries that do not overburden their children.

The table below from Generational Accounting Around the World is a ranking of the amount of needed real sector restructuring. Germany's imbalance or net long-term tax burden is nearly twice that of France and the average of France, Germany, and Italy (about $160,000 per capita, and a reasonable proxy for Europe generally) is three to four times that of the United States.

Generational Imbalance
Per Capita
Scaled to 1995 U.S. GDP and in 1995 U.S. dollars

Canada $3,400
United States $45,300
France $101,700
Italy $197,100
Germany $203,900
Japan $300,900

Bernd Raffelhüschen and Jan Walliser, two German economists, determined that future generations of Germans faced 156 percent higher lifetime taxes than current newborns, or an equivalent net lifetime tax rate of 54.5 percent. These economists concluded that Germany could restore balance by (1) raising income taxes 29.5 percent; (2) increasing all taxes 9.5 percent; (3) cutting transfer payments by 14.1 percent; or (4) reducing government purchases by one-fourth.

Investors who are indifferent between allocating capital into German or French investments for other reasons, will choose to invest in France once they incorporate France's superior generational competitiveness.

The same is true of talented people. They may be indifferent between living in, say, Paris or Berlin, but once they think through France's superior balance of benefits and taxes, they will choose to live in France.

Business leaders also understand that to induce talented people to stay in high imbalance countries, they will have to increase employee compensation enough to neutralize the higher net tax burden. Thus, even if business executives can negotiate favorable tax arrangements for their companies, they will still have to offset excessive net long-term tax burdens through higher employee compensation costs.

France's overall burden however appears to be significantly smaller than Germany's. It is not possible to put the matter in precise terms; however, France's generational competitive advantage probably explains the strength of France's stock market and why France's growth in the past several years surged ahead of Germany's.

Germany's recently an-nounced tax and pension reforms, however, have had a positive and galvanizing effect on market appraisals of Germany as an investment locale. On December 21, 1999 the Schroeder government surprised and delighted investors by announcing business-friendly, supply-side oriented tax reform proposals.

Bipartisan pension reform talks have begun, with both Green and center-right CDU/CSU agreed that Germany's pension benefit formula take explicit account of aging. By inserting a "demographic factor" into the pension benefit formula, benefit increases would slow as the worker-retiree ration sank.

Markets appear to be very impressed with how the German pension reform discussion reflects uncommon frankness about the challenge posed by demography; strong bipartisan consensus on the need to avoid saddling young workers with higher payroll taxes; and a commitment to private equity investment that bodes well for Germany's shift to a more equity-financed economy. The leitmotiv of Germany's press and political discussion is sustaining "generational equity" as Germany's population ages.

While success in these bipartisan pension reform talks is not guaranteed, that they are taking place at all within a consensus about the nature of the demographic challenge and need for generationally fair reform sets Germany ahead of its G7 partners. If Germany succeeds in implanting the principle that pension benefits must be scaled back to avoid increasing the tax burden on the young, Germany's attractiveness as a destination for capital investment will rise markedly.

In general, we find that when rates of reform are equal, the country with the lowest generational tax burden is favored by capital. But when a country accelerates meaningful reforms, it can overtake a country whose reform efforts lag, even if the quickly-reforming country has a larger overall burden to begin with. This is why investors are likely to increasingly reward Germany with capital flows if its pension reform negotiation, along with tax reform, advance this year.

Too many Americans dismiss European voters and leaders as being hopelessly saddled with old-line, statist views. These Americans need to take another look. The threads of new thinking that will fashion a stronger economic fabric are evident everywhere.

The new common currency, ably administered by the ECB, will continue to foster pressure within Europe for increased competition. A single currency and price stability are liberating. They facilitate movement, individual action, and entrepreneurial risk-taking.

The single market puts people, companies, and governments into competition with each other in a way that can only result in increased efficiency and growth. Clearly much remains to be done, but no one - especially Americans - should be blind to the new thinking emerging in Europe and the potential it holds.

While it may be premature to proclaim attainment of a European new economy, Europe is beginning to dismantle its structural rigidities and release its enormous physical, capital and labor endowments to be used more productively. When the thinking and policies advocated by younger leaders like Oswald Metzger and Christian Noyer are universally accepted, Europe will give the United States a run for its money.

Robert H. Dugger, Managing Director, Tudor Investment Corporation, and Robert C. McNally, Jr., Vice President, Tudor Investment Corporation


This article was published in European Affairs: Volume number I, Issue number III in the Summer of 2000.