European Affairs

Diverse National Policies May Offer the Best Route to EU Economic Reform

The article in the fall issue of European Affairs by Martin Neil Baily and Jacob Funk Kirkegaard, “EU Governments Should Be the Agents of Change,”misses one important aspect in an otherwise perfect analysis.

While most economists agree that the pace of economic reform in the older EU member states is rather sluggish, there seems to be a division of opinion as to whether EU-wide initiatives such as the Lisbon Agenda provide the right institutional framework for speeding up the reform process.

Discretion in economic policy allows member governments to take into account their countries’ unique national characteristics, and the outcome of their policies can serve as an inspiration or a warning to others.We can thus say that there is a learning effect associated with a diversity of economic policies.

Furthermore, the natural propensity of governments to spend some of their revenues in an inefficient or wasteful manner can be curbed by increased mobility of the tax base - the taxpayers, whether corporate or individual can simply move to another country. The discipline imposed by the possibility of relocation is sometimes called the “taming-of-the-Leviathan” effect. Obviously, however, the effect can apply only to activities by public authorities that are independent of central control by Brussels and not harmonized at EU level.

Taken together, the learning and the “taming-of-the-Leviathan” effects allow governments continuously to choose and implement the most suitable economic policies while also giving them an incentive to do so. Although diversity of economic policies is probably not a sufficient condition for enabling long-term economic development, it might be a necessary one.

In some of the core EU countries, however, there is a popular belief among both politicians and the general public that diverse economic policies involve substantial costs. Such costs are supposedly the result of tax competition or of so-called “social dumping,” when one country lures jobs away from another by offering allegedly unfair advantages to employers. The implication is that countries with highly redistributive tax policies, and/or high levels of social protection, suffer unwelcome capital outflows in favor of countries less committed to redistribution and social welfare.

Although tax rates and labor market regulations are not the only factors influencing decisions on capital location, they obviously play a certain role. That does not, however, mean that there is something inherently wrong with tax competition or social dumping. Nothing comes for free, and in today’s globalized world there might be a price to pay for higher redistribution or social protection.

Free competition among democratic governments in these policy areas can hardly be seen as unfair. It is a crucial element of the market economy, and of democratic governance, that people enjoy the right to decide what price they are willing to pay for certain goods or services. Increased harmonization of economic policy at EU level would clearly take that choice away from them. In addition, the alleged costs of diversity should always be weighed against its substantial benefits.

By further harmonizing economic policies at the EU level, the European Commission and politicians from the core EU countries might actually remove one of the reasons why the continent has reached its current level of economic development. Examples of such an approach include proposals for the harmonization of tax bases or even of tax rates, as well as the further harmonization of social policies included in the new EU constitution.

Now that the goal of making the European Union the world’s most competitive economy by 2010 looks unrealistic even to the leaders who adopted it in Lisbon five years ago, the time has come to discuss what kind of EU-wide institutional arrangements are really necessary to enable further economic development. At this stage of European economic integration, the current belief in “the more the better” no longer seems to be indisputable.

Anton Jevcak
Chair of Public Finance
Faculty of Economics
University of Dortmund, Germany