Harmonization of Fiscal Policies EUROPEAN ECONOMIC INTEGRATION Oldich

Harmonization of Fiscal Policies EUROPEAN ECONOMIC INTEGRATION Oldřich Dědek Institute of Economic Studies, Charles University

Unique features of EU budget n Small relative size of budgetary spending q q n Expenditures side q n Spending ministries remained in MS (pensions, education, defence, infrastructure, police and justice), only agriculture is split (accounted for approx. 90 % in early years of the Community) Revenues side q q n Starting from 0. 3 % of joint GDP in 1960, fixed at 1. 05 % of joint GNI for 2007 -13 period (120 bl. EUR in 2010), around 2 -3 % of all national budgets In contrast EU-27 average spending relative to GNP in 2007 was 46 % (Sweden 51 %, Czech Republic 41 %, Estonia 34 %) No direct or indirect taxation of EU citizens and companies Blend of own resources and MS contributions Principle of equilibrium q EU cannot run a deficit (estimated revenues for a financial year have to equal expenditures for that year), borrowing is severely restricted (no counterpart to national debt) 2

Size of European budget Source: European Commission, Financial Report 2004 and Financial Framework 2007 -2013 3

Contributions from member states (in 2002) EC: Financial Report 2004; Wallace et al. : Policy-Making in the EU (2005) 4

History – first reforms n Initial transition period 1958– 1970 q q n Financing obtained directly from member states (complex system of national quotas) Individual contributions adjusted according to the importance of policies for each member states Negligible amounts covering administrative functioning of European institutions Since 1965 sky-rocketing increase in CAP expenditures (approx. 80% of budgetary outlays) Reforms 1970, 1975 q q System of own resources adopted (allocated to the Community automatically) – initially strong opposition by France Institutional framework established for budgetary cycle (timetable for individual phases in preparing budget, competences of European institutions) Competences of European Parliament strengthened (power to adopt or reject the whole budget and propose amendments over so called noncompulsory expenditures) European Court of Auditors founded (1977) 5

Sources of budget n Traditional own resources (TOR) q q q n Share in VAT q q q n Source established in 1979 (erosion of traditional resources and need to provide financing for Structural Funds) Declining importance from peak of 65% to 11% (2011) Complexities due to different VAT tax rates and tax bases Contributions linked to GNP (since 1995 to GNI) q q n Revenue from tariffs on industrial products (common external tariff) Agricultural levies on imports from third countries Initially sufficient to cover expenditures, then constantly declining share (due to lower tariffs in GATT/WTO, growing EU membership, agreements with EFTA); currently approx. 12% (2011) Source established in 1988 (enhancing principle of ability to contribute) Maximum percentage of GNP/GNI Balancing item (activated if other sources prove inadequate) Ceiling 1. 27 % for 2000 -06, 1. 05 % for 2007 -13 (76 % in 2011) Others q Surpluses from previous years, fines, personal taxes of staff of European institutions, etc. 6

History – conflicts in 1970 s and 1980 s n Complaints from UK about being second-largest net contributor q q q n Little inflow from European budget: small share in agriculture meant small CAP expenditure; extra money lacking for new titles High outflow to European budget: large imports from third countries but tariff revenue being Community’s own source; highly industrialised country meant larger VAT contributions Summit in Fontainebleau (June 1984) agreed so-called British rebate: return of approx. 2/3 of net UK contributions (in exchange for increase in ceiling on VAT from 1% to 1. 4%) Controversies between Council and EP q q q Struggle of EP to strengthen budgetary competences (vacuum in Treaties) 1980, 1985 EP rejected budget proposal (on grounds of excessive growth in agricultural spending) 1982, 1986 Council sued EP at ECJ for breaching competences 7

History – multi-annual financial frameworks n n Financial perspective sets out priorities and multi-annual financial framework fixes maximum amount and composition of EU expenditure over given period Benefits q q n Greater certainty and stability (priorities are known from the outset) Ensuring adequate financing for projects extending over several years Annual budgetary procedure determines the exact level and breakdown of expenditures Financial perspective negotiated as package of reforms, more room for manoeuvre in finding compromises (grand bargains) Chronology q q Delors 1: 1988 – 1992 Delors 2: 1993 – 1999 Berlin Agreement (Agenda 2000): 2000 – 2006 New financial perspective: 2007 – 2113 8

Delors 1 and Delors 2 n Delors 1: 1988– 1992 (bill for Single Market) q q q Changing power balance after entry of poorer countries (1981 and 1986) Idea of close relationship between deepening of internal market (SEA) and deepening of economic and social cohesion Measures Expansion of Structural Funds and capping of CAP expenditure Fourth own source established – link to GNI (1. 4 %) Preservation of British rebate n Delors 2: 1993– 1999 (bill for Maastricht) q q q Extension of financial perspective from 5 to 7 years Approval of link between EMU and social cohesion Measures Higher expenditure limit at 1. 27% of GNI Suppressed VAT own source (more emphasis on ability to contribute) Cohesion Fund established and increase on spending on Structural Funds Preservation of British rebate 9

Berlin agreement (Agenda 2000) n Financial perspective for 2000 -2006 (background Commission paper Agenda 2000) Preparing the way for Eastern enlargement q Agreement on reforming CAP and SF Concept of “budgetary stabilisation” q Stronger voice of net contributors after 1995 enlargement q Costly unification of Germany q Worries about costly Eastern enlargement q More attention paid to budgetary management (resignation of Santer Commission in March 1999) q n n Measures q q q Expenditure ceiling preserved at 1. 27% of GNI Gradual drop of VAT source (from 1% in 2000 to 0. 5 % in 2004) Moderate drop in assistance to cohesion countries accompanied by preaccession aid to prospective members (PHARE, SAPARD, SPA) Cosmetic changes in size and structure of CAP expenditures (France blocked deeper reform) Preservation of British rebate (approx. 4 bl. EUR per year) 10

Financial framework 2007– 2013 n n Bill for the Lisbon Strategy and Europe 2020 Controversy about resources for the budget and budget ceiling q q q n Spending priorities q q n Many EU countries faced sluggish growth (Germany, France, Italy), difficult compliance with SGP December 2003: joint letter of major contributors (GE, FR, UK, NL, AT, SE) to EC President calling for a ceiling of 1 % Commission proposed to fix own resources at ceiling 1. 24 % GNI, Final agreement was 1. 05 % of EU GNI Budget headings: 1. Competitiveness, 2. Cohesion, 3. Natural resources, 4. Citizenship, freedom, security and justice, 5. Global partner, 6. Administration Heated debate over the draft budget for 2011 to fund addition tasks arising from Lisbon Treaty British rebate q q q Without correction increase to 7 bl. EUR per year and new members would have to pay part of it British Prime Minister Blair linked the question to reduced spending on agriculture but France opposed further CAP reform By way of compromise Britain agreed to give up one-fifth of rebate attributable to Eastern enlargement 11

Tax harmonisation n Arguments in favour of harmonisation q q q n Arguments against tax harmonisation q q n Different tax rates may harm tax neutrality and distort competition in internal market Race to bottom: Benefits of tax competition are temporary, in long run all countries are worse off (lower tax revenues, higher taxation of less mobile factors) Maintaining fiscal frontiers is costly, particularly after tariff frontiers have been dismantled (fiscal frontier = crossing-point which frees exports from domestic taxes and introduces tax duty for imports) Tax issues should in principle be the responsibility of sovereign national governments (power to tax is central power of a country) Tax uniformity may have differentiated outcomes in individual countries (different consumption patterns, different social systems, different factor mobility, etc. ) A number of independent policy-making tools needed after centralisation of some others (i. e. monetary or trade policy) Tax competition disciplines governments Areas of tax harmonisation q q q Harmonisation of tax rates (indirect and direct taxes) Harmonisation of tax base Harmonisation of tax exemptions 12

Classification of taxes n Indirect taxes q q q n Direct taxes q q q n Levied on consumption of a good or service Substantial impact on inflation Types: value added tax (VAT), consumption tax (excise duty) Levied on incomes of firms and individuals Impact on labour and capital mobility Types: corporate tax, personal tax, withholding tax, social and health insurance Tax issues are subject to unanimity rule in EU decision-making 13

Origin versus destination principle n Origin principle q q q n Goods should be taxed where they are produced (regardless of whether they are exported or consumed domestically) No fiscal frontiers are needed (consistent with abolishing tariff frontiers in internal market) Possible tax distortions in consumption (encouraging imports from countries with lower taxation) Destination principle q q q Goods should be taxed where they are consumed (regardless of whether they are imported or produced domestically) Domestic and imported goods compete under equal tax conditions (common principle in international trade) Fiscal frontiers are needed (refund of taxes paid domestically on exported goods) Stronger motivation for avoiding taxes (fictitious exports, smuggling) Possible tax distortions in production (higher indirect taxes on imported goods and lower indirect taxes on domestic goods) 14

Value added tax n n n Added value is the difference between price paid for inputs and price obtained for outputs Since 1967 introduced throughout Community (in France since 1954) – destination principle (tax paid in the exporting country is refunded) Benefits q q q n Non-discriminating between production for domestic and foreign market and between inputs produced domestically and imported Non-stimulating vertical integration motivated by tax savings only (better than older cascade tax) Natural safeguard against tax evasion (claims for VAT refund only after subcontractors have documented their tax liabilities) Degree of harmonisation q q q Standard rate within band 15 – 25 % Reduced rate 5 % applicable to a list of products (food, pharmaceutics, energy , water passenger transport, etc. ) Zero rate (existing rates can be continued but not extended) 15

Consumption tax n Tax levied on consumption of selected goods q q n Construction q q n Ad valorem (proportional to price of good) Specific (linked to physical quantity of good) Important impacts of harmonisation q q n Usual items: alcoholic, tobacco and petroleum products Less usual: coffee, tea, salt, playing cards Inflation level (tax rates tend to be high) Budgetary revenues (trend towards higher reliance on indirect taxes) Health and environmental issues Consumption tax is included in tax base for VAT (distortions in consumption taxes may translate into distortions in VAT) Degree of harmonisation q q Common list of products on which excise duties apply Minimum tax rates for selected products Abolition of duty-free sales Abolition of limits for personal consumption taken from one MS to another 16

Corporate tax n Low degree of harmonisation not corresponding to complete capital mobility in internal market q q n Different tax system q q q n Classical (firm is seen as legal entity, double taxation of dividends): DE, NL, AT, BE, … Imputed (firm is seen as representation of shareholders, who are eligible for tax credit): UK, FR, IT, ES, IE, … Many differences in details: taxation of distributed and non-distributed profits, tax levied on profits transferred abroad, depreciation policies, inflation accounting, preferential treatment of SMEs, etc. Different tax bases q n Migration of production capacities from higher to lower rate countries Tax avoidance in multinational corporations: transfer pricing (profit shifting in multinational firms) Initiative of Commission towards unification of rules Different levels of taxation q q Anglo-Saxon system based on lower taxation of firms (UK, IE, some new member states) Continental system traditionally based on higher taxation of corporations (GE, FR, Scandinavian countries, etc. ) 17

Personal income tax n n n Substantial impact on price of labour and mobility of labour force Part of extremely heterogeneous social systems (contributions to social insurance cover social transfers) Practically zero degree of harmonisation and zero ambitions to harmonise this area q Exceptions: agreements preventing double taxation of migrants 18

SGP – basic facts n n Motivation: preservation of fiscal discipline not only at the time of fulfilling Maastricht criteria but on a permanent basis after getting membership in EMU Adopted in June 1997 at the Amsterdam meeting of the European Council Came into force with the creation of the Euro Area (beginning of the Stage 3 of EMU) Legal background q q q n Ban on excessive deficits in Maastricht Treaty (defined in terms of 3 % limit for general government deficit and 60 % for general government debt) Practical details worked out in the SGP is not a Treaty but a set of European Council Resolutions and Council Regulations SGP is mandatory for all EU members, except for financial sanctions, which can be applied to Eurozone members only (non-members can be punished by suspending payments from Cohesion Fund) 19

SGP – economic justification n Spillover effects of excessive government borrowing q q n Free-rider effect: undisciplined behaviour brings benefits only when other countries preserve discipline q q n Growing aggregate demand encourages inflation in monetary union Appreciation of single currency in short run that damages exports Financial instability in longer run triggered by excessive debt Strength of spillover effects depends on economic size of national economy An individual member of monetary union cannot be punished separately for undisciplined policies A higher number of undisciplined governments undermines agreed fiscal rules Deficit bias effect: tendency of democratically elected governments to run excessive budget deficits for purely political reasons q q Politically more convenient to shift burden of repaying debt to future generations Influential election cycle 20

SGP – preventive arm (initial version) n Medium-term objective (MTO) q q q n Defined as deficit which is „close to balance or in surplus“ (CTBOIS) CTBOIS creates sufficient room for smooth functioning of automatic stabilisers and discretionary outlays while proximity to the 3 % limit prevents the fiscal policy to counteract economic downturn Member countries are expected to meet the MTO in medium term (structural deficit should improve by 0. 5 pp per year) Framework for multilateral surveillance q q q Member states prepare stabilisation programs (Eurozone countries) or convergence programs (non-Eurozone countries) Commission assesses these programs Council can address, on the basis of a proposal by the Commission, an early warning to prevent the occurrence of excessive deficit 21

Structural and cyclical deficit PO € POG NOG AO CD AO … Actual output PO … Potential output NOG. . Negative output gap POG. . Positive output gap AD … Actual deficit CD … Cyclical deficit SD … Structural deficit ε … elasticity SD AD 22

SGP – corrective arm (initial version) n Excessive Deficit Procedure (EDP) q q n Exceptional circumstances q q n EDP is initiated by Commission if during three consecutive years actual or planned deficit exceeds limiting value of 3% Commission prepares recommendations for Council containing remedial measures Council may approve recommendations (EDP comes into effect) or ask for new ones EDP is approved by qualified majority voting rule Country with excessive deficit is hit by severe recession (GDP decline of more than 2% – EDP is not automatically initiated) GDP decline is lower than 2% but higher than 0. 75% (exceptional circumstances must be documented) Sanctions q Obligation to create non-interest bearing deposit Fixed component = 0. 2% of GDP Variable component = 10 % of an amount by which actual deficit exceeds 3 % limit, maximum 0. 5 % GDP q n If excessive deficit is not corrected, deposit balances are turned into fine Example q q Deficit 5. 7 % 0. 2 % + 0. 1× (5. 7 – 3) = 0. 47 % GDP Approx. 18 bil. CZK, 0. 7 bil EUR for CR (nominal GDP in 2007 = 3600 bil. CZK) 23

SGP – arguments of critics n In favour of weakening q q q n SGP is too restrictive: sanctions can be avoided only in deep recession SGP is too rigid: unified rules do not take into account national specifics (different indebtedness, modernisation of infrastructure, financing of pension reform, etc. ) Problematic objective (deficits close to balance or in surplus): economy without government debt restricts investment in safe securities In favour of strengthening q q q Asymmetry: fiscal development is closely monitored only after appearance of difficulties and not in “good times” Failure to initiate EDP for breaching the debt criterion Politicisation: approval of sanctions is in hands of politicians (members of ECOFIN) 24

SGP – arguments of defenders n n Criticism comes from undisciplined governments that are not courageous enough to adopt unpopular reforms in “good times” Dilution of SGP rules is counterproductive vis-à -vis deficit bias of European governments Operational and transparent Pact requires simple and unambiguous rules Without sanctions SGP becomes toothless device for enforcing fiscal discipline 25

SGP – credibility crisis n Germany and France 2002– 2004 q q n Legal dispute seriously undermined credibility of the Pact q q n EDP initiated with both countries (plus Portugal) Portugal brought its deficit below the 3 % ceiling In case of France and Germany Council revised Commission‘s recommendations and adopted conclusions declaring that sanctions against the two countries are in abeyance Legal dispute: Commission took the Council to the Co. J for not respecting the Treaty, Co. J ruled that Council made a procedural error ECB warned against serious dangers by suspending the Pact Smaller countries attacked the failure of lager members to respect the fiscal constraints Sharp disputes lead to the reform of SGP rules in May 2005 26

SGP – March 2005 reform n Differentiation in MTOs q q n Speed in meeting MTO q q n Appeal to faster consolidation effort in “good times” Possibility to take into account structural reforms without jeopardising 3% limit EDP implementation q q n Eurozone and ERM-II members: deficit -1% of GDP for lowdebt and fast-growing countries, balanced budget for highdebt and slow-growing countries (cyclically adjusted deficit) Others: safe limit of 3% should be respected Confirmation of benchmark values of 3% and 60% of GDP Enlarged list of exceptional circumstances (sluggish growth, contribution to EU policies and international solidarity, other relevant factors) More time for adjustment 27

Six-pack n n Six-pack is a package of six legal norms that were adopted to reinforce the system of economic governance in EU and Eurozone Entered into force in December 2011 Applies to all member states with some specific rules for euro-area members especially regarding financial sanctions Content q q q Reinforced preventive and corrective arms of Stability and Growth Pact New surveillance mechanism over macro-economic imbalances Directive on the requirements for the fiscal frameworks of the Member States (technical features of formulation and implementation of fiscal policy) 28

SGP – Six-pack reform n Preventive arm q q q n Corrective arm q q q n Prudential expenditure rule for countries that are missing their MTOs Expenditure growth should not exceed a reference rate linked to potential GDP growth Significant deviations from the prudential rule can be punished with a sanction of interest-bearing deposit of 0. 2 % of GDP Non-interest bearing deposit of 0. 2 % of GDP at opening of the EDP Numerical benchmark for sufficiently diminishing debt-to-GDP ratio = distance with the 60 % reference value declines over 3 preceding years at an average of 1/20 the per year Non-respect of the rule may result in opening the EDP (after assessment of all relevant factors) Reverse qualified majority voting q Commission‘s recommendation is adopted by the Council unless a qualified majority of MS vote against 29

Surveillance over macro-economic imbalances n Preventive arm q q q n Corrective arm q q n Alert mechanism : a set of early warning indicators with thresholds arranged in the scoreboard whose aim is to detect MS with potential harmful imbalances In-depth review: detailed analyses focused on MS economies in which alert mechanism detected potential harmful imbalances Possible actions: 1. No problem, 2. Imbalances exist but are not severe, 3. Severe imbalances MS is placed in Excessive Imbalance Procedure MS prepares Corrective Action Plan (fine 0. 1 % GDP if found insufficient) Surveillance of Plan‘s commitments (interest-bearing deposit 0. 1 % GDP if found insufficient eventually converted into fine) Reverse qualified majority voting 30

Fiscal Compact n Treaty on Stability, Coordination and Governance in the Economic and Monetary Union q q n Content q q q n Mirroring EU rules at national level Signed by all EU countries except for UK and CR Balanced Budget Rule: structural balance meets the country MTO, rapid convergence towards MTO, temporary deviations in line with SGP Benchmark for government debt reductions (as foreseen in the reinforced SGP) Public debt issuance plans reported ex ante Enforcement q q If MS fails to transpose correctly, the matter will be brought to EU Co. J (possibility of sanction of up to 0. 1 % of GDP) Compliance with national rule monitored at the national level by independent institutions 31