So far, I’ve been describing the economic logic for fiscal federalism. However I have not qualified it. It's all nice and easy to argue that we need to tax the richest and subsidise the poorest, but how do you do this? Which pockets should the EU reach into and what should it pay for?
In the next lines I propose the following Euro-level fiscal tools : (1)Taxes on mobile factors that cause negative externalities, (2)an Income tax, and the maintenance of a (3)common education policy as well as a (4)common defence policy, with a tendency for expansionary military R&D expenditure during recessions. Finally I also argue in favour of (5)the establishment of an European Monetary Fund (EMF) to switch from cooperation to coordination of euro-area fiscal policies. This would be the best tool to keep and improve the theoretically good monitoring devices created by the SGP, while replacing its very ineffective legalistic procedures, in order to improve fiscal stability across the board.
I believe these are the necessary tools for the EU to minimise its risks of suffering from asymmetric shocks, while endowing it with the policy tools to deal with them, should they arise, as they inevitably will. They may however not be sufficient...
Taxing negative spillovers
What Budget Commissioner Janusz Lewandowski is arguing, to a large extent, is for the EU to tax those activities which most obviously cross borders. Just as a reminder from above, these are banks, financial transactions, carbon emissions (permits) and air traffic. These taxes are good for normal circumstances, not specifically for the problems arising from asymmetric shocks. There does not need to be any shock in any country for them to be in charge to do this. This is for two reasons. The logic behind taxing pollution can be best understood through the perspective that these are economic phenomena which spill over from one country to another. The idea here is to apply the logic of pigouvian taxes at the Euro-zone level in order to avoid cooperation problems of the prisoners’ dilemma type. This line of thought argues that if the market creates negative externalities (ie: costs that are not incorporated into the final price), then the state should intervene through taxation in order to make cost to the consumer and the producer representative of the cost to society (social cost). Pollution taxation is a famous example of such a form of taxation.As a result a country could tax its own pollution. However, this would pose two problems. If it is alone in doing so, then it puts itself into a competitive disadvantage in relation to its neighbors. At the same time if the point of the tax is to reduce pollution by increasing its cost, then it fails to solve this the problem as the neighbors fail to participate, thus still polluting the original country. Taxing these items at the EU level would be the most appropriate measure as it would ensure that all countries face similar business conditions, which would be more difficult to do if the countries did this.
Mobile means of production
Moreover the mobility of the first two items on Lewandowski’s list (banks and financial transactions), creates a race to the bottom to see whoever is able to tax the least. Because what is effectively being taxed is (financial) capital which is the world’s fastest and most responsive resource the problem will be particularly acute. A similar but qualified comment can also be applied to air traffic, which is effectively a tax on the income of the most mobile workers. Capital is the one resource that is absolutely proven to lead to a race to the bottom, not just within countries, but also across countries. This is a problem everywhere, not just within the Euro zone or the EU. In that sense a tax of this kind ought to actually be global, probably levied by the IMF the WB. Given that that’s certainly not happening anytime soon, I’ll settle for a tax levied at the EU level.
Dealing with the asymmetric shock – taxing expansion to fight contraction
So all the proposals put forward make sense. However, none actually deals with the above logic of asymmetric shocks in non optimal currency areas. A tax to deal with this problem needs to be levied on the country for whom the new interest rate is relatively low and be invested in the country for whom the new interest rate is relatively high. The problem is that this is clearly not feasible. The EU would face an enormous backlash if it were to tax countries differently. Two alternatives exist to deal with this situation.
The first is to maintain the present system of intergovernmental contributions into the EU budget, known as the GNI own resources (2003-2011 budgets here) where the rich obviously contribute more than the poor and where the commission then independently redistributes it. This is a common system in many countries for local governments. Sweden’s equalization grants (page 16 on slide 15) do this as does the UK through the NNDCs.
A reasonable alternative to this would probably be to create an income tax at the Eurozone level. Given that wages are all expressed in Euros, a country with higher GDP per capita should have relatively higher wages. In this sense, if EMU exposes countries to the afore-mentioned effects of asymmetric shocks, an income tax would mostly take money from the Germans (while also taking some out of the Greeks’ pockets). This tax rate could be created as an added level of taxation, to be annually and uniformly levied across the EU. Given its controversy it does not surprise me it did not figure in Lewandowski’s list. This is unfortunate because it is possibly the least distortionary form of taxation, so that using it would not particularly disrupt market incentives(p.2).
In principle I am in favor of having both, although I believe it is crucial to fade away a bit of the own resources relative weight in the EU budget, but Ill come back to this later on.
All these taxes are Pigouvian Taxes
To summarise, until now, I have agreed with the commission’s proposal for a tax on externalities that arise from national private economic behaviour as well as with its proposal for taxing the most mobile assets. Moreover, I also proposed the introduction of an EU income tax while keeping a smaller version of the GNI own resources. Now there is an overarching argument here in terms of pigouvian taxation. How do taxation of mobile factors and of income fit into that category? In this context I assume a more general meaning of negative externalities in that they don’t have to be economic variables such as pollution which is in and of itself negative, but rather that the causes or the consequences of these economic variables create negative externalities.
First, it may be argued that the inability of states to cooperate on the taxation of mobile means of production creates negative externalities as the resulting race to the bottom will lead to an undervaluation of the local resources. Secondly, and more to the point of the OCA discussion, because Germany has not done anything wrong to Greece, a negative externality does not arise from Germany’s behaviour. It arises from the fact that both of them live in the same currency union and share a common and thus inadequate interest rate set by the European Central Bank (ECB).
This is a somewhat confusing but actually practical fact, given that it provides the explanation for the tax, in that one country is hurt by membership, while providing the funds necessary for the pigouvian subsidy (tax base) from the extra boost in the originally non/shocked country. This should be the starting point of any discussion about expanding EU fiscal policy. As in other fields of European (or even national) policy making, subsidiarity should be upheld as a great guiding principle. One can then debate whether taxation should be marginal or lump sum, but the principle remains.
What should we spend on?
On the expenditure side, the logic of pigouvian negative taxation (subsidies) make the most sense. The logical implication of this argument is obviously that if there are positive market externalities the state should identify them and incentivise them by providing subsidies. Infrastructure would be a definite must, but it may only be relevant for new member states, as it is one which is generally made available upon joining the EU. The most fundamental investment that I can see the EU make is on Education and professional training and R&D as these are the fundamental tools to increase and diversify the stock of human capital necessary to create value added in any economy. There are two main points to this argument. The first is normative in that, you may disagree, but I believe the State (at whatever level) ought to be interested in providing economic growth and employment, while creating as few inflationary pressures as possible. A good way to achieve this, although one whose use should not be abused in an globalized economy, is through increases in the Aggregate supply. An investment in education provides a more productive labour force, which should then increase labour supply. The other point is positive in that the increase in (short term) aggregate supply is also the best to correct the damage done by sharing a common interest rate. Remember from the discussion above that the interest rate correction ends up causing a contraction in Greek supply. Thus an investment in education and R&D assuming that it matches the need of labour demand (ie producers) should help close the gap between the two countries. Note that given that an investment in education or R&D creates positive externalities, this system of fiscal levers does not require the investment to obligatorily be directed at the shocked country. Although I consider that the investment in education ought to be at least primarily targeted at the shocked country, I don't like the idea of earmarking expenditure in general and much less R&D investments to any given country. The idea of R&D subsidies is to improve efficiency. Thus it should go to the firms that can most efficiently make use of them. Moreover, investments in R&D, much as in education, create positive externalities. Thus, investing in R&D in Germany would also benefit its neighbours.
Finally, expenditure on R&D does not have to be specifically based on subsidies. It could also be used through direct state procurement, specifically for security purposes. This is a huge proposal, that entails the creation of a military union within the EU, and within NATO, not parallel to it. Disregarding momentarily geo-political military concerns, the point here is welfare economics. Thus the concern is to whether military expenditure would be good for the improvement of economic conditions in a Eurozone facing asymmetric shocks. As Chu and Lai explain at length, public military R&D can have two effects. On the negative side it can crowd out civilian investment. This is probably more relevant during times times of economic expansion than during recession. The other effect is that R&D conducted for the military creates spillovers with positive externalities for the civilian market. Thus if military R&D is good during recessions because it create positive externalities, if R&D in general is one of the best forms of investment and if investment is the best tool for stimulating economic growth, then the conclusion is that military expenditure on R&D is one of the best tools available to fight recessions. On the other hand this would also end replication efforts between EU countries defence departments, while it would allow defense policy to best exploit the economies of scale at its disposal. Of course this raises another problem about how to calm the concerns that this will revive the ghosts of militarist pasts. But that's another discussion.
Finally, if for some reason, these arguments do not resonate with EU institutions and they fail to agree what to do with the taxes collected, one can always invest them in an EMF (see below). This would be the last line of defence against bad fiscal governance in the EU
This is not a discussion of the SGP
This discussion is not equivalent to other discussions about replacing the Stability and Growth Pact by pigouvian taxes. In that context, the externality is not created by the ECB. It is created by the Member states expansionary fiscal policy. In the context of that debate, replacing the SGP by Pigouvian taxes at the EU level is advocated on the principle that it would serve as a better incentive to stop Member States inflationary fiscal expansions to spillover into their neighbours.
In the context of that debate taxes should be levied on the basis of inflated deficits and negative output gaps, and subsidies should be distributed to those countries with a responsible counter cyclical fiscal policy. As I see it, the main argument for replacing the SGP by a system such as this is that the SGP provides discontinuous effects, in that you are only (and statically) punished at above a certain level of that tax base and once you are below that level there is no reward.
A European Monetary Fund
However a better system than the one proposed in the link above is the one proposed by Wyplosz, and by Gros and Mayer (1 and 2), which would keep and improve the monitoring tools of the SGP, and create a fund akin to the IMF which would serve as an insurance mechanism into which member states would deposit in good times to insure against a rainy day where the markets would only lend at excessively restrictive and punishing rates making borrowing too expensive. As stated in previous post (Here) and Here, this arrangement has existed for a while(For the Eurozone and for Member states outside of it), but the next few years should see it getting fine tuned. These are my contributions to that discussion.
First of all, the EFSF should be made a permanent part of the EU, not some company with collateral from MSs. Next, the necessary funds should be made available with similar conditions to the ones imposed by the IMF, which in effect already happened to Greece. An idea which could be explored would be that the EMF not lend the money directly to the member state, but rather that some of its liabilities be transferred to the fund at a given interest rate, below the market rate, and for a certain maturity. Moreover, the EMF could provide two arrangements, one with fixed and relatively high interest rates (although still below market levels) and close date of maturity, and another with a flexible but relatively low interest rate for a later maturity. This flexible interest rate would then vary according to whether the government was proceeding in a sustainable way or not. Thus the second system would endow the EMF with higher monitoring powers for a longer period of time, in order to ensure the durability of refinancing.
In principle, if we had a very large pool of countries and if default was very unlikely, the money could then be paid out at zero interest to the country, thus making the fund literally and insurance tool. However, because in practice the pool of insured countries is relatively small, because default is not impossible and because it could have a domino effect, the system needs another deterrent in that it would require states to pay interests if they tap the fund's resources, but one below market.
The monitoring tools of the SGP should and seemingly will be reinforced by more scope for intervention of EUROSTAT, in order to ensure the quality of the data provided. These reinforced monitoring tools could then be used to determine what level of a time varying insurance premium should be periodically paid by each Euro-zone country to a specially designed agency of the European Commission Budget or ECOFIN Commissariates. This premium would depend on the sustainability of policies followed by each government. A framework such as this would be able to avoid moral hazard problems and create the right incentives for the internalization of the previously mentioned negative externality resulting from irresponsible fiscal policy.
Finally membership of this fund should be voluntary. Naturally, there would be a selection bias, in that countries most exposed to this type of problem would naturally rush to have access to this bailing out tool. That is why interests should be levied differently according to the perceived level of risk to which countries are exposed to. By doing so, the risk stemming from selection bias is eliminated. Moreover, given the level of interdependence among Eurozone countries, larger and or less exposed countries would also have an incentive to participate in this fund. Finally, an option should be created for all those member states of the EU which chose not to participate in the fund, for its resources to be made available to them upon the conditionalities highlighted above, plus the fact that that EU member state must join the fund, contributing to it as soon as it is out of the recession.
Conclusion: Fiscal tools, Timing and tax smoothing
In conclusion, I have proposed the following Euro-level fiscal tools: (1)Taxes on mobile factors that cause negative externalities, (2)an Income tax, and the maintenance of a (3)common education policy as well as a (4)common defence policy, with an eye for expanding military R&D during recessions. Finally I also argued in favour of (5)the establishment of an European Monetary Fund (EMF) to switch from cooperation to coordination of euro-area fiscal policies. This would be the best tool to keep the theoretically good monitoring devices created by the SGP, while replacing its very ineffective legalistic procedures, in order to improve fiscal stability accross the board.
Of course there should be a certain timing to these taxes which should be kept in mind. As is applicable to every fiscal policy, it should be counter cyclical, expanding in bad times and contracting in good times. This can be understood in light of the idea of tax smoothing. As a result all of these taxes should be optimised so as to maximise long run revenues during expansionary periods and maximise short run growth during periods of contraction. As such it may be necessary for the EU to either set itself a zero deficit rule for its own budget or to give itself the power to contract debt exclusively during recessions.
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