Institute for Research in Economic and Fiscal issues

IREF Europe - Institute for Research in Economic and Fiscal issues

Fiscal competition
and economic freedom


In Praise of Fiscal Divergence

This article appeared in the Wall Street Journal.

In the past year, Brussels has revealed its near-obsession with fiscal convergence in Europe. As the euro zone’s debt crises roil financial markets, the EU’s leaders have made clear that the only path they see to survival is centralized budgetary oversight and harmonized tax policy.

Despite this push, my think tank’s recent survey of taxation in Europe shows that fiscal and budgetary policies are growing even farther apart. One reason is that not all European countries are facing quite the same crisis: Some, such as the Netherlands, Norway, Slovakia, Luxembourg, Germany and Sweden, are close to balancing their budgets. Meanwhile, Greece, Ireland, Portugal, Italy, Spain, Britain, France and Poland must all urgently reduce their public deficits. To achieve this, their policies have followed predictable patterns, such as increasing indirect taxation by way of value-added and excise levies, hiking marginal income-tax rates and cracking down on tax evasion and fraud.

The outcome has been an even more varied array of rates, rules and practices across Europe’s tax regimes. Whether the overarching strategy will deliver the desired deficit reductions depends on the strength of these countries’ economic recoveries. But no one can expect miracles. For the most part, governments’ current entitlement pledges—namely for health care, education and pensions—will require their expenditures to grow at least as quickly as their economies.

This points to a second reason why fiscal policies are not converging: ideology. No European leader is calling for an increase in debt levels today, but nor are many willing to seriously question the sustainability of their respective welfare states. There are, however, some interesting exceptions. Probably the most innovative fiscal move of 2010 came from Slovakia, where employees’ bank accounts will, from now on, be credited with not only their "regular wages," but also with the social and health-care contributions that they will owe to the government, which their employers used to pay on their behalf. This is a good way to prepare the ground for much-needed reforms and entitlement cuts, by making taxpayers aware of the costs and benefits of the prevailing system.

For its part, Bulgaria is on the road to narrowing its public deficit to 0.5% of GDP in 2014 from an estimated 2.5% this year, having bucked conventional wisdom and maintained its 10% flat tax on private and corporate income tax throughout the economic downturn. And Denmark responded to the crisis by reducing its marginal income-tax rate to 56.1% from 63%.

Even in their attempts to fight tax evasion through closer international cooperation, countries have found themselves choosing separate paths. Last year Belgium’s Court of Appeals ruled that tax authorities couldn’t make use of documents that were acquired through theft, while the German Constitutional Court took the opposite stand.

This rising divergence between European jurisdictions is worrying to officials in Brussels, whose job security depends on centralizing European decision making. It’s also of concern to high-tax states such as France, which risk losing even more jobs and revenues to more welcoming regimes. But should anyone else worry about Europe’s lack of fiscal harmonization? Certainly not. Divergent fiscal policies are a direct expression of sovereign freedom.

Europe’s debt crises offered leaders the opportunity to radically change their economic and fiscal policies. Most decided to do nothing, and are still in the midst of trying to save their existing systems. A few decided to reform and are likely to reap the benefits of leaner government and more dynamic economies. "Harmonizing" policy in the image of Europe’s most burdensome taxation regimes would only tamp down healthy fiscal competition while penalizing those states that have gotten it right.

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