TCS Daily

Can This Agenda Be Saved?

By Constantin Gurdgiev - February 1, 2005 12:00 AM

George Bernard Shaw once observed that "The reasonable man adapts himself to the world; the unreasonable one persists in trying to adapt the world to himself. Therefore all progress depends on the unreasonable man." The problem with Shaw's dictum is that when a person faces the undesirable reality of his own creation, the only solution is to change thyself. This is precisely what the European Commission is failing to recognize when it comes to the issue of sluggish economic growth.

The Commission this week will re-launch the Lisbon agenda aimed at making the EU the world's most competitive economy by 2010. The proposal follows the chain of events that was started by the October 2004 report The EU Economy: 2004 Review and culminated with the January 26-27 conference of the European Economic and Social Committee.

The Lisbon agenda advocated by the Commission includes: (1) generating employment and increasing flexibility of the labor markets, (2) increased emphasis on R&D, (3) sponsoring stronger industrial base and (4) completing internal markets unification. However, no EU discussion of the policy issues can exclude politically correct blabber about the need to promote sustainability and "ownership" of the Lisbon process by the member states. The latter includes "the appointment in each state of a Mr/Mrs Jobs and Growth" in order to "coordinate the national reform efforts".

This Euro-talk apparently comes at the expense of the issues of lowering taxes and the regulatory burdens across the EU, which are found nowhere in the Commission documentation. If anything, the re-birth of the Lisbon agenda appears to imply exactly the opposite - more harmonization and industrial base protection means more regulations and indirect state support. This, together with increased state financing of R&D, adds to higher spending and, given the fact that 10 out of 25 EU states currently exceed the Growth and Stability Pact limits on deficit financing, means that taxes will remain high and may rise in real terms due to stealth taxation and brackets creep.

Despite the focus by the Barroso Commission on injecting new life into the clinically dead Lisbon agenda, the new policy objectives are about as realistic as the original 2010 deadline for the EU's planned Economic World Domination. Using the latest forecasts, the average GDP growth in the Euro zone between 2000 and 2006 is expected to be around 1.48 percent. The unemployment rate remained flat over the last 20 years, with young workers category staying at around 17 percent average for 1983-2003 period and 17.7 percent for the last three years. There is little that can be done to change this without directly tackling the main sources of growth underperformance: low domestic demand (caused by high income and consumption taxation), low supply of hours worked, and low entrepreneurship and labor force participation (all driven by the generous welfare systems and substantial labor markets rigidities) and low investment by the firms (caused, you guessed it, by high taxation of capital income).

All of these problems were identified in the European Competitiveness Report, 2004 (ECR), yet no policy proposal from the Commission addresses these bottlenecks. According to both reports, labor income tax and welfare benefits reforms are a top priority in all of the EU-15 countries (including low-tax Ireland). Wage bargaining policies (that reflect the degree of unionization and minimum wage policies) are the second highest priority in 10 out of 15 EU countries (again, including Ireland). Incidentally, according to the ECR, not a single country has policies in place aimed at such reforms. All other policies aimed at increased labor market flexibility are of importance in less than a third of the EU15 countries. The Commission priorities largely ignore these facts.

With respect to domestic demand, the ER shows conclusively that weak demand in the EU15 area is driven by excessive savings behavior. Not a word in the report is devoted to a well-established fact that a high marginal propensity to save out of income in Europe is induced by high taxation of consumption. Instead, the EU remains adamant about setting the minimum level VAT rate at a ridiculously high 15 percent level. The member states, entrusted to set their own rates above the 15 percent requirement, have outperformed Brussels in their zeal. Currently, standard VAT rates across the EU range between 25 percent in Denmark, Hungary and Sweden to 15 percent in Cyprus and Luxemburg. Adjusted for the relative size of each economy, the average standard rate of consumption taxation in the EU stands at around 18.5 percent. According to the Commission's figures, in 2001-2004 relative to 1996-2000, declines in consumption growth accounted for almost a third of the slower economic growth, 14 percent of employment growth slowdown and over the next 20 years is expected to account for a 68 percent decline in average annual growth rates in GDP. During 2000-2004, falling real consumption within the EU and a corresponding rise in the savings rates resulted in a deterioration of fiscal position in 13 out of 15 Euro-zone states.

Even more fundamental is the issue of EU-US labor productivity gap. Currently, the EU15 GDP per capita in purchasing power parities is 70 percent of the US level. One third of this is attributable to the productivity gap and 2/3 due to lower labor supply. Yet, if the Commission were to achieve its objective to increase employment, the productivity gap will widen as the EU economies are adding less productive workers to their labor pools.

The only way out of this trade off is through increased entrepreneurship and self-employment, which create more training opportunities and offer better skills matching. These require, you guessed it - lower taxes and less comprehensive safety nets. Recent events in Germany illustrate the extent to which European workers have become absurdly risk-averse under the current welfare system. Following introduction of the modest welfare reforms aimed at reducing unemployment benefits, thousands of German workers rushed in to file unemployment claims in order to enter the system before the changeover. The unemployment rate in Germany reportedly jumped up by as much as 0.2-0.4 percentage points.

Over the last decade, both in Germany and Britain, the majority of new entrepreneurs were foreign born residents with domestic residents preferring less productive, but safer activities, such as government jobs and union protection. In fact, a recent study released by IZA, Berlin shows that access to social welfare net in Germany was one of the major factors behind the differences in the willingness to undertake self employment between natives and the foreign residents.

Failing at Introductory Economics, the Commission continues to push for policies that exacerbate state interference in innovation. On November 24, 2004, the EU commissioner for science and research, Janez Potocnik, stated that the Commission's Report on R&D and innovation in Europe was a "reaffirmation of the validity... of the Lisbon strategy". Potocnik's conclusion: "clearly, a renewed and enhanced commitment [by the states] to research, innovation and education is required." Yet, the Report lamented the fact that "the importance of R&D expenditure remains... little understood". This at best places under question the Barcelona goal of raising the EU's research investment levels from the current 1.95 percent of GDP to 3 percent by 2010. If the benefits and efficiency of public spending on R&D are little understood, what is the logic behind these advocated massive increases?

The Innobarometer 2004 report on innovation provides some damning evidence of the ineffectiveness of state-sponsored research and development in attracting private sector interest. The study involved 4,534 firms surveyed across Europe, of which 20 percent reported receiving some form of public funding (40 percent of all firms that engaged in innovation during 2004). When asked whether public support was crucial to the realization of the innovation project, 71 percent of recipient firms responded "no". Germany was found to be the member state considered as being the most effective in promoting and supporting innovation - a whooping 14 percent of surveyed firms expressed their confidence in German government's promotion and support of R&D. More firms in Ireland (30 percent) received public support for conducting their market research studies for new products than any other member state. Spain (27 percent) and the Netherlands (26 percent) ranked highest for the proportion of firms which received public support for in-house or outsourced research.

These figures hardly support an enthusiastic response to the idea of spending more taxpayer funds on EU's R&D and innovation programs. To be fair, the EU plan talks about increasing private spending on R&D and science. Yet, by the ECR's admission, this will require more aggressive reduction in capital gains taxes and R&D-targeting tax breaks. Once again, the policy direction is as clear as the EU's unwillingness to follow it - lower taxes, lower government expenditure, not the lofty Lisbon policies or internal markets unification goals.

Finally, there is a puzzling growth-through-industrialization emphasis in the Commission agenda. In case the Eurocrats missed their history lessons, since the 1960s, the world has moved from industrial development to human capital-based service sectors. Today, the highest value added in the production chain occurs at the stages of design, development and marketing, not in manufacturing. Similarly, as identified in the ER, services are the only sectors with structural growth in employment. So why would the Commission place such an emphasis on sponsoring the EU's industrial production? The answer lies in the nature of Europe's manufacturing sectors that are dominated by heavily unionized behemoths often operating in the environments of regulatory protection and state supports.

Politics as usual prevails in Brussels. The failed policies of the past aimed at smaller, less painful reforms of the regulatory environment and ever heavier involvement of the EU in strategic sectors remain at the top of agenda. At the same time, the changes aimed at encouraging lower taxation of incomes, consumption and investment activity, and calling for reductions in government spending are no where to be heard. Neither rational nor irrational in its prescriptions, the Commission appears to be bent on administering the same medicine of half-solutions and loud proclamations that made the EU economy sick in the first place.


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