EMU: RECOVERY OR DECLINE?

NY Times recently reported on the agreed financial rescue assitance to Grecce from EMU (€110 billion) and IMF ($145 billion). Alongside Ireland and Mediterranean countries, the economic recovery of EMU is hampered by a high mountain of public debt and unfavorable macroeconomic data on growth, employment and current account.

Public debt in the European Union in 2009

Source: Eurostat (2009)

The graph I attached, shows the level of public debt in EU countries in 2009. Solid horizontal blue line shows the 60 percent debt-to-GDP ratio required by Maastricht criteria for each EMU entrant.

The underlying data (link) on economic recovery in the US point out a strong and robust recovery. The data from Bureau of Economic Analysis show that the US economy grew by 3.2 percent in Q1:2010 continued from a remarkable 4.6 percent growth in Q4:2009. While private consumption expenditure growth increased by 2 percentage points from the previous quarter, private domestic investment rebounded by 14.8 percent in Q1:2010 after a remarkable 46.1 percent increase in Q4:2009. In addition, labor productivity in Q4:2009 increased by 6.9 percent - the largest quarterly increase since Q3:2003 (link) On the other side, recent revision (link) of quarterly growth rate in the EMU has shown that quarterly GDP in Q1:2010 increased by 0.0 percent, revised from 0.1 percent. Industrial confidence, an important measure of manufacturing outlook, further decline by 12.2 index points.

The macroeconomic outlook for the EMU is downsized by high public debt and negative budget deficit which led 10-year bond premium spread between EMU economies and Germany (link). The premium spread between Greece and Germany stood at 8.57 percentage points on April 28 while the spread between Ireland and Germany was at 2.54 percentage points.

High level of fiscal deficits restrains the economic recovery of the EMU countries. In 2009, Spain, Ireland and Greece faced the highest deficit-to-GDP ratio while Denmark's 2 percent deficit-to-GDP ratio was the lowest in the European Union. NY Times recently collected annual dataset on public debt and budget deficit (link) in which an overview of key public finance indicators is availible.

The prospects of economic recovery in the EMU are further downgraded by unfavorable growth forecast. One of the key questions during the ongoing debt crisis has been whether the EMU will sustain fiscal discrepancy within the EMU since asymmetric fiscal policy undermine the ability of the common monetary policy. Even though Greece's debt crisis is the core of the debate regarding future viability of the single currency, growth estimates for Spain and Italy in 2010/2011 will determine the mid-term macroeconomic stability of the eurozone. European Commission recently updated the quarterly economic growth estimates for eurozone countries (link). Depending on the absorption of financial market spillovers into investment and net exports, economic growth estimates for Italy and Spain are quite pessimistic. After an estimated 0.1 percent growth rate in Q2, Spain's economy is likely to contract in Q3 by -0.2 percent and experience a slight rebound in Q4:2010. Quarterly economic forecast for Italy is positive throughout the year although the economic growth rate is likely to be close to zero. However, Italy's economic growth rate is likely to keep the increasing pace towards the end of the year although current macroeconomic outlook deters consumption, investment and inventories' contribution to GDP growth mainly because of high unemployment rate and sluggish productivity growth.

Robust economic growth is essential to the cure of high public debt. Since EMU countries have adopted a single currency, policymakers cannot trigger exchange-rate adjustment through currency depreciation. The latter would spill into higher inflation and modestly reduce the volume of public debt. Due to high unemployment and slower recovery of inventories, inflation rate is unlikely to rebound to pre-crisis levels.

EMU's most problematic countries' recovery is unlikely to be robust given public debt and deficit constraint on quarterly growth outlook. Without a prudent fiscal tightening, lower government spending, there will be a bleak economic outlook for the future of EMU countries which could result in a decade-long period of low growth, high unemployment and Japan-styled deflationary persistence.

EU vs. USA

I published a brief analysis (link) for the European Enterprise Institute, discussing a pattern of a growing income differential between the EU and America. The financial crisis diminished European growth rates and further widened the economic gap between the two continents.

Given a weak economic outlook for EU countries, the gap between European Union and the United States is likely to widen in the next decade although the US economy will be restrained by high tax burden and a growing federal debt. In 2010, I estimated the gap between the US and EU15 at 35-40 years, depending on EU's growth scenario.

EUROPE VS. USA

In NY Times, Paul Krugman (link) wrote about the comparison of European and U.S economic model, concluding that in the last 10 years, the European model of social democracy led to higher standard of living and, compared to U.S in output per hour and standard of living, and relative convergence of European countries relative to the U.S respectively.

The real convergence is a complex mathematical and empirical issue, so I will rather outline the key patterns of GDP per capita gap between the U.S and Europe and the economic explanation of it. I downloaded the data from the IMF and composed a graph which shows the GDP per capita (PPP-adjusted) in European countries as a percentage of the U.S GDP per capita. Switzerland is the only European country whose level of GDP per capita is more than 90 percent of the U.S level. Ireland, where the output contracted by 7.5 percent in 2009 (link), was once the poorest country in the European Union. Today, its GDP per capita reached 85 percent of the U.S level. In spite of the notorious advantages of the Nordic model, the GDP per capita level of all Nordic countries (excluding Norway), is below 80 percent of the U.S level. The UK GDP per capita is also far below the U.S level (75 percent). The levels of GDP per capita of the less developed countries in European Union (Slovenia, Greece, Portugal, Czech Republic and Slovakia) are all below 62 percent of the U.S level.

Source: IMF, World Economic Outlook

The basic economic question is the length of the gap between the U.S and European countries. To answer the question, we have to set certain assumptions. So, let's assume that the U.S output will increase by 2 percent in the long run. The economic theory would predict faster growth of less developed countries, since countries with lower levels of standard of living (GDP per capita) tend to follow-up the countries with higher GDP per capita. In economic literature, that is the so-called "catch-up effect". So, what would happen if the UK economy increased by 3.5 percent in the long run. A quick estimate shows that the time gap between the UK and US is 19 years. So, what happens of the US economy increases by 2 percent in each of the next year while, at the same time, the UK GDP per capita is 75 percent of the U.S level? A fairly quick estimate shows that, if the UK GDP per capita will reach the U.S level in 10 years (although an unlikely scenario), the UK GDP per capita would have to increase by 4.9 percent each year to catch-up the U.S level of GDP per capita. If France's GDP per capita reached the U.S level in 10 years (assuming 2 percent growth in U.S GDP per capita), it would have to increase the economic growth to 5.3 percent in each of the next 10 years. If the convergence objective is set at 20 years, the French economy would still have to grow at the annual rate higher than 3 percent.

The main question is why the European countries are still behind the U.S level of GDP per capita? There are, of course, many plausible explanations. As far as the GDP per capita is concerned, the difference in the level and growth of productivity is the most important figure in setting conclusions. After all, in the long run, productivity determines the standard of living across countries.

First, the European disease is mostly the result of high tax burden. High tax rates diminished the incentives to work, since each additional hour of labor reduced worker's marginal productivity. Hence, as professor Mankiw explains, the rise of European leisure (link) is mostly the result of fewer working hours. In addition, early retirement is a common phenomena across Europe. By 2030, each worker will support one retired individual in Germany. The coming of Europe's pension crisis (link) is a consequence of generous PAYG pension systems. Lower employment-to-population ratio led to higher tax rates to finance the financial liabilities for the retired. In addition, high government spending and periodic budget deficits discouraged productivity growth.

Second, another key to the explanation of the anemic growth rates in Europe is rigidity of the labor market. In many European countries, labor costs are very high (link). If the cost of labor market entry is high, people prefer longer studying and working in the shadow economy. The shares of shadow economy are relatively high in all European countries (link). The highest rates of shadow economy are in the following countries:

1. Slovenia 27%
2. Greece 26%
3. Italy 24%
4. Spain 21%
5. Belgium 20%
6. Germany 15%
7. France 13%

Source: ATKearney (2009), Friedrich Schneider (2005)

Third, Europe's relative decline compared to the U.S, is not a consequence of the lack of R&D investment. High percentage of R&D investment in the GDP is not a cure for the real cause. In fact, European universities rank far below the top universities in the world. In the field of engineering and computer sciences, the first non-US university is in the 15th rank. Europe's brain-drain is a known phenomena since many bright European minds immigrate to places such as the U.S, Canada and Australia. The outcome is deteriorating international ranking of universities and low efficiency of R&D expenditure on misguided projects such as the intention of the European Commission to build a "European MIT" (link) to boost Europe's global technology leadership.

Without higher growth of GDP, productivity and market working hours, European countries will hardly sustain the convergence towards the U.S level of GDP per capita. To boost economic growth, bold structural reforms are required to cut the rates of shadow economy, reduce tax and social security burden, decrease government spending and deregulate the labor markets.

EUROPEAN ANTITRUST POLICY

From The Economist (link):

"Nevertheless, it is unclear how a transatlantic row can be avoided along the lines of the spat in 2001, when a planned merger between General Electric and Honeywell caused a stink. The commission worries that a union between Oracle and Sun would reduce competition in the market for corporate databases. Oracle is the world’s biggest seller of proprietary software to run such databases, with a market share of nearly 50%. Sun is the owner of MySQL, the most widely used “open-source” database software, which already competes with Oracle’s products and could become more of a threat in the future. Neelie Kroes, Europe’s competition commissioner, spoke of her “serious concerns” that the deal would reduce choice and lead to higher prices."

IS SLOVENIA THE NEXT SICK MAN OF EUROPE?

Recently released data from OECD Economic Outlook (link) suggest that the recessionary period is likely ending as the output in world's major economies is reversing the trend of the past year. In 2009, the U.S economy is expected to contract by 2.8 percent annually. Germany, suffering from a significant decline in inventory orders and foreign demand, is set to contract by 6.1 percent and Japanese economy is likely to decline by 6.8 percent. The end of the global recession will be continued by a slow recovery as the economic growth in the OECD economies is most likely to reach 0.7 percent in 2010 after a 4.1 percent decline in 2009.

Besides Israel and Estonia, Slovenia is the next country to join the OECD. The macroeconomic outlook for Slovenia, unfortunately, remains sluggish. In Q2:2009, Slovenian economy contracted significantly. The output decreased by 9.3 percent. In Q1:2009, the economic activity decreased by 9.However, the data on GDP decline is too optimistic compared to the real sector. According to the latest availible data, the industrial production in April contracted by 28.26 percent, followed by double-digit consecutive declines each month. Investment, which in 2008 accounted for 28.9 percent of the GDP declined significantly. In Q1:09, the business investment contracted by 32.3 percent.

The pre-crisis boom in business investment was surged by quantitative easing and low interest rate which contributed to historic highs of credit stock. In addition to deteriorating macroeconomic outlook, the export of goods and services, which once used to be the core engine of Slovenia's economic growth, contracted by 21.1 percent in the Q1:2009. Thus, during 2008, the economic activity experienced unusually high rates of economic growth spurred by investment, foreign demand and historically high consumption spending. Throughout 2008, the economy was starting to exhibit strong signals of overheating.

By the beginning of the crisis, the economic policy pursued a radical debt-driven infusions of liquidity in the banking and bailouts to the real sector. Consequently, the state of public finance changed dramatically. For decades, Slovenia maintained on of the lowest public debt/GDP ratios in Europe. As a fiscal measure, low public debt had been of the merits that enabled the fulfillment of convergence criteria before entering the EMU.

As a result of government intervention, debt guarantees and surging public spending, the public debt is likely to soar from 21.5 percent of the GDP in 2008 to 32.6 percent of the GDP in 2009. The public debt is expected to rise further. If the current trend continues, the public debt is estimated to soar up to 53.7 percent by 2013 (link).

The black line and the left axis on the graph show general government balance while the left axis and yellow bar show public debt. Both categories are expressed in percent of the GDP.


Public debt and general government balance as a percent of the GDP (2004-2013)

Source: Ministry of Finance (link)

As we can see, the primary budget deficit will move from -0.27 percent of the GDP in 2008 to 6.58 percent of the GDP in 2009. By 2013, the deficit is estimated to move to -7.4 percent of the GDP. Compared to small and open economies, Slovenia's primary budget deficit is higher than in most small and open economies. It is, for instance, higher than in Denmark, Greece, Austria, Czech Republic, Finland, Luxembourg, Netherlands, New Zealand, Slovakia, Sweden, Switzerland and Norway. As far as I know, Norway is the only developed country without budget deficit in the near future (According to the OECD and Norges Bank, Norway will post 8.6 percent budget surplus in 2009, down from 18.8 percent in 2008. In 2010, the budget surplus will likely increased by 0.4 percentage point).

The government intervention in the real sector further regulated the labor market by introducing subsidies to employers to retain the employees and discourage layoffs to prevent the rise in unemployment. However, recent data suggested that public sector employment grew significantly while private sector employment declined respectively. In Q2:09, private sector employment decreased by 9.3 percent. Public sector employment, on the other hand, increased by 1.4 percent on the annual basis.

For at least two decades of transition, Slovenia's gradualist economic policy favored rigid and inflexible labor market embodied in collective bargaining, high tax rates on labor supply and barriers to entry. The economic policymakers created discriminatory labor market structure which still discourages young graduates from entering the labor market after graduation. Consequently, unit labor costs are among the highest in the EU. Recently, The Economist snapped a nice chart, showing that tax burden on labor supply in Slovenia is the highest in the world (link). In combination with ageing population and of the youngest retirement generations in the world, the abovementioned labor market dualism further encouraged policymakers to raise health and social security contribution rates. It lead to one of the lowest growth rates of private sector employment in the EU. It further lead to the highest tax wedge in the EU and the unusually high growth of unit labor cost relative to productivity growth. In addition, strongly regulated labor market is the major cause of Slovenia's low productivity convergence relative to the EU15. The majority of central European and Baltic countries have been lowering the productivity gap behind the Euroarea much faster than Slovenia.

In 2009, Slovenia reach 90 percent level of EU27's GDP per capita. Compared to the Euroarea, Slovenia reached 83 percent level of the GDP per capita. Compared to EU15, which is a reasonable measure of comparison, Slovenia reached 81.7 percent level of GDP per capita. Compared to Switzerland, Slovenia sustains only 64 percent level of Swiss GDP per capita (link). Interestingly, if Slovenia were a part of the U.S, its GDP per capita would be at the 54 percent of the U.S level, even lower than in Mississippi and West Virginia - the least developed states in the U.S.

Although Slovenia is often cheered as being the "Switzerland of the East" and the most developed former communist country, its economy will likely resemble slow growth in Italy, Germany and France rather than dynamic growth in Singapore, Hong Kong, Australia and Switzerland. Current economic policies are the recipe for eurosclerosis, experienced by pre-Thatcher Britain. If such pattern of economic policy will continue, the Slovenian economy will, sooner or later, exhibit economic stagnation with low economic growth, onerous tax burden, high structural unemployment and rapidly ageing population.

MACROECONOMIC OUTLOOK IN EUROZONE

European Commission has recently published the interim forecast for GDP, inflation, unemployment and balance of payments in the euroarea (link). The financial crisis and recessionary downturn induced by a negative demand shock have virtually stalled the European economy. The Commission predicted a -1,8 percent GDP decline and further forecasted a modest recovery starting in Q1 or Q2 in 2010.

In a comparative perspective, while the Japanese economy is facing an incredible -10 percent output gap (link) and prompting the government to infuse fiscal pumps, the US economy is set to decline by about 1.6 percent annually in 2009 as predicted by the IMF (link), but the US economy is expected to recover more responsively than the Eurozone. Eurozone's weakening domestic economy is a lingering worry for a long-term growth perspective. Germany, the main trading partner to European economies, is expecting -2,3 percent economic growth in 2009. France's GDP is set to plummet by 2,3 percent while Italian economy is expected to shrink by aout 2.0 percent annually. Basically, the eurozone is facing asymmetric shocks when different sets of fiscal policies throughout the continent impede the smooth functioning of optimum currency area and its monetary policy.

Following a dramatic fiscal expansion in all Eurozone countries (For instance, Slovenia's public debt is expected to soar from 23 percent in 2008 to 38 percent of the GDP in 2009), policymakers and interest groups have pledged a call for protectionism in labor market, public sector and trade. There is no doubt that tight and highly regulated labor market is causing European sclerosis - the inability of European economies to catch-up the U.S level of productivity and purchasing power parity.

An obscure size of European public sectors is the second sign of European sclerosis leading to higher-than-natural rate of unemployment, wage pressures and deadweight loss in the labor market when inelasticity of labor supply creates job-search disincentives resulting in a regulated labor market and a spiral of wages that is far behind the real level of productivity.

PENSION REFORM AND MACROECONOMIC STABILITY

The issue of pension reform is definitely the most challenging macroeconomic issue in the time to come. Faced with unfavorable demographic situation, economic policymakers in Western countries will need to reconsider the structure of the pension system to ensure the long-term sustainability of pension systems and overall macroeconomic stability as well. Negative demographic trends, namely a decreasing labor supply relative to increasing retirement rates as post-WW2 baby-boom generations retire and the burden of the welfare state is beared by the existing labor supply thru higher tax burden unless the reforms are launched.

Jose Pinera predicted (link) that Europe's aging population and the unsustainability of pension systems in the Euroarea could distort the functioning of optimum currency area and, consequently, launch a series of instability issue in the euroarea due to the inability of fiscal policies to cope with the exponentially growing net financial liabilities to the retirement system. Ageing population is, of course, more pronounce in the euroarea and Japan compared to the United States or Canada. In G7, assuming ceteris paribus, dependency ratio is expected to move from 40 percent to 70 percent by 2050.

The evidence from the OECD predicts that by 2050, Spain and Italy will face the highest dependency ratios. In Sweden, where private retirement accounts have been introduced (link) as a long-range supplementary to PAYG system back in 2000 (link), the trend of the ratio of population aged 65 and over is expected to reverse between 2030 and 2040. The United States is the only advanced country where the share of population aged 65 and over is not expected exceed 40 percent of the overall population (link).

Recently, Martin Neil Baily and Jacob Funk Kirkegaard of the Peterson Institute wrote a book entitled US Pension Reform: Lessons from Other Countries (link). The authors examined the prospects for the reform of the pension system in the United States considering the evidence from abroad. They showed that southern (Spain, Italy, Greece, Portugal) and continental (France, Germany, Belgium, Austria, Hungary, Slovenia) European countries are in the dead-end scenario of weak total assets of the pension system, unsound government finances. Although Austria, Spain and Belgium had a surplus structural fiscal balance in 2006, these countries are still unfamous for high corporate and personal income tax burden which has, by all empirical proportions, a negative overall effect on labor supply as working time is substituted for leisure activities, while as those of you who studied introductory micro and macro, productivity is the key to higher standards of living.

There is a three-step approach that European welfare states must face sooner or later if these countries want to avoid a continuous macroeconomic crisis whose effect is similar to oil supply shocks in 1970s. First, pension systems should be privatized by the introduction of private retirement accounts and PAYG net financial obligations should diminish gradually either in the framework of fiscal policy rule or in terms of partial lump-sum in the intragenerational transfer. Second, the transition to private retirement accounts must ensure the combination of risk-management approach to portfolio investment and returns managed by private pension funds. Sound and smart regulation should not be avoided such as the avoidance of investment into toxic assets backed by subprime mortgages where a decreasing interest rate has virtually inflated assets prices and propelled a the burst of the bubble that spurred the financial crisis in 2008/2009.

However, lessons from financial crisis and financial innovation will probably peer the question whether pension funds shall benefit from investing in asset-backed securities. Traditionally, pension funds diverse the portfolio structure by hedging or diversification into a stable and predictable rates of return with low beta coefficient on most of securities as pension fund managers aim to reduce the variability of return rates as risk fluctuates except for in optional accounts. And third, European countries should immediately deregulate its rigid and inflexible labor markets and also strongly decrease marginal and average tax rate on personal and corporate income and should nevertheless immediately raise the retirement age in the effort to stimulate labor supply and avoid early retirement. The combination of high tax burden, early retirement age and inflexible labor markets is a vicious circle where stagnation, ageing time bomb and macroeconomic crisis are the main consequence of delaying pension reforms into the future while such reforms never really happen.

GOOD NEWS FROM IRELAND

WSJ reports (link) that Ireland intends to curb public spending by €1.4 billion in response to widening budget deficit.

TAX CUTS IN EUROPE

Forbes reports (link) that Hungarian Prime Minister announced the abolition of 4 percent solidarity tax, a unique layer of tax on company profits that used to finance government's welfare expenditures. In addition, the government announced a decrease in corporate tax rate from 18 percent to 16 percent and payroll tax rate by 10 percentage points. However, after Slovenia and Croatia, Hungary is among the last remaining economies in Central-Eastern Europe without flat-rated income tax (link) that would boost economic growth, investment and job creation. Surprisingly, Greece introduced a gradual reduction in corporate and individual income tax by 5 percentage points over the next five years (link).

ANOTHER EVIDENCE WHY EU FARM SUBSIDIES ARE DEADLY HARMFUL

EU Observer has recently quoted (link) the study conducted by a team of British scientists showing that, each year, farm subsidies on behalf of EU's common agricultural policy cause strong heart diseases and stroke-related deaths as a consequence of too high nutrition values per se, given the amount of fat that farm producers can use to produce food. This is an additional sign why EU's common agricultural policy is a roadmap in the wrong direction. Taking some basics of the microeconomic theory into account, we can see that EU farm subsidies lead to massive overproduction of milk and diary products simply because producers do not meet a sufficient amount of market information as a consequence of subsidy distortions. Again, subsidies can be attributed only if there is more negative neighborhood effects that the amount of positive ones while agricultural sector is a case study that would suffice the criteria for subsidy giving as there is a market-clearing price mechanism. World Health Organization revealed that EU's annual milk production subsidies amount 16 billion EUR, including a 500 million EUR butter consumption stimulus.

The EU Observer noted (link):

"Looking at the 15 EU states before the 2004 round of enlargement, the annual "mortality contribution attributable to CAP was approximately 9,800 additional CHD deaths and 3,000 additional stroke deaths within the EU," the study says, with France, Germany, Italy, Spain and the UK seeing the highest numbers of excess deaths."

Market liberalization and an immediate end of subsidizing agricultural production would certainly boost the shift towards consumer choice and demands. In turn, that would also bring positive neighborhood effects since producers' prices would be closer to marginal cost level which means that the severity of heart diseases and stroke-related deaths and consequences would disappear faster and easier. Frankly, it's about time to end the tyranny of EU's agricultural subsidies and CAP. The effect of farm subsidies revealed by British scientists are another strong argument and evidence of the mischief of subsidy-giving.

WILL CANADA, POLAND AND FINLAND JOIN THE FLAT TAX CLUB?

The proposition to move towards flat-rated income tax has been suggested in Canada (link), Finland (link) and Poland (link).

AUSTRIA: ALPINE TAX HAVEN DEFENDS FINANCIAL PRIVACY LAW

Austria firmly rejected the initiative from the European Union to ease and possibly remove the legislation that aims at client data privacy and banking quality (link). The EU tries to impose sanctions on jurisdictions known for sound financial privacy, competitive tax policy and bank secrecy laws (link).

FLAT TAX IN POLAND?

Poland, the biggest economy in central Europe might introduce a low and single-rated flat tax (link)

HUNGARY'S LOW GROWTH DISEASE

When studying and/or doing a job in macroeconomics, it is important to keep an eye on three key features: economic growth, inflation and unemployment. Macroeconomic analysis also emphasized the stability of macroeconomic aggregates such as GDP, public spending and budget consumption. An article Tax tinkering won't fix Hungary's growth problem published by The Guardian briefly outlined Hungary's macroeconomic turbulence in terms of low growth, high government spending and pretty high unemployment rate. Hungary's economy is facing significant macroeconomic problems. In third quarter of the year, Hungary's output grew by as little as one percent (link). In addition, fiscal issues accelerated the fragility of macroeconomic stability.

Tax reform: evidence from Sweden and Iceland

From previous decade onwards, tax reforms have become the guideline of macroeconomic policy. Significant tax cuts on labor supply, entrepreneurship and savings boosted the competitiveness and growth performance in those countries that implemented rigorous economic reforms. In Iceland, the combination of the lower government spending and tax cuts on personal and corporate income generated the Laffer Curve effect, when tax revenues were higher (in the share of the GDP) while tax rate on corporate income was lower (link). Sweden imposed substantial marginal tax cuts and tax revenues grew substantially in the share of the GDP (link).

Don't expect significant Laffer Curve effect in case if public spending is not reduced substantially

As a successful "case-study" of macroeconomic and microeconomic transformation into a market economy, Hungary (link) welcomed foreign investment by slashing the corporate tax rate to the lowest level in Europe, after Ireland and Cyprus. However, Hungary's policymakers decided to build a model of economic policy based on high government spending (link) and resumed budget deficit. The main source of the issue is not budget deficit itself, but the size of government spending in the share of the GDP. Including transfer payments and consumption, Hungary's government spending is extremely high. In recent year it equaled 49,5 percent of the GDP.

High marginal tax rates lead to tax evasion and underground economy

Hoping to restore revenue increases after imposing tax cuts on productive activity in the absence of lower government spending is hopeless nevertheless. Discretionary fiscal policy, high marginal and overall tax rates and highly volatile public finance besides high public expenditures are the main reasons why tax evasion occurs. Tax evasion is nothing else but the consequence of the fact that investors and individuals perceive the opportunity cost of high tax rates as significant. The usual effect of high and marginally progressive tax rates is that tax evasion accelerates the establishment of informal sector known as grey or underground economy. In Hungary, grey economy equals an estimated 17-18 percent of the GDP (link).

Hungary in regional competition

Slovakia (link), Hungary's neighbor went through a period of pro-growth economic and tax reforms. Tax rate on personal and corporate was slashed to flat 19 percent and government spending, including consumption and transfer payments, was reduced substantially. As a result, Slovakia became the Monaco on Danube, a high-growing Eastern European economy known as investment haven. A significant number of international companies such as Peugeot, Citroen and Volkswagen set their production establishments in Slovakia. Also, Slovakia's economy experienced a robust, non-inflationary output growth while Slovakia's macroeconomic institutions streamlined competitive, non-discretionary and stable macroeconomic policy based on expenditure cuts and growth agenda. Hungary has been losing its investment potential subject to abovementioned reasons. Recently, two companies - Audi AG and Servier - have taken alternative consideration of their operations location because of Hungary's statist tax system (link) and discretionary macroeconomic policy.

Reform or die slowly

In 2007, Hungary imposed the 3rd highest tax hike on labor supply in OECD. This could be a substantial incentive for tax evasion. Consequently, productivity growth would definitely stagnate. Timid initiatives to impose tax reform are completely useless unless government spending is cut radically. As a consequence, there would be much less pressure on budget deficit which is estimated to drop from 9,2 percent of the GDP to 4 percent of the GDP. However, deficit is often the wrong number. Also, social security contributions present a persistent barrier to employment and job growth. Long and generous unemployment periods do not create a job-seeking. Nonetheless, the combination of high unemployment and low growth is a deadly situation where the risk of stagnation is huge in case if substantial pro-growth reforms are not implemented. As an economy in transition, Hungary's macroeconomic policy will have to cut spending radically or it will quickly become the France of Eastern Europe (link).

Rok SPRUK is an economist.

Copyright 2008 by Rok SPRUK

IRELAND'S HIGH PERSONAL TAX RATES

Despite an attractive corporate tax scheme, Ireland suffers from punitive taxation of personal income. Indeed, throughout the years of pro-growth reforms that turned a lagging economy into a high-growing Celtic tiger, Irish policymakers reduced top personal income tax from 65 percent to 42 percent. Despite a significant reduction in top personal income tax rates, Ireland's personal tax regime remains quite unfavorable. Sunday Business Post recently reported how low-tax jurisdictions such as Portugal where no capital gains tax is charged, Bermuda, Monaco, Switzerland, Liechtenstein, Cayman Islands and British Virgin Islands attract successful individuals, tax exiles and lure direct investment.

WILL THE LARGEST EUROPEAN ECONOMY RECOVER FROM A NON-REFORM DISEASE?

The Economist has recently published an article about the current state of Germany's economy. At this time, Germany faces persistent structural problems affect the dynamics of economic performance. The sub-prime mortgage mess has not been stretched to German market as less than 10 percent of German exports go to the United States and thus, German exposure to U.S slowdown is not huge. Germany's economic growth is estimated to fall from 2,6 percent in 2007 to 2 percent or less in 2008. What is actually behind a lingering growth performance? The growth of export performance is likely to decline, facing a drop from 8 percent in 2007 to 4,8 percent in 2009.

Among the economic issues, there was a significant surge of inflation which hit 3,1 percent annually in 2007 mostly due to higher food and energy prices. A detailed analysis of the demand conditions may reveal that the coefficients of price and income elasticity of demand have been quite inelastic, moving somewhere in the interval between 0 and 1. The suppliers know very well, that if demand is quite inelastic and consumer behavior quite monotonic, price increases could prop up their income. Germany's inflation rate may be transiotry as there are strongly supported expectations about the normalization of energy and food prices in the period to come.

Although consumer sentiments remained well-positioned, consumption-inflated spending may not boost the potentials of German economy on the way to recovery from low overall growth.

Germany's future and prosperity will crucially depend on the pace of economic reforms. The policy outcome of current government coalition is mixed. Labor-market reforms contributed one fifth to overall growth but there is a number of issues hampering the ability of German economy to operacompete successfully in a global environment. Bundesbank, German central bank, has shown that the contribution of labor to economic growth is likely a result of drawing unskilled workers into labor supply. Also, German government cut public spending and put limits on the growth of overall spending. Quite logically, the investment picked up an incentive and grew at a higher rate.

An impeding obstacle to Germany's prosperity is the attitude oriented against the economic reforms. The preference of economic justice over the need for tomorrow's change is a road to self-destruction. The consequence of such a misty combination of political and voting behavior is the lack of willingness and political courage to implement much-needed reforms. Steming away and streaming for status quo is what causes riots, dissatisfaction and an endless cycle of statist propaganda inflated by politicians, interest groups and the media.

Unemployment benefits, raising the minimum wage in public sector and similar policy implementation strongly discourage the economic performance from going to growth to searching for privileges from the state through various mechanism such as tax system, collective bargaining and public sector. In Germany's case, the raise of minimum wages in a state-controlled postal company, is nevertheless a sign of rent-seeking. If such collective demands are granted, the steps in the wrong direction will multiply. There is hardly any argument for the minimum wage. On demand side, minimum wage is a form of taxation that raises the overall cost of labor and increases the probability of being fired or unemploymed in the future. On supply side, the minimum wage reduces the productivity potentials and does not stimulate labor supply to spend more hours in the market.

Regulating job market will not boost job creation subject to external pressure on the allocation of labor resources and productivity of the labor supply. The pursuit of various form of unemployment insurance, which has flipped Germany into a mirage of structural unemployment, discourages laborers from seeking a job. It rather encourages seeking priviliges from the state and the lack of incentives to search job due to unfavorable working environment and the influence of trade unions on job growth and labor market.

The question is whether Germany will move out of the cage of low growth and discouraging structural picture. The answer is mix of particular sets of policy conditions and macroeconomic estimates. On macroeconomic level, inflation expectations remain favorable and consumer price index is expected to normalize subject to transitory shock on particular prices. On fiscal level, estimates suggest that more should be done to decrease public spending, cut taxes on productive behavior and reduce government size and consumption. Many futures answers to thequestion of where Germany will stand in the future, will depend on whether the polocymakers will give up the political payoffs emerged from rent-seeking and special interest groups.

Going in the reverse way, where political decision-making neglects economic costs, further makes it quite difficult for policymakers to implement long-range reforms regarding health-care, welfare state and labor market. In those areas, the presence of pressures from interest groups and trade unions will radically oppose the economic reforms to protect the benefits handed to special groups and priviliged from the state. There is no need to endure old-styled western European type of corporatist society where the interests of stakeholders are protected at first hand.

There is always a need for change in economic and structural terms, just as deregulation and openness created German economic miracle after the World War 2. Change is the engine of tomorrow's freedom and progress and an opportunity is rare, while a clever man will never let it go.

Rok SPRUK is an economist.

Copyright 2007 by Rok SPRUK

HIGH TAX JURISDICTIONS ARE AS BAD AS MONOPOLIES AND OIL CARTELS

SWITZERLAND VS. EU

The EU recently persecuted Switzerland because because bureaucrats in Brussels believe that Swiss market-friendly model of cantonal tax competition is a form of state-aid.

Here is a report by Tax-news.com:

"The European Commission is basing its legal argument against Switzerland on the latter's alleged breach of state aid rules, which, in the EU, are in place to prevent member states from favouring certain companies and industries with beneficial tax rules and subsidies. But the Swiss say that the EC's arguments rest on shaky very legal ground, pointing out that the country is neither an EU member or part of the Single European Market, nor party to the competition regulations of the EC Treaty, including those on state aid. Moreover, Bern insists that even if the tax laws in question were covered by the 1972 Free Trade Agreement, they would not fall under the EU's definition of state aid, because they do not favour certain companies or industries."

Swiss Federal Council issued a report on state-aid to companies (link). Claiming that regional (cantonal) tax competition is a government aid is a myth. In fact, EU countries such as Germany and France maintain a bulk of government-owned enterprises.

An example of government intervention into the course of market forces is EU's Common Agricultural Policy (CAP) massively endorses income redistribution from European taxpayers into the hands of agricultural lobbies. Another obscure example of statism is EU are subsidies as a "third-party" payer problem.

The majority of EU's budgetary means and fiscal expenditures are funded directly into farming in the form of subsidies. 65 percent of all EU subsidies go to manufacturing, causing disallocation and the distortions in output and productivity. In addition, there're vast sub-funds whereby subsidies and handouts are granted to enterprises in the EU.

On the other hand, there is no such thing in Switzerland. Even more, Swiss government does not penalize businesses competing in low-tax jurisdictions compared to EU's expanding of the power of government such as efforts to establish tax harmonization.

POLAND: REFORM OR DIE

In Poland, the liberal Civic Platform won the very recent elections by a narrow margin ahead of socially conservative Law and Justice (here, here, here, here and here).

The current economic and structural picture in Poland is mixed. Despite the great impact of the stabilization and market liberalization on economic performance in the past 17 years, Poland, as well as other Central European countries, maintained a high level of public spending in the share of the GDP. Poland scores low on Corruption Perception Index with a rampant track on the overall corruption. The index is measured on the scale between 0 (highest) and 10 (lowest). Poland slumped from 4,6 in 1998 to 3,4 in 2005.

The reason for such persistent corruption is the fact that Poland's government spending has not fallen below 40 precent of the GDP yet. In turn, higher level of spending and more extensive government and public administration negatively affect the overall capacity of the economy to operate and sustain robust growth subject to convergence process.

As a positive thing, under previous government, the burden of government size and spending was reduced, which was an additional influence on Poland's 6-7 percent economic growth rate, which is still low on Eastern European average. One of numerous disadvantages of the government chaired by Law and Justice was a an assertive foreign policy and a brisk growth of populism, curtailing individual liberties through the coercive dogmas of Catholic values, in addition to the enforcement of protectionism and criticism of free-market views based on the doctrine primarily adopted by socialist movements.

Civic platform's leader Donald Tusk pledged to accelerate the privatization of state-owned assets more rapidly and energetically as previous government did. He also pledged to adopt replace the current progressive income tax with 19 percent flat income tax. Polish economy is doing well at the moment driven by strong foreign direct investment and solid export performance. Mr. Tusk's also promised to reform Poland's wasteful public finance, inefficient and oversized bureaucracy and a lagging infrastructure.

A victory of Poland's now-leading party inspired by liberal political views might play a crucial role in building and implementing a reform agenda as a sign of relief with positive impacts on overall growth foundations such as reduced tax burden and an active fight against corruption through reducing the size of government and improve the inadequte public administration.

BATTLING WELFARE LEGACY IN SWEDEN

In Wall Street Journal there is a good article outlining the implementation of economic and structural reforms on the road to recovery from a typical generous experiment of the welfare state (link).