Fiscal capacity for euro area- towards a bigger EU budget?

Rosiak, Tomasz Working Paper Fiscal capacity for euro areatowards a bigger EU budget? Institute of Economic Research Working Papers, No. 93/2015 Provided in Cooperation with: Institute of Economic Research (IER), Toruń (Poland) Suggested Citation: Rosiak, Tomasz (2015) : Fiscal capacity for euro areatowards a bigger EU budget?, Institute of Economic Research Working Papers, No. 93/2015, Institute of Economic Research (IER), Toruń This Version is available at: https://hdl.handle.net/10419/219709 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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Tomasz Rosiak The paper submitted to VIII th INTERNATIONAL CONFERENCE ON APPLIED ECONOMICS CONTEMPORARY ISSUES IN ECONOMY under the title MARKET OR GOVERNMENT? Institute of Economic Research and Polish Economic Society Branch in Toruń 18-19 June 18-19, 2015, Toruń, Poland Toruń, Poland 2015 © Copyright: Creative Commons Attribution 3.0 License Tomasz Rosiak [email protected] Faculty of Management Warsaw University Fiscal capacity for euro areatowards a bigger EU budget? JEL Classification: E60, E61, E62, E63 Keywords: Fiscal capacity, Fiscal federalism, European Union, Euro area, EU Budget Abstract: The European Union has recently implemented one of the biggest reform packages in its history. Developed solutions are designed to (1) strengthen EU’s resilience to shocks and (2) improve its shock absorption capabilities. It seems that so far stress was mainly placed on the first objective. Among the reforms, which satisfied the second objective, the European Stability Mechanism (ESM) plays a key role. However, this is not the only solution. The European Union is also developing a fiscal capacity for the euro area. On the base of a subject literature study, I have developed a model with boundary conditions of fiscal federalism, which then was compared to macroeconomic data for the EU. Results of my findings show that the European Union, and especially the euro area, share a lot of characteristics typical for fiscal federalism. From this point of view, a budget for the euro area seems to be the best form of fiscal capacity. However, it could bring further fragmentation of economic integration process in the EU which probably would not positively contribute towards the stability in the political sphere. Introduction Global financial crisis and sovereign debt crisis has launched an unprecedented program of reforms in the European Union. There seem to be no significant disagreements among economists about the causes of crisis, however the proposals for remedies for the EU are not so obvious. In this work I come forth with the assumption that the European Union is similar in substance to the federation model. As a confirmation of the statement formulated above, I may indicate a number of characteristics which prove that the EU does not differ from countries implementing this model (see: Appendix 1). Presented data show that the European Union is not a unique structure neither by economic development, nor by complexity of administration division. What distinguishes the European Union from other federal countries is national diversity of European society. However, cultural patterns seem to be rather close and one can expect that the tendency will be for them to converge. In my opinion, the biggest problem is a high number of official languages which reduces mobility of labour force within the European Union. This does not bring EU closer to the fulfillment of Optimum Currency Area criteria and the reduces capacity of shock absorption (Tchorek, 2013, pp.187-190). That is why I assume that conducted reforms should lead the European Union to a model of fiscal federalism as a complex solution which could be able to ensure economic stability. Yet, a lot was done in the monetary sphere of the euro area’s economic governance. However, recent economic theory (Rosiak, 2014a, pp.119-121) and practice, put increasing emphasis on the role of fiscal policy. So far, the aim of reforms in the fiscal policy area was mainly to reduce euro area’s vulnerability to shocks and strengthen the monetary policy through a fiscal consolidation in member countries. The only permanent solution for shock absorption is European Stability Mechanism (ESM). Functioning of the ESM envisages assistance mainly through loans. Its ability for stabilizing the euro area economy is rather limited (comparing its lending capacity of 500bln euro to whole euro area GDP), therefore one can say, that stabilization functions, like intertemporal stabilization or interregional-insurance, have not been sufficiently provided yet. The main objective of this paper is to examine whether a new proposal for creating fiscal a capacity for the euro area will fulfill the gap between EU structures and the model of fiscal federalism. Particular emphasis was put on stabilization functions which would help in ensuring sound economic governance. Methodology In my research I have used descriptive approach which, thanks to conducted literature study, allowed me to specify essential features of fiscal federalism. Having collected general features I compared them to the advancement of the EU’s pre-crisis integration. Afterwards, I assessed whether recent reforms bring European Union, and especially the euro area, closer to the model of fiscal federalism. Finally, knowing main drawbacks of conducted reforms in the fiscal federalism context, I gave comments about potential forms of fiscal capacity for the euro area. Has European Union developed a model of fiscal federalism? Until recently, literature on fiscal federalism defines only two main boundary conditions of fiscal federalism: presence of a monetary union i and a common market (Weingast, 1995). In my paper (Rosiak, 2014b) I introduced main characteristics of this model based on review of literature of fiscal federalism. Those are: • Multilevel system of governments • Presence of central and local budgets • Distinctive features of central budget:  Size in range from 10% of GDP to 50% of GDP  Built in functions:  Redistributive  Intertemporal stabilization  Interregional insurance  Taxation assignment:  Central budget can run deficit while local ones should be balanced • Presence of transfers and subsidies as a management tools externalities • Specific allocation of competences Features listed above are typical for the model of fiscal federalism. However, it is not necessary to meet all criteria cumulatively. From the fiscal policy perspective, the most important are presence of central and local budgets, features of central budget, presence of transfers and subsidies as management tools for externalities. These features allow for flexible allocation of policies entitlements between central and local budgets. The role of central budget studied Stiglitz (Stiglitz, 2004) who concluded that provision of national public goods and services as well as provision of stabilization functions should be domain of central budget (see: Fatas, 1998; De Grauwe, 2012; Borzel & Hosli, 2003). For effective resources should be provided. This leads to a question of the proper assignment of taxes to the appropriate level of state administration? This dilemma is also called a tax-assignment problem (see: Tiebout, 1965; Gordon, 1983). Literature on fiscal federalism envisages that, to ensure proper financing, revenues from non-benefit taxes should be collected by the central government, while local ones should collect revenues from benefit taxes as a payment for quality of public goods and services they supply (see: Oates, 1999 or Mueller, 2004). The role of the central government is supreme in relation to local ones. That is why it should have an influence on local decisions thorough system of transfers and subsidies as a main tool for triggering externalities (Boadway, Shah, 2009). Table 1 presents a detailed look at the advancement of the pre-crisis European integration in the context of fiscal federalism. Table 1: Fiscal federalism features in European Union Feature Fiscal Federalism European Union Multilevel system of governments Exist Exist Presence of transfers and subsidies Exist Exist Size of central budget At least 5-7% of GDP (optimum 20% - 25%) ≈ 1% of GDP Budget characteristic Central: possible deficit Local: balanced Central: balanced Local: possible deficits Redistribution mechanism Exist Exist Budget functions Central: redistribution, intertemporal stabilization, interregional insurance Local: allocative Central: redistribution, interregional insurance (very limited) Local: intertemporal stabilization, allocative Taxation Central gov.: non benefit taxes Local gov.: benefit taxes Central gov.: 0,3% of VAT Local gov.: all types of taxes Source: based on Rosiak, T. (2014b). Fiscal federalizm as a solution for eurozone problems. Problemy Zarządzania, vol. 12, nr 4(49), t.2, Wydawnictwo Wydziału Zarządzania Uniwersytetu Warszawskiego, Warszawa, p. 181 As showed above main differences between the model of fiscal federalism and the advancement of pre-crisis European integration are: insufficient size of the central budget, possibility of running deficit by central budget and lack of intertemporal stabilization and interregional insurance functions. Although the main task of recent reforms was to strengthen the euro area, and not constructing fiscal federalism within euro area, many of new solution bring it closer to the analyzed model. First of all the European Economic Governance Package, the so called sixpack, has made a shift of powers, especially in the area of budgetary procedures, towards European institutions. However Grosse (Grosse, 2013) calls it negative federalism, which builds mainly disciplinary functions without creating new incentives for externalities. The ESM has expanded the function of interregional insurance. Nevertheless the size of the central budget remained the same and stabilization capabilities, however extended, remained rather limited compared to the size of the European Union’s economy. Table 2: EU reforms in the fiscal federalism context Area of FF Impact of reforms on EU integration development Increase in the size of the EU budget NO Possibility of running deficit by central budget NO Building-in an intertemporal stabilization function YES – to a limited extent by ESM Building-in interregional insurance function NO Centralization of fiscal policy YES – to some extent by centralization of some aspects of budgetary procedures Centralization of economic governance YES – by better coordination of structural policies through sixpack (European Semester + MIP) Source: based on Rosiak, T. (2014b). Fiscal federalizm as a solution for eurozone problems. Problemy Zarządzania, vol. 12, nr 4(49), t.2, Wydawnictwo Wydziału Zarządzania Uniwersytetu Warszawskiego, Warszawa, p. 185 As shown in Table 2 the main goal for fiscal capacity will be provision of interregional insurance function and enforcement of intertemporal stabilization function. It is worth to mention that full compliance with the fiscal federalism’s conditions would be possible only in the case of shift of powers, where local budgets would be balanced and the central one could run a deficit. Fiscal Capacity for euro area Fiscal capacity will be the second mechanism, after ESM, with abilities to stabilize the euro area’s economy through transfers. All previous solutions (e.g. Sixpack, Twopack, Fiscal Compact and Pact Euro plus) imposed restrictions on national budgetary procedures and thus limited the demand generated by national governments (Heins & de la Porte, 2015, p. 4). The legitimacy of its creation is motivated by the same rationale that is imposed by the literature of fiscal federalism referring to the functions performed by the federal budget - the ability to stabilize the economy and influence (through transfers) structural reforms conducted in the euro area. More precisely, the ability to stabilize the economy would rely on the incorporation of two functions that fiscal federalism envisioned in the central budget, and that the EU budget did not have: the intertemporal stabilization and interregional-insurance. As was shown in Table 2 ESM provides only intertemporal stabilization function and with a limited capacity. Necessity to establish a mechanism for the fiscal capacity of the euro area was expressed in two reports from 2012 named 4 Presidents Reports ii (Towards…, 2012a; Towards …, 2012b). The June Report defined the broad lines of the further integration of the euro area. Lowering euro area’s vulnerability to shocks and an improvement of its absorption capabilities was indicated as a main goal. Referring to the integrated budgetary framework, clearly identified and named was the need to build a fiscal union that would ensure the stability and security of the euro area. Authors consider, also in the medium term, the possibility of joint debt issuance, which also contributes to a further fiscal integration and the need to redefine the role of the central budget in new institutional and economic realities. At the end, there is expressed the need for further development of a road map that would lead to the creation of a genuine Economic and Monetary Union. The December Report goes deeper into the topics raised in the June Report, focusing mainly on aspects of coordination of budgetary policies and joint economic governance. It has also developed a general framework of implementation of the vision from the first report. It has been divided into 3 stages. The goal of the first one, planned from the end of the year 2012 and for the year 2013, was to found the fiscal stability of the euro area and to break down the relationship between the liquidity of banks and public debt. The second, planned for the years 2013-2014, assumed the implementation of integrated financial framework and further support of structural reforms. The third stage, covering the period after 2014, is the most important one from the point of potential fiscal federalism in the European Union, because it envisages improvement in flexibility of the EMU’s functioning by creating a central mechanism for shock absorption. All monetary unions have their fiscal capacity mechanisms (Towards…, 2012b, p.9). Vulnerability to shocks and the lack of effective mechanisms of shock absorption seems to confirm the need to implement such an instrument also within the EMU. In the euro area the additional function that would implement such a mechanism would be a promotion (through various financial incentives) structural reforms which could contribute to higher economic growth in the future. However, form of the fiscal capacity has not been clarified yet. The December Report only sets out, that the contribution and the payment from the fiscal capacity will match the position of the member country in its economic cycle. Vetter (Vetter, 2013, p.1) proposed 4 possible forms of fiscal capacity: 1. A common budget, 2. An insurance mechanism against strong cyclical fluctuations, 3. A common unemployment insurance scheme, 4. An equalization scheme for interest burdens. The idea of separate euro area budget is not new and quite popular among economists studying European Union’s problems (see: Verdun, 2015). Implementation of the fiscal capacity in the form of a separate budget for the euro area (1) would require an indication of its revenue sources. From a few concepts of revenue sources one may indicate: membership fees proportional to the size of the member country’s economy or in form of taxation. There are two possible ways of tax collection: by introducing a new tax e.g. financial transaction tax (see: or as part of the nationally collected tax e.g. part of an income from collected VAT. Each approach has its drawbacks. The new membership fee or a portion of VAT revenues will adversely affect the condition of tight local budgets. The financial transaction tax would require fairly complex algorithms for receiving this revenue from various countries (the proportion of the financial markets in different countries relative to GDP vary considerably). No matter the source, economists estimate that euro area budget would need approximately 2% of GDP in revenues (see: Wolff, G., 2012) . Budget form of fiscal capacity would incorporate interregional insurance function. Another advantage of this solution would be the possibility to install automatic stabilizers, which, on the one hand, allow for a quick response to economic fluctuations (automatism) and the support for the counter-cyclical fiscal policy stance on the other. From the point of view of the European integration process, creation of a new, separate budget could be considered a step back (the current shape of the central budget of the European Union is in fact the result of the consolidation of budgets of European Communities). Other reforms such as the Fiscal Compact or the Euro Plus Pact are intergovernmental agreements, so as for now they can be perceived as a desintegrating mechanisms as well or as a part of bigger disintegration process within European Union (Vollaard, 2014, p.4). However, documents include a commitment to incorporate them into the EU law. On the other hand, fears about the collapse of the euro area seem to be exaggerated. The EU citizens are becoming more utilitarian in their understanding of the euro and its institutional framework, so they rather would not vote for withdrawal from the euro area or the European Union (see: Ioannou at al., 2015, p.169) Insurance mechanism against strong cyclical fluctuations (2) could be financed from contributions made by the member states in time of economic growth. Payments would be realized if a negative shock occurred. The problem, which is associated with this solution is the selection of an appropriate methodology to determine the moments of mobilizing resources and their total amount. They should, on the one hand, correspond best to the realities of the euro zone and been acceptable to all 19 states on the other. Vetter (Vetter, 2013) suggested that assistance should be provided in a country where the negative output gap will reach 2% of GDP. Country experiencing such problems could then receive a payment from the insurance mechanism in the amount of e.g. 25% of the shortfall. The most significant disadvantage of this solution is the need to develop additional scenarios for years in which almost all euro area countries fell into recession. This occurred in 2009, when all euro area countries fell into recession, as well as in 2012 and 2013, when nearly half of them had negative economic growth. Stiglitz J.E. (2004). Ekonomia sektora publicznego. Warszawa: Wydawnictwo Naukowe PWN, Tchorek, G. (2013). Nierównowagi fiskalne i makroekonomiczne w strefie euro a nowe rozwiązania instytucjonalne. Management and Business Administration. Central Europe, Vol. 21, No. 2(121), p. 186–204 Tiebout, Ch. M. (1965). A pure theory of local expenditures, The Journal of Political Economy, Vol. 64, No 5, http://dx.doi.org/10.1086/257839 Verdun, A. (2015). A historical institutionalist explanation of the EU's responses to the euro area financial crisis. Journal of European Public Policy, 22:2, pp. 219-237, DOI: 10.1080/13501763.2014.994023 Vetter, S. (2013). Do all roads lead to fiscal union? EU Monitor, European integration, 11 April 2013, Vollaard, H. (2014). Explaining European Disintegration. Journal of Common Market Studies, DOI: 10.1111/jcms.12132 Wolff, G. (2012). A budget for Europe’s monetary union. Bruegel Policy Contribution, 2012/12 Reprots: Towards A Genuine Economic And Monetary Union, (2012a). Report by President of the European Council Herman Van Rompuy, European Council, EUCO 120/12, 26 June 2012, Brussels Towards A Genuine Economic And Monetary Union, (2012b). Report by President of the European Council Herman Van Rompuy, European Council, 5 December 2012, Brussels