Fiscal Policy Lessons from Europe

Moreover, this is just the calm before the storm. Left on autopilot, the burden of federal spending will increase dramatically. This is partially due to demo­graphic forces, such as the looming retirement of the baby boom generation, but is also the result of reck­less policy choices, such as the creation of a new pre­scription drug entitlement.

In a worst-case scenario, the Congressional Budget Office (CBO) estimates that government outlays could consume as much as 55.8 percent of GDP by 2050. Even a more optimistic scenario shows that the burden of federal spending will still nearly double, climbing to more than 37 percent of GDP.[2] Further­more, these figures do not count state and local out­lays, which currently consume more than 11 percent of GDP and will probably expand in future years.[3]

Many European nations have already allowed the burden of government to climb to these levels. Gov­ernment spending consumes more than 50 percent of GDP in France and Sweden and more than 45 percent in Germany and Italy.[4] These nations provide useful lessons about the economic consequences of bigger government, and these lessons suggest that America is on the wrong track. Even a cur­sory review of European economic performance shows that excessive government has serious adverse effects: slower growth, higher unem­ployment, lower living standards, and a bleak future.

One of the most important les­sons to be learned is that GDP is linked to policy. For instance, the CBO's long-run forecasts assume that inflation-adjusted GDP will grow by about 2 percent annually, regardless of whether government consumes 21 percent of economic output or 56 percent of economic output. The dismal performance of the European economies shows that this is a deeply flawed assumption and indicates that America's future is at even greater risk than the CBO estimates suggest. Bluntly stated, the United States is in danger of becoming a decrepit welfare state like France.

Comparing Europe and the United States

Western Europe[5] and the United States are wealthy, and both achieved this status over the past two centuries in part because of sensible policies and institutions. While much of the world was and still is crippled by the absence of functioning mar­ket economies, Europe and the United States have enjoyed centuries of remarkable growth thanks to property rights, the rule of law, and minimal gov­ernment.

For much of the 19th century, many European nations were richer than the United States. The United Kingdom and the Netherlands at various times have enjoyed the globe's high­est living standards.[6] The United States took the lead in the first half of the 20th century, thanks to strong growth, but also because World War I and World War II caused extensive damage to Europe.

In 1950, the United States had nearly twice the per capita GDP of Western Europe. Over the next two decades, however, European econo­mies enjoyed strong growth.[7] Amer­ica's advantage shrank, and a number of European nations appeared to be on pace to surpass the United States.

Europe's Shift to Statism

However, Europe and the United States then began to move in oppo­site directions, and public policy seems to be one of the biggest rea­sons for the shift. Beginning in the late 1960s and early 1970s, politi­cians in most European nations increased the size and scope of gov­ernment. Government also expanded in America during that period, but the increase was more muted. More important, beginning in 1980, Amer­ica began to liberalize its economy and curtail the growth of government.

As a result of these historical differences, the bur­den of government in Europe is substantially larger than it is in the United States. Chart 2 shows that the burden of government spending relative to GDP has risen dramatically in Europe, while the U.S. has largely avoided the same mistake.

The growth of government in Europe has re­sulted in considerable economic damage because both spending and taxes undermine incentives to engage in productive behavior. On the spending side of the ledger, bigger government encourages people to rely on handouts rather than individual initiative. On the revenue side, the higher marginal tax rates needed to finance programs reduce incen­tives to work, save, and invest.

Not surprisingly, these divergent policies resulted in different economic outcomes.[8] Simply stated, the United States is now substantially outperforming Europe. As the following statistics indicate, this has dramatic consequences for the economic well-being of citizens on both sides of the Atlantic.

• Per capita economic output in the U.S. in 2003 was $39,700, almost 40 percent higher than the $28,700 average for EU-15 nations.[9] (See Chart 3.)
• Over the past 10 years, the U.S. economy has grown at an average annual rate of 3.3 percent in real terms, 50 percent faster than the EU-15's growth rate of 2.2 percent.[10] (See Chart 4.)
• A report prepared for the European Commis­sion admitted that "since 1996 the average annual growth in EU [European Union] output per head has been 0.4 percentage points below that of the US. From holding its own, Europe is now losing ground."[11]
• The report also acknowledged that "labour pro­ductivity in the EU is on a trend growth path which is lower than that of the US. Over the period 1996-2003, the EU-15 productivity growth rate averaged 1.4%, as opposed to 2.2% recorded for the US."[12]
• "In the EU," confesses another European Com­mission report, "there has been a steady decline of the average growth rate decade after decade and per-capita GDP has stagnated at about 70% of the US level since the early 1980s. The dis­parity between the EU and the US has been par­ticularly remarkable in recent years. For instance, over the period 1995 to 2001, the US economy accounted for over 60% of the cumu­lative expansion in world GDP, while the EU, with only a slightly smaller economy, contrib­uted less than 10%."[13]
• Americans enjoy more leisure than Europeans because they can afford to purchase labor and goods that reduce the amount of time spent working at home. According to one German study, "overall working time is very similar on both sides of the Atlantic. Americans spend more time on market work but Germans invest more in household production." The report further notes that "these differences in the allo­cation of time can be explained by differences in the tax-wedge and wage differentials."[14]

  

• A comparative study by Timbro, a Swedish think tank, found that EU countries would rank with the very poorest American states in terms of liv­ing standards, roughly equal to Arkansas and Montana and only slightly ahead of West Vir­ginia and Mississippi, the two poorest states.[15]
• In August 2006, unemployment in the European Union was 8.0 percent, including a 7.9 percent unemployment rate in the group of nations that use the euro. The U.S. unemployment rate in the same month was only 4.7 percent.[16]
• Unemployment rates tell just part of the story because they measure only the number of unemployed compared to the number of those in the labor force. The size of the labor force is an equally important statistic. In the United States, more than 70 percent of the working-age population has a job, compared to less than 65 percent in the European Union.[17] (See Chart 5.)
• Not only is the unemployment rate in the U.S. significantly lower than the EU-15 unemploy­ment rate, but there is also a stunning gap between the percentage of unemployed who have been without a job for more than 12 months-12.7 percent in the U.S. versus 42.6 percent in the EU-15.[18] (See Chart 6.)

  

• According to an article in The American Enterprise, "Since the 1970s, America has created some 57 million new jobs, compared to just 4 million in Europe (with most of those in government)."[19]
  
  

  

• The article also notes that "Europe's best brains are leaving in droves. Some 400,000 E.U. sci­ence and technology graduates currently reside in the United States, and barely one in seven, according to a recent European Commission poll, intends to return"; that "European immi­gration to the United States jumped by some 16 percent during the 1990s"; and that "there are now half a million New York City residents who were born in Europe."[20]
• There are nearly 20 million unemployed in Europe, including nearly 20 percent of those who are under age 25.[21]
• The European Commissioner for Economic and Monetary Affairs admitted, "The most pressing challenges that Europe currently faces are the lack of growth and new jobs, the grow­ing competitive pressures from an integrating world economy.… [T]he EU economy still lacks resilience.… Potential growth remains low at around 2%. Europe's labour force is still grossly underutilised as witnessed by low employment rates as well as high and persistent unemployment."[22]
• A special competitiveness panel of the Euro­pean Commission acknowledged that "many young scientists continue to leave Europe on graduating, notably for the U.S. Too few of the brightest and best from elsewhere in the world choose to live and work in Europe."[23]
• Thanks in part to lower tax rates and the oppor­tunities created by an economy with less gov­ernment, "millions of Italians, Irish, Germans, and other Europeans have voted with their feet in favor of America's balance between work and leisure, with no discernable flow in the oppo­site direction."[24]
• Thanks to higher levels of economic output and lower levels of taxation, Timbro found that the average person in the U.S. enjoys about $9,700 more yearly consumption than the average EU resident, a difference of 77 percent.[25] (See Chart 7.)
• A study found that "American households…have far more domestic appliances, television sets, computers, telephones and cars than in most European countries."[26] 

  

• Average total dwelling space in Europe is just under 1,000 square feet. In the U.S., it is 1,875 square feet for the average household and 1,200 square feet for poor households. Adjusting for household size, one finds that poor households in the United States have slightly more dwelling space than the average European household. The average poor American has more square footage of living space than does the average person living in London, Paris, Vienna, and Munich.[27]
• British Prime Minister Tony Blair warned the European Parliament, "What type of social model is it that has 20 million unemployed in Europe? Productivity rates falling behind those of the USA? That, on any relative index of a modern economy-skills, R&D [research and development], patents, infor­mation technology, is going down, not up."[28]
• A study by Eurochambres esti­mated how long it would take Europe to catch up to America, assuming no more growth in the U.S. It would take Europe 18 years to reach U.S. income levels, 14 years to reach U.S. levels of productivity per employee, 24 years to reach U.S. levels of R&D investment, and 26 years to reach U.S. employment levels.[29]
• According to German financial reporter Olaf Gersemann, "If labor productivity in Germany and the U.S. continue on the same path as from 1996 to 2003, per capita income in Germany will grow by only 44 percent by the time Amer­ican incomes double in 2026. Put differently, within a generation, Americans will enjoy twice the economic status that Germans do."[30]
• The Organisation for Economic Co-operation and Development (OECD) admits that Europe is lagging. As reported by The Wall Street Jour­nal, "GDP per capita in Germany, France and Italy is falling, relative to the U.S., to levels below those recorded in the 1970s…. 'At cur­rent trends, with demographics the way they are, the average U.S. citizen will be twice as rich as a Frenchman or a German in 20 years,' Jean-Philippe Cotis, chief economist at the OECD, told us."[31]
• In 1980, foreign direct investment in the United States totaled $127 billion, according to the Bureau of Economic Analysis. Today, it totals more than $1.7 trillion. In 1980, there was $90 billion of foreign portfolio investment (just counting holdings of government and pri­vate securities) in the United States. Today, there is more than $4.6 trillion.[32] Much of that money-capital that finances new invest­ment-comes from Europe and at least partly reflects the more market-oriented policy envi­ronment in the United States.
• As noted by Jean-Claude Trichet, president of the European Central Bank (ECB), "When com­paring the euro area's economic performance to the US, there is evidence of increasing dispari­ties in growth. Since the beginning of the 1990s, the gap in per capita income growth between the US and the euro area has continu­ously widened-by 0.8% on average per year during the 1990s, increasing to 1.3% per year from 2002 onward."[33]
• "Over a period of 20 years," admits Trichet, "we have been the witnesses of a very significant structural change across the Atlantic. From the eighties to the first years of the twenty first century the growth of labour productivity per hour has been multiplied by more than two in the US when it has been divided by two in Europe. Overall in this respect the relative position of the US and of Europe has changed by a factor 4 to the detriment of Europe."[34]
• Women lag behind in Europe. Reporting on a study from the International Labor Organiza­tion, Newsweek noted that "women account for 45 percent of high-level decision makers in America, including legislators, senior officials and managers across all types of businesses. In the U.K., women hold 33 percent of those jobs. In Sweden-supposedly the very model of glo­bal gender equality-they hold 29 percent. Ger­many comes in at just under 27 percent, and Italian women hold a pathetic 18 percent of power jobs.… Europe is killing its women with kindness-enshrined, ironically, in cushy wel­fare policies that were created to help them."[35]

These remarkable comparisons show Europe's stagnation and are particularly embarrassing for EU politicians. With great fanfare in March 2000, EU officials committed themselves to the goal that, within 10 years, Europe would "become the most competitive and dynamic knowledge-based econ­omy in the world, capable of sustainable economic growth with more and better jobs and greater social cohesion."[36] The Lisbon Strategy, as it is called, is a noble goal, but Europe has no chance of achieving this goal by 2010.

Indeed, Europe is falling farther behind the United States in terms of per capita economic out­put. As noted by the head of the European Central Bank, "since the launch in 2000 of the Lisbon strategy, the annual growth rate for the Euro area has averaged 1.8% per year (compared to 2.8% in the US), thus remaining behind its main competitor."[37] Politicians in Europe sometimes act as if growth will magically materialize if they form another committee to discuss competitiveness, but others apparently understand what is happening: Only 29 percent of Europeans think the European Union will catch the U.S.[38]

What Is Wrong with Europe

Europe's economy is weak because government is too big. Excessive levels of government spending result in the misallocation of labor and capital for unproductive uses. The taxes needed to finance these counterproductive outlays exacerbate the problem, particularly since many European gov­ernments impose high marginal tax rates on work, saving, investment, and entrepreneurship.

Chart 8 shows that government spending con­sumes nearly 50 percent of economic output in EU nations, compared to 36 percent of GDP in the United States. This is regrettable for Europe since academic research indicates that government spending has an adverse impact on economic per­formance, particularly when the public sector climbs above 20 percent-25 percent of GDP.[39] 

Yet not all forms of government spending are created equal. Some types of outlays, especially government consumption and transfer spending, are particularly harmful to growth. Other outlays- such as those for defense, administration of justice, infrastructure, and education-impose less dam­age.[40] Europe is further disadvantaged because politicians spend more money on consumption and transfers. As shown in Chart 9, consumption outlays use up nearly 21 percent of GDP, compared to less than 16 percent in the United States. Simi­larly, transfers consume more than 15 percent of output in the European Union, compared to just 12 percent in the United States.

The tax side of the ledger is similarly dismal for Europe. Tax revenues consume more than 40 per­cent of GDP in European Union nations, compared to about 26 percent in the United States.[41] (See Chart 10.) Just as different types of government spending impose varying degrees of economic damage, the same principle applies for taxation.

Both theory and evidence confirm that taxes on income and profits are the most debilitating to eco­nomic performance, followed by payroll taxes. In both cases, European governments have generally made the wrong choices. Taxes on income and prof­its consume 14 percent of GDP in European Union nations compared to less than 12 percent in the United States. (See Chart 11.) The payroll tax gap is even larger, with such levies consuming almost 12 percent of GDP in Europe compared to less than 7 percent in the United States. (See Chart 12.)

While the overall tax burden is commonly calcu­lated by measuring tax revenues as a share of GDP, this is an imperfect measure. Its biggest shortcom­ing is that tax rates and tax revenue sometimes have an inverse relationship. If a nation has very high tax rates, taxpayers will have a much greater incentive to change their behavior in ways that reduce tax­able income. This Laffer Curve effect means that a nation collects very little revenue in absolute terms or as a share of GDP, even though the burden of taxation is very high. Ire­land and Germany illustrate this phe­nomenon. Germany has Europe's highest corporate tax rate at 38 per­cent, yet corporate tax collections are only 1.3 percent of GDP. By contrast, Ireland's 12.5 percent corporate rate generates revenues totaling 3.8 per­cent of GDP.[42]

Marginal tax rates are a better mea­sure of the tax burden because the dis­incentive effect of taxation is determined by the tax rate on incre­mental units of income. For instance, if taxpayers are allowed to earn $40,000 with no tax but then face a 100 percent tax rate on every dollar above that amount, they are highly unlikely to choose to earn more than $40,000 because the marginal tax rate on those additional dollars would be confiscatory. This extreme example highlights the importance of marginal tax rates, which is why the top tax rates on personal income and corporate income are good measures of whether a nation has a competitive tax regime. It is also important to compare the degree to which nations impose extra layers of taxation on income that is saved and invested, since the effective marginal tax rate on that income will be higher if governments are allowed to tax it more than one time. (For a discussion of the argument that Europe­ans are choosing leisure over work, see Appendix 2.)

While the United States enjoys a substantial advantage over Europe with regard to the aggregate tax burden, the advantage shrinks  when one looks at marginal tax rates on personal income. The aver­age top tax rate in the European Union is nearly 50 percent, which is not that different from the 43 per­cent top tax rate (including the average of state income tax rates) in the United States. It is worth noting, though, that Americans can choose to live in states that do not impose income taxes, so the 35 percent federal tax rates is the mandatory maxi­mum, although the 2.9 percent Medicare payroll tax pushes the effective marginal tax rate higher.[43] Another interesting feature of the U.S. system is that the top tax rate is not imposed until income reaches more than $325,000. As Chart 13 illus­trates, the most punitive tax rates in Europe gener­ally are imposed once income reaches twice the average wage.

Irelandas a Role Model for Europe

By global standards, European nations enjoy comfortable living standards, but this is due largely to strong growth before the ex­pansion of the welfare state. Since then, economic perfor­mance has stagnated. Many of these nations now suffer from high unemployment and wide­spread pessimism about the fu­ture, but this does not mean that reform is hopeless. Even France and Germany, Europe's least competitive economies, could restore economic growth by im­plementing the right policies.

The role model that they should follow is Ireland. Twenty years ago, Ireland was an economic basket case with double-digit unemployment and an anemic economy. This weak performance was caused partly by an oner­ous tax burden. The top tax rate on personal income in 1984 was 65 percent, the capital gains taxes reached a maximum of 60 percent, and the corporate tax rate was 50 percent.[44] Then poli­cymakers decided to reduce the burden of gov­ernment. Tax rates, especially on capital gains and corporate income, were slashed dramati­cally.[45] Today, the personal income tax rate is 42 percent, the capital gains tax rate is just 20 per­cent, and the corporate income tax rate is only 12.5 percent.

Supply-side tax cuts were matched by deep reductions in the burden of government spend­ing. As explained in a recent European Central Bank study:

The so-called "Programme for National Recovery" rested essentially on a deep-rooted expenditure reform. Almost the entire fiscal adjustment during Phase 1 was placed on the spending side, with primary expenditure falling by 12% of GDP over the seven-year period after 1982. In the second phase, public spending fell again by over 10% of GDP. For the total period since 1982, spending even came down by over 20% of GDP to around 35% of GDP in recent years.[46]

These aggressive free-market reforms yielded enormous benefits. The Irish economy has expe­rienced the strongest growth of all industrialized nations, expanding at an average of 7.7 percent annually during the 1990s.[47] In a remarkably short period of time, the "sick man of Europe" has become the "Celtic Tiger." Unemployment has dropped dramatically, and investment has boomed.[48]

There is every reason to believe that other European nations would enjoy the same results if their politicians were to adopt similar reforms. The accompanying chart shows that free-market policies have led to a dramatic improvement in Irish living standards, whereas European nations that cling to statist policies are gradually losing ground to the United States.

The payroll tax is an area with a more significant American advantage. Payroll tax rates in the United States are 15.3 percent, and the rate falls to 2.9 per­cent as income climbs above $94,200. In Europe, by contrast, payroll tax rates average more than 30 percent, and those punitive tax rates are often imposed on all income-a policy that undermines the tenuous link between taxes paid and benefits received. (See Chart 14.)

The corporate income tax is one area in which America clearly is at a competitive disadvantage. As shown in Chart 15, the United States has an extraordinarily high corporate tax rate, particularly compared to the average 30 percent tax rate in Europe. The federal rate is 35 percent, and state tax rates (which generally cannot be avoided since states tax corporate income using formulas based on characteristics such as sales or assets) push the total tax rate closer to 40 percent. Moreover, the United States is one of the few nations that impose an additional layer of tax on companies that com­pete in global markets. As indicated in Chart 15, a handful of other nations impose "worldwide taxa­tion," but U.S. rules are the most onerous.

Like many other nations, the United States imposes double taxation on some forms of income. For instance, income from equity investment is rou­tinely subjected to extra layers of tax. Income is first taxed at the corporate level, as discussed above. If the after-tax income is invested in the company, the increase in the company's value is taxed by the capi­tal gains tax. If the after-tax income is distributed to shareholders, it is subject to the dividend tax. The good news is that Bush tax cuts reduced the double taxation of both dividends and capital gains to 15 percent. However, even with that much-needed reform, America still suffers from a competitive dis­advantage. (See Chart 16.)

Finally, the United States imposes a much smaller tax burden on con­sumption. European Union nations are required to levy a value-added tax (a comprehensive form of national sales tax) of at least 15 percent, and the average tax rate is 19.8 percent. The United States has no equivalent tax. Sales taxes exist in 45 states, but the rates average 5 percent, and these levies are usually imposed on a rather narrow base, leaving substantial shares of consumption untaxed. (See Chart 17.)

The Role of Other Policy Choices

Fiscal policy is one of many factors that affect economic performance. Trade, regulatory, monetary, environ­mental, and labor policies are just a few of the other factors that deter­mine competitiveness. As discussed, Europe suffers from slow growth, and most European nations have large public sectors. Could these fac­tors be unrelated? Is it possible that Europe's stagnation is the result of non-fiscal policy choices?

Certainly, fiscal policy is just one of the factors that determine economic performance, and some evidence sug­gests that some European nations are suffering from excessive government intervention. Yet the relevant question is whether non-fiscal policy mistakes are responsible for the gap between Europe and the United States. The answer almost surely is no. According to the Index of Economic Freedom, every EU country is at least somewhat market-ori­ented, earning a ranking of either "free" or "mostly free." If the fiscal policy variables are removed from the equation, one-third of the EU-15 nations actu­ally have more economic freedom than the United States.[49] (See Chart 18.)

The biggest non-fiscal policy impediment to European competitiveness is probably labor reg­ulation. Chart 19 shows that the burden of labor regulation is particularly severe in Europe. By contrast, European nations tend to be more laissez-faire in their approach to business regulation. (See Chart 19.)

Excessive regulation is partly responsible for Europe's anemic economic performance, but even the nations with relatively market-oriented regula­tory systems enjoy less prosperity than the United States. (For a discussion of the deficiencies of the "Scandinavian model," see Appendix 1.) High taxes and burdensome spending surely explain much of the gap between the United States and Europe. As the next section explains, big government and eco­nomic vibrancy are incompatible.

Learning from Europe's Decline

The United States can learn much from Europe. First and foremost, Europe serves as a warning about the consequences of big government. If American politicians allow the welfare state to expand, economic performance will suffer. Since demographic pressures and misguided policies have put America on a path toward much bigger government, this is a particularly timely warning. Simply stated, a French-size government will mean French-style stagnation.