COMMUNICATION FROM THE COMMISSION TO THE COUNCIL AND THE EUROPEAN PARLIAMENT THE CONTRIBUTION OF PUBLIC FINANCES TO GROWTH AND EMPLOYMENT: IMPROVING QUALITY AND SUSTAINABILITY

TABLE OF CONTENTS

Summary and main conclusions iii

1. Introduction

2. How do public finances affect growth and employment-

2.1 Overview of EU public finances at the start of the 21st entury

2.2 The impact of public finances on growth and employment

3. Maintaining sound public finances in stage 3 of EMU

3.1. New budgetary challenges are coming to the fore

3.2 The way ahead and the response by Member States

4. Towards more employment-friendly tax and benefit systems

4.1. The structure of tax/benefit systems in the EU

4.2 The way ahead and the response by Member States

5. Public finances for the knowledge-driven economy

5.1 Comparing the structure of the government spending

5.2 Physical capital (infrastructure)

5.3 Human capital investment

5.4 R&D and innovation

6. Long-term sustainability of public finances

6.1 Overview of the budgetary implications of ageing populations

6.2 The way forward and the response by Member States

Annex A: Reforms of tax systems

Annex B: reforms of benefits systems

Annex C: Reforms of health care systems

Annex D: Reform of public pension Systems

Summary and main conclusions

Background

The Lisbon European Council of 23-24 March 2000 requested the Council and the Commission to present a report to the Spring 2001 European Council assessing the contribution of public finances to growth and employment, and on the basis of comparable data and indicators, whether adequate concrete measures are being taken in order to:

* alleviate the tax pressure on labour and especially on the relatively unskilled and low-paid, improve the employment and training incentive effects of tax and benefit systems;

* redirect public expenditure towards increasing the relative importance of capital accumulation - both physical and human - and support research and development, innovation and information technologies;

* ensure the long-term sustainability of public finances, examining the different dimensions involved, including the impact of ageing populations, in the light of the report to be prepared by the High Level Working Party on Social Protection.

This report of the Commission and Council will help ensure that the variety of policy measures identified by the Lisbon European Council take full account of their public finance implications.

The ECOFIN Council examined a progress report [1] at their meeting of 7 November 2000, which they considered to be a good basis for the Commission-Council report to be presented to the Stockholm European Council,

[1] ECFIN 586-00-EN.rev1

How public finances affect growth and employment

Public expenditures and taxes account for between 40% and 50% of Member States' GDP. The assessment of the impact of public finances on growth and employment is not straightforward. Governments pursue many policy objectives (to improve resource allocation, redistribution, stabilisation) through a variety of policy instruments (regulation, spending, taxes), which inevitably means that the impact of public finances on the real economy is multiple and complex. Nonetheless, there is broad agreement on three main channels through which public finances can enhance potential growth and employment, as follows:

* the accumulation of productive factors. Governments contribute directly to growth and employment by enhancing factor accumulation. Investment in physical (infrastructures), human (education and training) and knowledge (R&D and innovation) capital, and, to a lesser extent, social spending, affect long run output and growth potential. However, if higher public investment is financed through a rise in distortionary taxes or if it increases deficits and consequently public debt, it may crowd-out private investment.

* providing the right incentives through tax and benefit systems. By influencing people's and businesses' decisions on work, saving and investment, tax and benefit systems affect the functioning of the real economy. Welfare systems play an important role in correcting market failures and ensuring social cohesion, and, via these channels contribute to growth and employment. Efficient social protection can be viewed as a 'productive' factor. However, it is necessary to ensure that tax and benefit systems are conducive to higher participation and employment rates.

* providing a stable macroeconomic climate. Sound public finances contribute to macroeconomic stability and support monetary policy in maintaining stable prices at low interest rates. Both effects are conducive to private investment and saving. Sound public finances, by reducing public debt and consequently the interest burden, creates room for a reduction in distortionary taxes and/or an increase in productive public spending. Finally, sound public finances will also enhance growth and employment in the long-term by helping countries cope with the substantial pressure to increase public expenditures, especially on pensions and health care as a result of ageing populations.

The challenge of maintaining sound public finances in EMU

Recent budgetary developments indicate that the EU is on the right track. The Stability and Growth Pact (SGP) goal of "close to balance or in surplus" is within reach and public debt is on a steady downward path. At the same time, reforms are being introduced to lower the tax burden from historically high levels. This is a considerable achievement bearing in mind that the deficit for the EU as a whole was at 6% of GDP only seven years ago.

However, the picture is not altogether favourable. Firstly, there is emerging evidence of a pro-cyclical loosening of the budgetary stance at a time when the output gap is turning positive in most Member States. The fact that the EU as a whole is forecast to still have a structural deficit in 2001 suggests that a relaxation of budgetary adjustment has occurred in some Member States compared with the 'real' adjustment effort implied by their stability and convergence programmes. Further consolidation may be required if Member States are to live up to the commitment of reaching the SGP goal ahead of schedule.

With the SGP goal within reach and a favourable economic environment, new budgetary priorities are coming to the fore. The report considers, on the basis of a number of criteria, whether recent tax reforms can achieve a sustainable reduction in the tax burden while maintaining the commitment to fiscal discipline. Although tax cuts are appropriate in most EU countries, there appears to be a need for matching reductions in government expenditure in order to avoid a deterioration in structural budget balances. In addition, the employment and growth effects of some tax reductions could be enhanced by framing them within a comprehensive package encompassing targeted measures to reduce distortionary taxes and appropriate reforms of benefit systems. The Commission invites Member States to examine the merits of the criteria for assessing tax cuts and scope for their implementation as part of the budgetary surveillance process at EU level.

Towards more employment-friendly tax and benefit systems

Tax reforms in recent years have focussed on the need to reduce the burden on labour, which increased by one-third in the past 30 years. Overall, progress has been made towards making tax systems more employment-friendly, lowering the fiscal burden on labour as well as reducing marginal tax rates. However, overall labour taxation in many Member States still remains very high by international standards. Furthermore, the reform effort has been unequal with a comprehensive approach to reform of the tax system in some countries contrasting with a piecemeal approach in others.

Many countries have taken steps to reduce taxes, notably employer's social security contributions, and more recently personal income taxes especially at the lower end of the earnings scale. Although most reforms provided for generalised reductions in taxes, some countries clearly targeted reductions at low-paid families with children.

Changes in net replacement rates have been relatively small, while only few Member States have developed in-work benefits to boost earnings of low-paid workers. The relationship between financial incentives and the willingness of the unemployed to search and take up jobs depends very much on the conditions attached for receiving benefits, as well as on the way in which benefit schemes are administered. There has been a tendency tighten benefit entitlement conditions, thereby supporting participation in active labour market programmes. However, these efforts in shifting the balance from passive to active labour market policies must be speeded up, reinforced and intensified.

Public finances for a knowledge-driven economy

Assessing the contribution of public finances to a knowledge-driven economy is timely given the ongoing debate on the "new economy". However, there are considerable difficulties making cross-country comparisons on public expenditures as there is a lack of data on both inputs by the public sector (i.e. a comparable functional classification of spending) or outputs (the efficiency and economic benefits of such expenditures). Aside from data limitations, comparisons should take account of differences in the incentive structure for private agents, tender procedures, public procurement, outsourcing, and finally taxes. Unfortunately, given the limited data available, it has only been possible to partly respond to the mandate of the Lisbon Council.

Greater efforts are needed to increase the investment necessary to facilitate the development of the information society Governments must also put more emphasis on education and training in order to equip European citizens with the necessary skills for an information society, while promoting the involvement of the private sector on innovation and R&D activities. Such efforts have to be made in a framework of sound fiscal policies with the increase in capital accumulation being financed through expenditure restructuring and not via an increase in overall public spending Furthermore, restructuring of public spending should be complemented by institutional and structural reforms that enhance the role of market mechanisms and introduce adequate incentive systems to promote private accumulation of physical and human capital.

The long-term sustainability of public finances

In the coming decades, the population of EU Member States will undergo substantial changes in size and age profile. Recent Eurostat population projections show that the EU working age population (aged between 20 and 64) will stay broadly stable at some 230 million persons until 2015, but thereafter fall to 192 million by 2050. At the same time, the numbers of elderly persons aged over 65 will rise from 61 million persons in 2000 to 103 million in 2050. This implies that the old age dependency ratio for the EU (defined as persons aged over 65 as a percentage of working age population) will rapidly increase from 27% in 2000 to 53% in 2050.

Ageing populations will lead to substantial pressure for increased spending on public pensions. Long-term projections provided by the Ageing Working Group of the Economic Policy Committee show that ageing populations could lead to increased pension expenditure of between 3 and 5 percentage points of GDP in most Member States. The projections show that the expected increase in public expenditure on pensions will be slower than the rise in the dependency ratio: this suggests that reforms in the 1990s have gone some way limiting the increase in spending on public pensions due to ageing populations. Available estimates point to increased spending on health care due to ageing populations in the order of 3 percentage points of GDP. Overall, ageing populations represents a major challenge to the sustainability of public finances, with the most acute challenge facing countries having a large stock of outstanding public debt and that finance pension systems on PAYG basis.

The scale of the phenomenon calls for a comprehensive approach to addressing the budgetary implications of ageing. Firstly, Member States should pursue fiscal consolidation and reduce public debt levels at a faster pace, thereby reducing the interest burden which could offset part of the spending rise due to ageing. Secondly, labour market reforms leading to an increase in employment rates would help offset the negative impact of demographic developments on the size of the labour force. As emphasised in the report of the High Level Working Party on Social Protection, particular attention must be paid to raising participation rates amongst women and older workers. Reforms are required to ensure that tax and benefit systems provide positive incentives to stay in the labour market, to reduce recourse to early retirement programmes, improve access to life-long learning, facilitate the reconciliation of professional life and family life for example via the provision of affordable child care facilities.

Finally, despite measures introduced in recent years, further reforms of public pension systems are needed. These should aim at promoting higher participation rates among older workers and women, ensuring greater actuarial fairness with a closer link between contribution and entitlements, and a better balance between the different pillars within the pension systems. In many Member States, funded pension provision will be expected to play a greater role. Policy responses should be decided well in advance of the increase in old-age dependency ratios, so that people can make the necessary adjustments to their old-age provision.

The EU can play a constructive role in helping Member States address the budgetary consequences of ageing populations. The Commission will support efforts to extend long-term expenditure projections which assess the impact of ageing population on health care spending and long-term care for the elderly. The Commission will also strive to ensure that the issue of long-term sustainability is fully incorporated into the Stability and Growth Pact framework, and Member States should ensure that this issue is comprehensively addressed in their stability and convergence programmes. Finally, the Commission will examine the possibility of establishing, in cooperation with Member States, a European Longitudinal Ageing Survey, with a view to assisting countries in the design of public policies that cater for the changing needs of an ageing population.

1. Introduction

The mandate

The Lisbon European Council requested the Council and the Commission to present a report to the Spring 2001 European Council assessing the contribution of public finances to growth and employment, and on the basis of comparable data and indicators, whether adequate concrete measures are being taken in order to:

* alleviate the tax pressure on labour and especially on the relatively unskilled and low-paid, improve the employment and training incentive effects of tax and benefit systems;

* redirect public expenditure towards increasing the relative importance of capital accumulation - both physical and human - and support research and development, innovation and information technologies;

* ensure the long-term sustainability of public finances, examining the different dimensions involved, including the impact of ageing populations, in the light of the report to be prepared by the High Level Working Party on Social Protection.

With a view to advancing work on the Commission-Council report, the ECOFIN Council of 7 November 2000 examined a progress report [2] prepared by the Commission services which draws upon the DG ECFIN report Public finances in EMU-2000 [3]. The ECOFIN Council concluded that the progress report provides a good basis for Commission-Council report to be presented to the Stockholm European Council in spring 2001.

[2] ECFIN/586/00-EN.rev1

[3] ECFIN/339/00-EN, May 2000, published in European Economy, Reports and Studies, No 3, 2000.

Aim of the Commission-Council report to the Stockholm European Council

A variety of Community instruments already contain recommendations on various aspects of public finances. Macroeconomic issues are dealt with in the framework of the Broad Economic Policy Guidelines (BEPG) and the Stability and Growth Pact (SGP). Structural aspects of tax and expenditure polices are dealt with in the BEPG, the Employment Guidelines (EG), and reforms in product and factor markets are assessed as part of the Cardiff process. The Commission-Council report focuses on the contribution of public finances in enhancing growth and employment, and thereby ensuring that they play a full role in achieving the EU's new strategic goal.

The Commission-Council report can help ensure that the variety of policy measures identified by the Lisbon European Council take full account of the public finance implications of policy initiatives to achieve the Lisbon objectives. It is imperative in the drive to reform tax and benefit systems, and to redirect public expenditures towards physical and human capital accumulation, that the commitment to sound and sustainable public finances is credibly adhered to at all times.

Outline of the Communication

Part 2, after presenting some stylised facts on public finances at the start of the twenty first century, reviews the complex interactions of public finance with economic growth and employment, and thus provides the analytical framework for the rest of the report.

Part 3 focuses on the need for sound public finances as a condition for growth and employment. It assesses the challenges which Member States face in sustaining the budgetary consolidation process in stage 3 of EMU. It considers whether recent measures can achieve a sustainable reduction in the overall tax burden, while at same time respecting the commitment to budgetary discipline.

Part 4 of the report assesses recent steps towards more employment-friendly tax and benefit systems, i.e. whether they improve incentives to work, save and invest. After examining the structure of tax/benefit systems in the EU, part 4 assesses the impact of recent reforms introduced by Member States especially on unskilled and low-paid workers.

Part 5 looks at the role of public finances in promoting a knowledge-driven economy. It contains detailed assessments on public investment in physical capital (infrastructure), human capital, R&D and innovation.

Part 6 looks at the long-term sustainability of public finances in light of the impact of ageing populations on pension and health care systems. It draws upon projections of the Economic Policy Committee (EPC) working group on ageing populations examined by the ECOFIN Council of 7 November 2000, and work of the High Level Working Party on Social Protection. It examines whether Member States are taking adequate measures in a variety of policy fields to address the budgetary implications of ageing populations.

2. How do public finances affect growth and employment-

2.1 Overview of EU public finances at the start of the 21st century

The scale of the Lisbon challenge

The Lisbon European Council of 23-24 March 2000, established a new strategic goal for the EU, namely "...to 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." In particular, the Council called for the EU to "... raise the employment rate from an average of 61% today to as close as possible to 70% by 2010". Essentially, the EU has to exploit fully its economic potential so as to achieve higher living standards benefiting its citizens.

The scale of the challenge can be seen by contrasting the evolution of GDP per capita in the EU and US. After a period of catching up from the 1950s until the early 1980s, EU GDP per capita (measured in purchasing power parities) fluctuated at around 70% of the US level until 1990 (see graph 2.1). However, throughout the 1990s, the gap in relative GDP per capita widened and GDP per capita in the EU today is only 65% that of the US, some 9 percentage points lower than the peak reached in the early 1980s.

Graph 2.1: GDP per capita in the EU relative to the US 1970-2002

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Source: Commission services

Such an evolution of relative living standards is explained by lower growth and poorer employment performance in the EU than in the US. Roughly speaking, the size of the EU economy in 2000 has doubled since the early seventies, whereas US GDP in 2000 is more than two and a half times its level in 1970. Yet, it should be borne in mind that such differences mainly arise in the 1990's and to some extent may reflect cyclical differentials. Even more striking than the difference in growth performance between the two economies is the gulf in job creation. Today, occupied population in the EU as a percentage of the population of working age is currently 15 percentage points lower than in the US, whereas in 1970 they were comparable on both sides of the Atlantic.

To reverse this relative decline, the EU needs to mobilise all available resources. The Lisbon European Council recognised that "achieving the new strategic goal will rely primarily on the private sector". However, with public expenditures and taxes accounting for between 40 to 50% of national income in EU Member States, public finances have a central role to play in realising this objective. Such a role is analysed in detail later in this part, after providing an assessment of the overall structure of public finances in the EU.

Overview of public finances in the EU Governments intervene in the economy for a variety of reasons - to supply public goods and to correct market failures, to redistribute income across regions and individuals, and to stabilise output over the economic cycle. For such purposes, they use a wide range of instruments notably regulation, taxation and public expenditures. By influencing private agents' decisions on work, saving and investment, public finances affect the functioning of the real economy. To identify the links with growth and employment, it is useful to review some of the key characteristics of EU public finances and economic performance at the start of the twenty first century.

An extraordinary increase in the size of the government expenditures has taken place over the past 30 years, and it now accounts for almost half of EU GDP (see graph 2.2). General government expenditures amounted to 35% of GDP in 1970, but rose continuously to peak at over 50% of GDP in 1993. Since then, total expenditures of general government have declined somewhat to about 46% of GDP in 2000. However, the size of the public sector in the EU remains 13 and 20 percentage points of GDP higher than the US and Japan respectively, where it grew by only 4 percentage points of GDP over the same period.

Graph 2.2. General government: expenditure, revenues and borrowing in the EU, 1970-2002

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Source: Commission services

The increase in the size of the public sector until the early 1990s occurred in parallel with the emergence of large and persistent deficits (illustrated by the shaded area in graph 2.2). Almost without exception, the average general government deficit in the EU as a whole was above 3% of GDP from 1975 onwards, attaining a historical high of 6% of GDP in 1993. This development contrasts with the US and Japan, where high and persistent budget deficits were much less frequent.

With budget positions on a clearly unsustainable path and with a view to prepare for EMU through respect of the Maastricht convergence criteria, policy makers enacted a strong budgetary adjustment from 1992-93 (see graph 2.3). The general government deficit for the EU as a whole fell by 5 percentage points of GDP between 1993 and 1999. Viewed at Member State level, some spectacular turnarounds in fiscal performance were achieved such that by the end of 1999 no EU country had an excessive deficit position, i.e. deficits are well below the 3% reference value set down in the Maastricht Treaty.

Graph 2.3. Budgetary imbalances in the EU 1977-2002

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Source: Commission services

High and persistent deficits led to rapidly increasing government debt. The ratio of government debt to GDP for the EU increased from less than 30% in the late 1970s to a peak of 72% in 1996 (see graph 2.3). Since then, the upward trend has been reversed. However, the stock of government debt is still too high at 64% of GDP in 2000, and remains above 100% of GDP in three Member States (B, EL and I).

A tendency to run pro-cyclical fiscal policies is another feature of budgetary behaviour over the past 30 years. Instead of reducing government deficits and debt ratios when economic growth was favourable, governments have tended to undertake a discretionary loosening of the budgetary stance (see shaded areas on graph 2.3 which represent periods in which economic activity was above trend). This necessitated budgetary tightening during downturns to prevent deficits and debt from spiralling out of control. Fiscal policies have thereby amplified the effects of cyclical swings in a pro-cyclical way rather than having the desired stabilising effect.

Apart from investment, every component of public spending rose over the last thirty years. In particular, interest payments as a share of GDP increased from less than 2% of GDP in 1970 to 4% in 2000. Conversely, during the same period, investment spending was halved, from 4% of GDP in 1970 to 2% in 2000 [4].

[4] The above figures refer only to general government expenditure. However, there is a wider circle of enterprises of public, mixed or private ownership which are in charge of the provision and/or management of network infrastructure (transport, energy, telecommunications, water supplies) and which may benefit from different degrees and forms of financial support from the general government, either for investments (e.g. grants for infrastructure construction) or for operation (e.g. public service compensation).

Graph 2.4. The structure of public spending in the EU, 1970-2002

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Source: Commission services

In parallel with such an evolution of total spending, the tax burden grew continuously over the past thirty years to a historical peak of some 46% of GDP in 1999. It is only projected to start falling as of 2000. In addition to this increase in the tax burden, a shift has taken place towards higher taxes on labour (see graph 2.4). The shares of social security contributions and direct taxes in total tax revenues increased by 3 percentage points each since 1970. Concomitantly, the share of indirect taxes in total tax receipts fell by 6 percentage points. Overall, the tax burden on labour accounts for the bulk of the increase in the total tax burden in most Member States.

Graph 2.5. The structure of government resources in the EU, 1970-2000

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Source: Commission services

2.2 The impact of public finances on growth and employment

These stylised facts might suggest that the rapid growth in size of the public sector, the changes in the composition of tax revenues and expenditures, and the persistence of large structural deficits leading to high levels of debt, all could have contributed to the EU's poor growth and employment performance in recent decades. However, the assessment of the impact of public finances on growth and employment is not straightforward. The reason is that governments pursue many policy objectives through a variety of policy instruments which inevitably means that the impact of public finances on the real economy is multiple and complex.

In addition, there is a large array of factors other than public finances which affect long-run growth and job creation. In particular, the functioning of product, capital and labour markets, and demographic developments also play a paramount role. The effects of public finances on growth and employment depend on the interplay between fiscal policies, the overall regulatory framework, as well as on private sector reactions to public actions. Moreover, where the impact of the size of spending on growth and employment is concerned, international comparisons may be misleading. Simple across-country correlations between growth and the size of the public sector lead to rather ambiguous conclusions, while activities efficiently carried out in a country by the public sector may belong to the private sphere in other countries.

Despite such complexities, there is ample evidence in the economic literature about the role of public finances in affecting growth and employment. Public finances can enhance potential growth and employment by (1) contributing to the accumulation of physical and human capital, (2) providing the right incentives through tax and benefit systems, and (3) ensuring a stable macroeconomic environment.

The accumulation of productive factors. Governments enhance factor accumulation directly by investing in physical (infrastructures), human (education and training) and knowledge (R&D and innovation) capital. Social spending also plays a role, in particular by supporting investment in human capital. Public investment can also have an indirect, positive impact on total factor accumulation if it complements private investment. For instance, the provision of efficient transport, energy and other infrastructures may enhance the productivity of private sector investment and attract further investment. This complementarity can be reinforced through private-public-partnerships, which improve the efficiency of public investment by introducing cost-benefit considerations and, at the same time, ensures that social returns are factored into private investment decisions.

A priori, public spending on capital accumulation has a positive effect on growth and employment. However, the potentially growth-enhancing effects of public investment can be offset by the reactions of private agents. What counts in the end for economic growth is not public accumulation of productive factors per se, but total (public and private) factor accumulation. An increase in public investment will have limited or even negative effects on growth if it crowds out private investment. These crowding-out effects can arise for several reasons:

* public provision of goods and services needs to be confined to areas where there is a clear-cut case for public sector involvement, and should not inhibit economic activity that can be more efficiently carried out by the private sector. In well-known cases, public involvement has gone hand in hand with the existence of laws foreclosing entry and with abusive use of exclusive rights, which have prevented and optimal participation of the private sector. Liberalisation and privatisation in recent years have transformed a number of sectors where public sector involvement was hitherto justified on the grounds of natural monopoly. Many of these newly liberalised product and service sectors are at the forefront of incorporating new technologies and the creation of high value-added jobs. However, the need for public intervention has not disappeared. In particular, through regulation, public authorities play a fundamental role in ensuring an efficient functioning of such markets by avoiding abuse of dominant positions.

* the contribution of public investment to growth and employment also depends on how it is financed. In the past, part of public spending has been financed through deficits leading to the accumulation of a large stock of public debt. This constitutes a relatively risk-free asset, and as such it reduces the attractiveness of more risky private investment. In addition, high debt levels put upward pressure on interest rates which, by increasing the cost of capital, further reduce the number of profitable private investment projects. Therefore, mounting debts can reduce overall capital accumulation and prevent the economy from incorporating new technologies at a pace necessary to sustain competitiveness and the creation of high productivity jobs.

* Furthermore, the benefits of public spending can be undermined if they are financed through distortionary taxes that discourage investment and employment creation (see below).

These considerations on the potential crowding-out effect of private investment underline the importance of increasing public accumulation by restructuring public expenditures, as recommended by the Lisbon European Council

Providing the right incentives through tax and benefit systems. By altering incentives to work, save and invest, tax and benefit systems affect private factor accumulation and consequently growth and employment. The social protection system makes a contribution to correcting market failures by providing insurance against unemployment and illness and cover for old age, thereby promoting a more efficient allocation of resources. Social protection also plays a redistribution role which, by reducing social conflict is also conducive to growth and employment. A well designed social protection and assistance system can raise economic efficiency. Programmes, such as, for instance, unemployment insurance or family allowances, as well as policies promoting social integration, can increase participation and labour supply, while enhancing the social acceptance of structural reforms.

However, these positive effects could be counterbalanced by a negative impact on the supply and demand for labour. For instance, unconditional generous unemployment insurance and long benefit duration, if not combined with job placement support and monitoring of availability to work, might lead to benefit dependency and unemployment traps at the lower end of the wage scale. Early retirement systems, while providing a safety net to older workers in bad times, prevent them from re-entering the labour market in good times or encourage them to quit the labour market prematurely. Overall, concrete experiences in Europe and abroad support the view that reforms of tax and benefit systems, including the way in which benefits are administered, can increase participation and employment rates.

As regards taxation, high labour taxes at the lower end of the wage scale, together with steep tax breaks and high withdrawal of income-tested benefits, are a source of poverty traps and lower human capital accumulation. Whereas a reduction of the total tax burden may have a positive impact on private investment, a larger impact can be achieved if tax cuts concern highly distorting taxes (see part 4 below). Targeted tax cuts at the lower end of the productivity scale would improve incentives for firms to demand unskilled labour.

The comprehensiveness of tax/benefit system reforms is another decisive element to improve long-term growth prospects. By taking a comprehensive approach to reform, Member States can create positive growth effects, and exploit the mutually supporting impact of consistent policy strategies acting in different fields. Comprehensive reforms which provide incentives for labour force participation and human capital formation can also enhance the innovative potential of the economy, promote entrepreneurial spirits and private sector led investment and innovation.

Providing a stable macroeconomic climate. Ensuring a macroeconomic framework conducive to growth and employment requires strong budgetary discipline. This is taken to mean budgets which achieve a broadly balanced position over the economic cycle, and low or steadily decreasing public debt. In the EU context, this means a debt ratio well below the 60% of GDP reference value.

Budgetary discipline impacts on growth and employment via a number of direct and indirect channels.

As regards direct channels, sound public finances by supporting monetary policy in maintaining stable prices, can result in lower interest rates. This could enhance private investment, leading to higher growth of the capital stock in the medium and long run. Secondly, the running down of public debt will lower the interest burden, providing room for reducing distortionary taxes and/or an increase in productive public spending: as described above, both actions can facilitate factor accumulation. A further direct channel is via aggregate saving, which is the sum of private and public saving. To the extent that increased public saving raises aggregate national saving, additional resources may become available for productive investment.

Budgetary discipline also indirectly affects growth and employment by contributing to macroeconomic stability. First, it may foster stable inflationary expectations, thereby reducing uncertainties and improving predictability for savers and investors to plan for the long run. Second, budgetary discipline ensures that governments can allow the automatic fiscal stabilisers to operate fully in the face of economic downturns thereby smoothing the business cycle. This capacity to cope with economic downturns is especially relevant in EMU, as budgetary policy may have a greater role to play in helping countries smoothen the business cycle given the loss of national monetary autonomy. Finally, achieving balanced public finances today will help countries cope with the long-term budgetary challenge posed by ageing populations. Lower levels of public debt will reduce the interest burden and thus partially offset increased public expenditures on pensions and health care A failure to place public finances on a sound financial footing to cope with ageing populations, may lead to unsustainably high tax rates in the future which will hamper growth and job creation.

3. Maintaining sound public finances in stage 3 of EMU

3.1. New budgetary challenges are coming to the fore

The previous section underlined the contribution which sound public finances can make to growth and employment directly (by freeing up resources for additional factor accumulation by both the public and private sector), and indirectly (by providing the stability conducive to savers and investors, and by being better able to cope with economic shocks). Meeting the targets of the Stability and Growth Pact (SGP) of budget positions which are "close to balance or in surplus" is an essential pre-condition in setting the framework for achieving the objectives of the Lisbon European Council.

Budgetary consolidation has continued in stage 3 of EMU within the framework of the SGP. Results for 2000 exceeded expectations with the general government deficit for the EU as a whole falling from 0.7% in 1999 to 0.1% of GDP. While these results are positive, the lowering of the deficit largely stemmed from increased revenues due the cyclical upturn rather than reduced spending. Budget deficits are expected to fall further in coming years, albeit slowly. The stability and convergence programmes provide for the actual deficit of the euro area to fall to almost balance for the EU by 2003. This implies that the medium-term goal of the SGP is within reach for all Member States.

Achieving and sustaining the SGP goal of budget positions which are close to balance or in surplus will result in the stock of public debt being run down at a fast pace. By reducing the interest burden, this would create room to cut taxes and could partially offset increased future spending on pensions and health care due to ageing populations. Moreover, a lower level of government debt would reduce the vulnerability of public finances to changes in interest rates. This will be especially important in the case of Member States with debt ratios above 100% of GDP. Several Member States have debt ratios still close to the 60% reference value, which are well above levels observed in the past.

As countries approach balanced budget positions, there may be greater scope for reducing the tax burden, a development that could make an important contribution to raising potential output and employment. This process is already under way. However, it is essential to get the right balance between cutting taxes, investing in public services and sustaining fiscal consolidation so as to achieve a durable reduction in the tax burden. It would be counterproductive to make tax cuts now, only to find that they are not sustainable over the cycle or in the long-run and have to be reversed during a future economic downturn.

Taking a longer-term perspective, Member States need to prepare for the economic and budgetary implications of ageing populations. As outlined in chapter 6, increased spending on public pensions and health care due to ageing populations poses a considerable long-term risk to the sustainability of public finances in many Member States. The concept of sustainable public finances is not limited to financing additional age-related spending without increasing deficits and public debt. It also encompasses the need for pension and health care systems to be conducive to high employment rates, the need for a lower tax burden in line with the Lisbon objectives, ensuring that other essential public expenditures are not squeezed out, and taking account of fairness both within and between generations. A comprehensive reform strategy is required to meet the budgetary impact of ageing, encompassing the running down of public debt, labour market reforms to raise employment, and reform of public pension systems. A window of opportunity exists to introduce further reforms prior to the retirement of the baby-boom generation after 2010.

3.2 The way ahead and the response by Member States

The 2000 Broad Economic Policy Guidelines recognise the short and medium-term fiscal policy challenges identified above, and in particular the need to introduce expenditure restructuring and reductions in the tax burden while enhancing budgetary consolidation. The remainder of this section examines whether Member States are on track to meet these commitments.

Achieving the SGP goal ahead of schedule

Member States are expected to improve on the targets for 2001 set down in the stability and convergence programmes. The autumn 2000 forecast shows a balanced budget for the EU for 2001, which compares with a deficit of 0.7% of GDP in the updated 1999/2000 stability and convergence programmes. However, one should not conclude from these forecasts that Member States have surpassed their SGP targets. In fact, when account is taken of the better than expected starting position in 1999 and the fact that growth will be higher in both 2000 and 2001 than was assumed in the programmes, Member States on average could be expected to surpass the SGP targets by 0.9% of GDP without having to make additional adjustment efforts.

On this basis, the autumn 2000 forecast suggest that a relaxation of budgetary adjustment has occurred in some Member States compared with the 'real' adjustment effort implied by their stability and convergence programmes. This implies that further consolidation may be required if Member States are to live up to the Broad Economic Policy Guideline of pursuing, where appropriate, further fiscal consolidation beyond the minimum requirements of the Stability and Growth Pact .

Are taxes being cut in a safe and sustainable manner-

In the 1999-2000 updates of the stability and convergence programmes, as well as in specific announcements in the context of the draft 2001 budgets, Member States have outlined further plans to reduce the overall tax burden and to reform their tax systems (see chapter 4).

The Commission services report on Public Finance in EMU - 2000 identified four criteria for assessing whether tax reforms can achieve a sustainable reduction in the tax burden while at same time maintaining the commitment to fiscal discipline. They are: (1) Member States must meet or make progress to the medium-term budget target of 'close-to-balance or in surplus'; (2) reforms should take into account the cyclical position and must not be pro-cyclical; (3) account must be taken of the level of government debt and long-term budget sustainability; and (4) tax reductions should form part of a comprehensive reform package. Meeting these criteria would help ensure that tax reforms have a sustained and positive impact on growth and employment.

The first criterion implies that uncompensated tax reductions only be envisaged in Member States that already meet the medium-term budget target of 'close-to-balance or in surplus'. When this target is not met, tax cuts need to be matched or indeed surpassed with expenditure reductions so that progress towards the SGP goal is maintained. While considerable progress has been made in complying with the close-to-balance rule, some countries still have some way to go. In particular, cyclically-adjusted deficits in 2001 are forecast to remain at or above 1% of GDP in six Member States (D, F, I, A, P, EL).

The second criterion underlines the importance of avoiding an unwarranted structural deterioration of the public finances, which would prevent the automatic stabilisers from dampening the effects of the cycle. This can be assessed by looking at the changes in the cyclically adjusted primary balance over the cycle. Between 2000 and 2001, the cyclically adjusted primary surplus is expected to fall from 3.5 % to 3.1% for the EU as a whole. This could point to a loosening of the budgetary stance at a time when the output gap is turning positive in most Member States.

To avoid such a pro-cyclical loosening, tax cuts may need to be matched with corresponding expenditure reductions. However, economic and budgetary situations vary across countries, and the scope, timing and speed of further adjustment will need to be tailored to national circumstances. Countries with structural deficits and high debt ratios may need to focus on fiscal consolidation. Other Member States may need to redress shortfalls in public sector investment. Countries need to determine what combination of investment in public services and tax reform will most effectively raise potential output and employment. It is essential to get the right balance, which takes proper account of the position of the economic cycle and the base from which the developments are taking place.

The third criterion requires that account be taken of the level of government debt and long-term budget sustainability. Clearly, Member States whose public debt remains close to or above 100% of GDP should give priority to its reduction before envisaging large scale tax cuts. However, even Member States with debt levels at or below the 60% reference value could consider a faster pace of debt reduction as part of an overall strategy to prepare for the increased costs of ageing populations. Assessing tax cuts in light of the budgetary implications of ageing populations is not straightforward. Available estimates (see chapter 6) show that with the exception of a few countries, ageing populations could result in significantly higher public expenditures. Credibility in the long-term sustainability of public finances will be undermined if the tax reforms already announced are not matched with an equal willingness to tackle structural imbalances in the financing of pensions and health care.

The fourth criterion calls for tax reforms to form part of a comprehensive reform package. Inter alia, this suggests that tax cuts be focussed on areas where they have beneficial supply side effects, and that they be complemented with reforms to benefit systems to improve incentives for employment and entrepreneurial activity.

Overall assessment

Recent budgetary developments clearly indicate that the EU is on the right track. The SGP goal of "close to balance or in surplus" is within reach and public debt is on a steady downward path. At the same time, reforms are being introduced to lower the tax burden from its historically high levels. However, further progress is required in some Member States to comply with the SGP "close-to-balance" objective, there is a risk of a pro-cyclical fiscal stance and public debt levels remain high. Overall, on the basis of four objective criteria, in Member States where tax cuts are most appropriate, there appears to be a need for them to be accompanied with reductions in government expenditure. Past experience has shown that for tax cuts to be permanent (and hence not having to reverse them when the economy slows down), they need to be accompanied with spending reforms that tackle head on the underlying reasons for the high tax burden. Having demonstrated a capacity to undertake fiscal consolidation in the run-up to EMU when the economic environment was less than favourable, Member States must now demonstrate their continuing willingness to pursue responsible fiscal behaviour during 'good' times.

4. Towards more employment-friendly tax and benefit systems

4.1. The structure of tax/benefit systems in the EU

How tax and benefit systems interact with the labour market

The search for policies to improve the functioning of the labour market and the current debate on the revision of welfare systems in Europe are interrelated. The common link is the impact of incentive effects of both tax and benefit systems on the behaviour of economic agents. Reducing the disincentive effects of tax and benefit systems is widely regarded by policy makers as being of paramount significance in tackling high structural unemployment. There is the need for a better balance between the equity goals and efficiency goals of tax/benefit systems. The former encompass the aim of providing, through tax-financed redistribution mechanisms, an adequate income to avoid the phenomena of the "working poor" and increasing income equality. The latter deal with the need to increase incentives to make work pay.

The impact of tax and benefit systems on labour supply comes through two main channels. A first channel is the benefit level relative to earnings: this affects the participation decision and can give rise to the so-called "unemployment trap". The second channel is the increase in disposable income (taking into account the combined effect of increased taxation and withdrawal of means-tested benefits) as earnings rise, and its impact on work effort or hours worked (the so-called "poverty trap").

On the supply-side, it is difficult to give a precise prediction as to the size or direction of the labour supply in response to tax changes. However, there is considerable evidence that tax changes are relevant for some groups of people, especially partners in couples where one spouse is not working (usually married women), lone-parent families, and low-skilled workers.

On the demand side, tax policies that increase labour costs to employers tend to reduce profitability and competitiveness, thereby reducing labour demand and employment. Furthermore, tax policies that reduce the prices of non-labour productive factors relative to labour tend to modify the relative factor intensities to the detriment of labour. This is particularly true in the case of low-skilled labour, for whom the degree of substitution by capital is higher than for skilled workers. This is why particular attention has to be paid to the degree of taxation on workers with low skills; this is the segment of labour market which is more likely to face the risk of "poverty" or "unemployment" traps when work does not pay and for which demand is more sensitive to cost.

Overview of tax and benefit systems

As measured by the implicit tax rates [5] on employed labour, the overall tax burden on labour in the EU has been steadily increasing over the last thirty years. In 1970, social security contributions and personal income taxes on labour income represented slightly less than 30% of total labour costs. Ten years later, in 1980, figure was 35% and reached a peak of at around 42% in 1996-97. Since then, the average tax burden on labour in the EU has been decreasing, and in 2002 is projected at 40% (graph 4.1). Almost three quarters of the burden arise from social security contributions (SSC) [6]. In the US, the tax burden on labour is about 25% and is equally divided between SSC and personal income taxes. Within the EU, the implicit tax rates are significantly above average in S, B, DK, D and F, whereas low rates are recorded in IRL and the UK.

[5] The implicit tax rate is the ratio between taxes on employed labour (personal income taxes on labour income and social security contributions) and total labour costs.

[6] In Europe, social security contributions are mainly determined by insurance principles, since they give rise to individual insurance or benefit entitlements. In some industrial countries, such as the US, social insurance is partially financed on private grounds.

Graph 4.1. Implicit tax rates on employed labour in the EU and the US, 1980-2002

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Source: Commission services

The tax burden on low-paid labour, an important factor in determining low-skilled unemployment, is also substantially higher in the EU than in the US (see table 4.1). Only in IRL, L, and the UK are the average tax rates on low and middle wages similar to or lower than those in the US. In A, B, DK, D, FIN, F, I and S, social security contributions and personal income taxes represent 40% or more of the cost of a single worker with no children earning 67% of the average wage. The bulk of such a high tax burden on low-paid labour arises from social security contributions, while the share of personal income taxes is relatively minor.

Table 4.1. The tax burden on low and middle wages

(Income tax plus social security contributions in 1999 as % of labour costs)

>TABLE POSITION>

From the perspective of incentives to increase labour supply and especially to assess the risks of "poverty traps", marginal tax rates [7] are more relevant than average rates. Over the period 1997-99, most Member States (D, L and S excluded) succeeded in lowering marginal tax rates on low and medium earnings. This reduction was greatest in E, IRL, and NL. Nonetheless, marginal rates remain high, ranging from 40% to 50% and are even higher in B, D, DK, FIN, NL. However, in a majority of Member States the marginal tax rate is lower than in the US.

[7] The OECD calculates the marginal tax rate as the additional personal income tax and employee social security contributions paid when gross wage earnings rise. This is a combined (explicit and implicit) marginal rate in that it takes into account the withdrawal of income-tested family allowances and tax credits. For details on this and other issues discussed in this chapter, see the note to the EPC on "Reforms in tax benefit systems in order to create employment incentives", ECFIN/0590/00-EN.

The distortionary effects of taxes very much depend on their interplay with benefit systems. Many countries means-test family allowances and other benefits. Thus, as income rises, benefits are phased out and this is equivalent to an additional tax that can raise the marginal rate to very high levels, thereby discouraging any extra work-effort.

As far as total government spending on social protection is concerned, it has diminished as a percentage of GDP in most Member States since 1993, predominantly via the share of benefits which are directed to working-age population. Such a fall can be attributed to a number of factors, including normal cyclical evolution of economic growth and unemployment developments, and benefit reforms to a lesser extent.

Table 4.2. Social transfers in the EU, 1993-1997 (% GDP)

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In 1997, total transfers were some 19% of GDP in the EU as a whole. Only in the lower income countries (EL, E, IRL, P) was the share of total transfers in GDP considerably lower than the average (table 4.2). Overall, one quarter of social transfers goes to working-age people in the form of disability, unemployment and social assistance. Of the three items, the latter is relatively marginal. Unemployment benefits accounted for more than 3% of GDP in B, DK, the NL, and FIN. Disability benefits above 3% of GDP are only found in the NL and FIN.

The level and duration of unemployment benefits in relation to earnings are important in determining the take-up of jobs to the extent that job seekers have some choice. Net replacement rates [8] for low-paid workers are relatively high in several countries (see table 4.3) and this may lead to unemployment traps [9]. In the case of families with children, the out-of-work income in the first month of unemployment is 80% or more of in-work income in eight countries (DK, FIN, NL, S, L, P, F and UK). The net replacement rate after five years out of work remains close to that of the first month. In some countries (FIN, NL, S, L, UK and I), it is even higher than in the first month, and only in EL (and F) is it markedly lower. For single earners, the net replacement rates are somewhat lower than for families with children, and they fall more rapidly if they stay unemployed.

[8] Net replacement rates describe the relationship between out-of-work and in-work income, taking into account the impact of means-tested benefits and taxes paid in both situations. It is defined as a ratio of disposable income based on social benefits when out of work and disposable income earned from work.

[9] It should be borne in mind that work-related costs (viz. transportation and child care) and other factors, not included in replacement rates, also reduce the take-home pay and further reduce the attractiveness of taking up employment.

Economic incentives to take up low-paid or part-time jobs are rather low in most countries. In 1997, the amount of incremental earnings which were "taxed away" when the unemployed person moved from being unemployed and in receipt of benefits to part-time employment (a 40% work effort) was very high in most countries: over 100% in half of countries (L, P, A, FIN, D, B, EL) and 80-90% in the rest of the countries (except in France: 70%). In addition, the effects that tax and benefits have on household income vary in function of family characteristics. In most countries, the incentives for the second earner to take up a job are higher when the principal earner works compared with when he/she is on unemployment benefits. Yet, even when the principal earner works, around 50% of the income increase is taxed away in B, DK and D.

Table 4.3. Net replacement rates of the employed at low (67% of APW) wage level, 1997

>TABLE POSITION>

4.2 The way ahead and the response by Member States

Community recommendations

The unemployment problem has been high on the EU political agenda ever since the Commission's White paper on growth, competitiveness and employment of 1993. The BEPG since 1998 have invited Member States to (i) review and adapt tax and benefit systems to ensure that they actively support employability and job creation, and (ii) reduce the overall tax burden and especially the tax burden on low-paid labour, within continued fiscal consolidation, i.e. via reduced spending or shifts to environmental, energy or consumption taxes. These recommendations have also been included in the Employment Guidelines since 1998, in particular in guidelines 4 and 14. Also the Communication on a concerted strategy for modernising social protection calls for reforms to "make work pay".

Such policy recommendations have been deemed necessary on the ground:

* The financing of increased public expenditure, including social security systems, has contributed to an excessive tax burden, particularly on labour, and, therefore, to lower growth and employment;

* the considerably lower tax and social contribution burdens in other countries, such as the US (which mirrors a lower public expenditures in percentage of GDP and higher private expenditure on social security);

* similar fiscal changes under way in other countries, which have triggered fiscal competition inside and outside the EU;

* the diversion of labour demand and supply to the informal economy, for instance, in order to evade high pressure resulting from taxes and high social security contributions;

* the growing awareness that tax/benefit systems in the EU appear to lower the work incentives faced by people with low earning potential.

This last factor, in particular, and the wide acknowledgement of the need to "make work pay" explain why one feature of many of the reforms has been (and should continue to be in the future) the reduction of taxation on labour, especially on low-skilled workers. There is also a growing perception that, at least in the near future, tax reforms should be more focused on enhancing labour supply responses, given the need for a substantial increase in the participation and employment rates in view of the ageing population. With a view to avoiding undue distortions in product markets and, particularly, in the functioning of the Internal Market, such reforms must be implemented in accordance with Community regulations on state aids.

Lowering the tax burden on both capital and labour is expected to enhance physical and human capital accumulation, increase participation and boost the demand for labour. General reductions of personal income taxes may contribute to wage moderation by reducing the tax wedge on labour. Moreover, in a number of Member States, reforms aiming at reducing the degree of progressivity of income taxes may enhance incentives to participate in the labour market at the top end of the household earnings scale . This could particularly impact on high-skilled second earners, most of whom are women. In addition, cuts targeted at the lower end of the wage scale will mitigate risks of unemployment and poverty traps. They will have a positive effect on the demand for low-productivity workers, as long as tax reductions are effectively passed on to firms. Also, the lowering of taxes on labour will contribute to making work pay by increasing the after-tax take-home pay.

To illustrate the potential effects of various tax and benefits reforms on the economy, the report Public finances in EMU - 2000 presented a number of simulations for the EU using the Commission services' QUEST model. These simulations are summarised in box 1. All in all, tax cuts can have sizeable effects on output, investment and employment. However, in order to ensure their durability, the need to be accompanied by offsetting spending reforms. It is also important to conduct tax reductions within the framework of comprehensive economic reforms so as to enhance the beneficial effects of shifting the tax burden away from labour to other tax bases.

Simulated long-run effects of tax reforms on GDP, employment and investment.

According to analysis presented in Public Finances in EMU -2000, the effects of tax cuts depend on whether or not they are accompanied by spending retrenchment (see table 4.4). A tax cut, fully offset by a reduction in government consumption, is likely to have a positive economic impact in the longer run. Depending on the type of tax reform a reduction of taxes in the order of magnitude of 1% of GDP, could increase GDP between 0.5 and 0.8% after 10 years. Employment could be higher between 0.5 and 1% and investment would be stimulated. The economic expansion would also lead to a reduction of government deficits of roughly 0.5% of GDP after 10 years. A tax cut, without offsetting spending cuts, would however lead to an increase in the budget deficit of around 0.75% of GDP. That means that the degree to which tax reforms are self financing is only about one quarter.

The impact on employment would be larger if the tax cut is targeted on labour. The long-run effects on employment of a reduction by 1% of GDP in the tax burden on labour income offset by a reduction in government consumption, amount to 1% (1.5 million jobs). This contrasts with the 0.5% increase obtained for general tax cuts. That result must, however, be interpreted with caution, as it depends strongly on the assumed benefit rule. Overall, employment effects are larger if the reservation wage is constant in real terms than if unemployment benefits are linked to net wages. In the first case, the tax cut is partially passed onto firms and in the form of lower wage costs. As a result, employment increases without lowering net wages.

Another strategy to reduce taxation on labour, in line with the Employment Guidelines, is a tax shift from labour income to indirect taxes, such as taxes on consumption, energy and polluting activities [10]. Consumption taxes are less distortionary than labour income taxes because they fall on all production factors and not only on labour. In the case of a consumption tax on environmentally damaging goods, the tax will help reduce an existing distortion. The positive effects are not however straightforward since the impact of a tax shift from labour income to consumption depends very much on the benefit system and especially on the accompanying policies towards recipients of social transfers and unemployment benefits. All in all, the key issue is whether the tax shift is passed onto firms and results in a lowering of gross wages. This, in turn, depends on whether benefits change to compensate the impact of value added taxes on consumer prices. A reduction of labour taxes by 1% of GDP, coupled with an increase in value added taxes, would increase employment by almost 0.7% in the long run if transfer recipients are not compensated for their income loss. However, if transfer recipients were fully compensated for the increase in value added taxes, the employment effect would be half that figure.

[10] Tax shifts away from labour towards energy are sometimes expected to generate a "double dividend"

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The main features of tax reforms in Member States

In the updates of the stability and convergence programmes, in the national action plans for employment, as well as in more recent announcements in the context of the budget plans for 2001, Member States have indicated their intention to reduce the overall tax burden and to reform their tax systems. These proposals together with a number of reforms already applied during the last three years are summarised in annex A. While reforms vary in coverage and depth, most Member States are reducing the total tax burden mainly by cutting direct taxation on personal and corporate income. Nevertheless, several countries have reduced SSC in recent years.

Annex A suggests that there is a common direction in EU tax policies towards lowering the tax burden on labour. Most Member States have already implemented and others have just announced personal-income-tax-cutting initiatives (reduction in marginal rates, increase in both family allowances and minimum exempted income) and reductions in both employers' and employees' social security contributions. Some of the initiatives are clearly across-the-board tax cutting measures (D, ES, F, I, NL). Many consist of lowering marginal tax rates at the top and the bottom of the income scale, (D, IRL), or sometimes on all the income brackets (NL, F, L, ES, ES, FIN, S, I). Reforms also provide higher family allowances and higher thresholds for income tax (UK, I, ES) so that fewer wage earners pay tax. In some cases (UK, NL), family allowances have been transformed into tax credits. In other Member States, tax-cutting measures appear to be more targeted at reducing fiscal pressure at the low-to-middle end of the income distribution (B, , DK, EL, A, IRL, and UK).

Cuts in social security contributions are targeted more at employers than at employees in most Member States (B, EL, ES, F, IRL, I, NL, FIN). Some Member States are granting tax rebates to employers for providing new jobs (I, P, EL), or more specifically for recruiting young workers (B), long-term unemployed or low-paid workers (FIN, NL, S). In the UK, subsidies are granted to the employers when they recruit young formerly unemployed workers.

Reforms of personal income taxes are also reducing the burden on capital, albeit to a lesser extent than that on labour, because personal income taxes are also paid on capital income. In addition, measures implemented by many Member States also concern corporate income. In a majority of Member States, the reduction of capital taxes is carried through a lowering of corporate taxation and taxes on capital gains [11]. In other countries, the reforms are more limited and aim at improving the functioning of capital markets and at creating incentives for risk, venture and intangible capital.

[11] However, it is worth mentioning that FIN has increased corporate income taxes this year.

Under the growing pressure of the liberalisation of goods, services and capital markets, Member States are facing increasing tax competition. Although improving the functioning of capital markets seems to be a major aim of reforms, tax competition may also have been a driving force for lower taxes on capital. In the absence of tax co-ordination at the EU level, the constraints stemming from tax competition may remain a medium-term obstacle to targeting tax reforms in the Member States at those areas where reforms would be most beneficial for growth and employment. The adoption of the fiscal package proposed for saving and business taxation, will help broaden the tax base and enable future reductions in tax rates.

As regards indirect taxes, measures announced to date have been rather scattered. Leaving aside I and NL, where general increases in VAT rates have been announced, changes in indirect taxes in other Member States only affect a small share of the total taxes base (e.g. lowering VAT on certain labour-intensive sectors). Therefore, the tax-shifting away from labour to other tax bases such as consumption has been very limited.

The main features of benefit reforms in Member States

The most recent reforms of benefit schemes are presented in annex B. Reforms of unemployment benefit schemes have mainly involved the control of eligibility requirements and the improvement of the way benefit schemes are administered. No country has recently carried reduced benefit levels or duration (DK is an exception where the duration still remains one of the longest). There has been some tendency to increase in-work or employment related benefits, such as targeted wage subsidies, tax credits, and/or benefit transfers to the employer recruiting an unemployed person. These reforms seem to provide support to active labour market programmes. However, they have been undertaken mainly by giving additional benefits if the unemployed decide to take up a job or labour market training. Measures include enabling workers to keep unemployment benefits during training, back-to-work schemes and transferring benefits, or providing other wage subsidies to the employer when an unemployed person has been recruited (B, D, E, NL, P, FIN, S, UK). Some countries (B, P, A, FIN), have also made efforts to encourage part-time work instead of unemployment, mostly by means of loosening conditions for part-time unemployment benefits.

Even though there is some tendency to increase the use of in-work and employment-related benefits (B, F, IRL, UK), the shift from passive to active measures has been limited. Passive benefits remain important and particularly the introduction of in-work benefits on a larger scale has not taken place. Moreover, many reforms, especially in favour of young and long-term unemployed, seem to provide only temporary help in terms of better incentives for work. It remains to be seen whether this is sufficient to keep these people in permanent employment, or at least significantly beyond the period when the extra bonuses are paid.

After a long period when early retirement was the norm, most Member States (B, DK, D, F, I, NL, A, FIN, S, UK) have been determined in reforming schemes so as to induce older workers to prolong their working life. Among the means used for this purpose are also the tightening of eligibility rules and making early retirement less attractive (B, DK, F, I).

When interpreting the changes described in annex B, one has to keep in mind that the starting positions of countries and reforms less closely related to the functioning of the labour market, have not been considered in the table. Therefore, very firm conclusions on reform efforts are not possible. In addition, the implementation of a comprehensive reform strategy takes a long time and results can be seen only after a number of years. The experiences of some Member States (e.g. DK, NL) show that unemployment can be significantly reduced by pursuing long-term reform strategies.

Overall assessment

All in all, the tax reforms implemented in the past three years represent a move in the right direction. Many Member States have made progress in rendering the tax system more employment friendly, by lowering the fiscal burden on labour as well as by reducing marginal tax rates. However, overall taxation on labour still remains very high by international standards in many Member States. Furthermore, the reform effort has been unequal across Member States. Some countries have undertaken a more comprehensive approach while in others the reforms of the tax system have been piecemeal.

As shown in graph 4.2, already implemented or planned tax reforms are lowering the tax burden on labour in most Member States. On the basis of Autumn 2000 Commission Forecast, the implicit tax rates on employed labour are expected to fall by more than 1 percentage point in the EU as a whole as well as in the euro area. Quite large reductions are projected for D, IRL, L and NL [12]. The reforms introduced or announced to date mainly concern direct taxes, which typically have large distortionary effects.

[12] Changes shown in the graph should be interpreted with care, since they may not only reflect structural changes in the tax burden on labour, which will be due to tax reforms, but also cyclical developments independent of such reforms.

Graph 4.2. Changes in implicit tax rates on employed labour, 1998-2002 (pps)

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Source: Commission services

Where the tax burden on low-paid labour is concerned, early effects of the reforms can be observed in the evolution of the tax burden on low-paid labour between 1997 and 1999 (graph 4.3). Except in B, and the NL, where taxes on average and low wages slightly increased, the tax burden was reduced across the EU. Especially significant are the reductions observed in IRL, I and E. Further reductions directed at the low end of the wage scale are expected as a result of more recent tax cutting measures, especially in France, Germany, Italy and the Netherlands. All in all, it is still fair to say that, in most countries, the tax reductions on labour have been more general than targeted.

As regards benefit systems, efforts to improve work incentives have focused more on benefit eligibility than on net replacement rates, where changes have been relatively small, without any clear pattern of targeting. In most countries, unemployed people still face few economic incentives to take up job at low wage levels. There has been some tendency to increase employment-related benefits, thereby supporting active labour market programmes. As shown in the Joint Employment Report, there has been a growing emphasis on active labour market policies, but these efforts in shifting the balance from passive policies must be speeded up, reinforced and intensified.

Graph 4.3. Changes in average tax rates on low wages, 1997-1999

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Source: OECD, Taxing wages 1998-1999

5. Public finances for the knowledge-driven economy

5.1 Comparing the structure of the government spending

Considerable differences in the structure of public spending across Member States

Public expenditures account for between 40% and 50% of Member States' GDP. The total share of government expenditure in GDP varies considerably across Member States. It ranges from some 50% of GDP in B, DK, F, A, and S, compared with less than 40% of GDP in IRL and the UK. However, at 31% of GDP, the size of the public sector in the US is much lower than in any Member State.

In most Member States, government consumption represents almost half of total government expenditures, while social transfers account for around a quarter (see graph 5.1). Significant differences are recorded across countries as regards the respective shares of public investment and interest payments. The share of public investment in total spending is highest in EL, E, IRL, P and L. Regarding interest paid on debt, the share in total government spending is comparatively high in B, I and EL.

Graph 5.1 The structure of government spending, 2000

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Source: Commission services

Almost every component of government spending in GDP increased in size between 1970 and 2000 (see graph 5.2), except public investment. In many countries, interest payments and social transfers account for almost half of the total increase in government expenditure observed between 1970 and 2000.

Graph 5.2. Changes in the components of government spending, 1970-2000 (% of GDP)

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Source: Commission services

The difficulties in comparing public expenditures across Member States

The Lisbon European Council focussed on those public expenditure that make the most direct contribution to growth and employment, in particular those which support the strategic goal of moving towards a knowledge-driven economy. The European Council called for an assessment, on the basis of comparable data and indicators, whether adequate concrete measures are being taken in order to redirect public expenditure towards increasing the relative importance of capital accumulation - both physical and human - and support research and development, innovation and information technologies.

To this end, the remainder of his chapter examines Member States' efforts to redirect public expenditure towards capital accumulation, both physical and human, and to support research and development, innovation and information technologies. Such an examination is timely given the ongoing debate on the so-called "new" economy.

However, there are considerable difficulties making cross-country comparisons and caution needs to exercised when interpreting data. Unlike other chapters in this Communication, there is a severe lack of timely data on both inputs by the public sector (i.e. a comparable functional classification of spending) and output (the efficiency and economic benefits of such expenditures). It has also proved difficult to obtain detailed information on recent measures being taken Member States'. Consequently, it is not feasible at this stage for the Commission to fully respond to the request of the Lisbon Council, and further work will be required in the future.

Comparisons of public spending should also take account of institutional differences across countries, including the distribution of total factor accumulation between public and private sectors. In the end, what counts for growth is total rather than public capital accumulation taken in isolation. As regards fostering the "new" economy, providing a proper incentive structure for private agents is at least as important as direct public sector intervention [13]. In this respect public spending in the form of state aids needs to be carefully controlled to ensure that it does not delay necessary restructuring or protect enterprises from the effects of market developments. Account also needs to be taken of differences across Member States in tender procedures, public procurement, outsourcing, and taxes. Unfortunately, the data available does not allow for a thorough assessment of such factors.

[13] This seems to be particularly relevant where investment in fixed telecom infrastructure is concerned. Such an infrastructure is financed either fully by private operators or by enterprises in which the state retains partial ownership but whose investment is classified as private not public. In particular, all investment in mobile infrastructure is private investment. In addition, mobile operators for 3rd generation mobile licences have been a source of public revenues.

Notwithstanding these limitations, greater efforts are needed to increase the investment necessary to facilitate the development of the information society. Governments must also put more emphasis on education and training in order to equip European citizens with the necessary skills for an information society, while promoting the involvement of the private sector on innovation and R&D activities.

Such efforts have to be made in a framework of sound fiscal policies so as to keep the tax burden on a decreasing path and to enable countries prepare for ageing populations. To meet the objectives of the Lisbon European Council, efforts to enhance capital accumulation must come through expenditure restructuring, and not an increase in overall expenditure. Furthermore, restructuring of public spending should be complemented by institutional and structural reforms in order to optimise government spending, enhance the role of market mechanisms and introduce adequate incentive systems to promote private accumulation of physical and human capital. To some extent, higher rates of technical progress in the US are due to more research and development efforts undertaken by US companies. It needs to be assessed whether tax systems in the EU are sufficiently conducive to investment in intangible capital, such that Europe can compete with the US in the high tech sector.

It is through a balanced combination of spending restructuring, tax policies, and structural reforms that the EU can meet the challenge brought about by the new economic, technological and institutional setting.

5.2 Physical capital (infrastructure)

Despite the large increase in total public spending over the last 40 years, government investment as a share of GDP dropped from above 4% in the 1960's and early 1970's to below 2% in the late 1990s. In 2000, it is expected to reach a minimum of 1.8% of GDP in 2000. Commission forecasts projected the share of public investment in GDP to be around 2½% by 2002.

Aggregate figures for the EU conceal some important differences across Member States. Over the past thirty years, public investment increased significantly in L, P and EL, while it recorded relatively large falls in B, D, A, DK, S and the UK. This contrasts with the US, where the share has remained stable, and at 3% of GDP continues to be higher than the EU average (graph 5.3). In E, F, L, NL, P and EL, public investment as a share of GDP is comparable to or higher than in the US, while in B, D, A, DK and especially the UK, public investment represents less than 2% of GDP.

Graph 5.3. The share of public investment in GDP, 2000.

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Source: Commission services

On the basis of Commission forecasts, changes in public investment levels between 1999 and 2002 are expected to be limited (graph 5.4). L is a remarkable exception. Other notable increases are projected for the UK, and in the three catching-up countries, P, EL and E (to levels close to 4% of GDP). Reductions, albeit smaller in scale, are projected for A, D and B to what are relatively low levels of public investment. Falls in the share of public investment in GDP are also expected in FIN, S and IRL, but they will remain higher than the EU average.

Graph 5.4. Expected changes in public investment 1999-2002

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However, these changes in public investment should be interpreted with caution. An increasing bias in the recording of government investment might exist as a consequence of new, more market-oriented approaches to government investment decisions. These approaches have been initiated in the search for greater efficiency and value for money. They have led to an increased use of market mechanisms in public activities, the privatisation of commercially viable operations and a more direct involvement of the private sector in the production and provision of public services.

Governments have made efforts to increase efficiency and management control by introducing market mechanisms in their operations. Methods used can be internal pricing, budgetary targeting and market price oriented fees. These methods are employed not only in public enterprises, but also in the running of government agencies in general. A more market-oriented approach can also be seen in the way large infrastructure projects are sometimes managed via enterprises partially or totally government owned and operating on a commercial basis.

Additional efficiency gains could be achieved by effectively implementing Community rules on public procurement, leading to a EU-wide and competitive public procurement markets. Although countries are coming under increased pressure to liberalise public procurement markets, the currently low levels of intra-EU cross-border transactions in such markets suggest that much effort is needed in this area. Although the figure has followed a positive path during the 1990's, public procurement published in the Official Journal as percentage of GDP is below 2% [14]. A fully effective opening-up of such markets would help optimise public spending on infrastructure.

[14] The figure is well below the actual size public procurement markets, which encompasses not only public investment but also the bulk of public current consumption.

An important element to be taken into account when assessing National Accounts figures on public investment is the increasing number of "Public-Private Partnerships" (PPP). PPPs are institutional arrangements to contract out the production of public services. They allow governments to focus more on the quality aspects of the provided service. The accounting effect of this approach is to reduce the frontload direct public investment because investments that hitherto would have been recorded in government accounts are now instead borne by buying services provided by the private corporate sector. When the government purchases the service, they are recorded as current expenditure, so that consecutive purchase of services over a number of years are a substitute for a front-loaded government investment expenditure.

Finally, when assessing and comparing developments in public spending, it should be borne in mind that increasing public investment in infrastructure may not always be growth enhancing, since infrastructure stock may be subject to the law of diminishing returns. In the richest economies, many of the basic investment needs in traditional government areas have been completed, and additional increases might be wasteful [15]. This means that the sectoral and functional composition of public investment is an important factor to be considered. Unfortunately, the information in this field is almost non-existent, and where available is scattered and difficult to compare. Further efforts are needed to assess to what extent Member States are ready to face future pressure on public investment arising from:

[15] However, obsolescence and the need to maintain operational the existing stock of infrastructure are likely to call for sustain public investment. In addition, economic growth by itself may require additional investment even in the richest countries in order to avoid bottlenecks, which may limit its progression.

* the widespread introduction of information technologies that will oblige networks to be upgraded;

* the integration of environmental considerations. Infrastructure will have to adapt to new requirements and especially to consume less energy so as to reach Kyoto objectives: this will require more investments in mode of transport others than roads and aviation.

* enlargement, and the need to reinforce the East-West and North-South dimensions of networks.

5.3 Human capital investment

Despite being classified as current spending, education represents a direct contribution of public finances to the accumulation of human capital. Raising investment in human resources is also crucial to help in the smooth transition towards the knowledge-based economy and society. Indeed, the Employment Guidelines have made the development of human resources a priority issue seeking to extend education and training access to all and promote comprehensive lifelong learning strategies. The Lisbon European Council set clear objectives for increasing the annual per capita investment in human resources and Member States are invited to set national targets.

A detailed diagnosis of public accumulation of human capital should be done on the basis of a functional distribution of public spending, which as stressed above is not readily available.

In the EU, education has been traditionally funded by governments. Public resources allocated to all levels of education represented on average 5% of EU GDP in 1997 (table 5.1). While total public expenditure on education as a percentage of GDP tends to remain fairly stable within Member States over the period [16], the data show some significant variations across Member States. In 1997, the range is defined by DK and S at the top end and EL at the bottom. FIN and A are also significantly above the average. The remaining Member States do not differ significantly from the EU average, especially if one excludes pre-primary education.

[16] The total figures for 1997 are not completely comparable to previous years because GDP figures for 1997 are compiled according to ESA95. In addition, OECD figures indicate that spending as a share of GDP has increased between 1990 and 1996.

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Table 5.1. Public expenditure on education (% of GDP)*

Regarding the different levels of education, public expenditure in the EU during 1997 on primary education and tertiary education each amounted to approximately 1% of GDP, while spending secondary education amounted to 2.5% of GDP: as shown in table 5.1, there are large variations across Member States.

Governments must put more emphasis on education and training in order to equip European citizens with the necessary knowledge, skills, and competence, for them to be able to adapt to the rapidly changing patterns of living, learning and working environment. Several initiatives undertaken towards this direction include the Employment guidelines, the Memorandum on Lifelong Learning, the Community action programmes Leonardo and Socrates, Strategies for jobs in the information society. The Employment Guidelines (13, 14 and 16) invite Member States to set targets regarding increased per capita investment in human resources.

The Commission has undertaken one step in this direction by launching the eEurope initiative in 1999 and the eLearning initiative in 2000. Member States have decided to work together to harmonise their policies in the field of educational technology and share their experience. eLearning aims to support and coordinate their efforts and to accelerate the adaptation of education and training systems in Europe.

Graph 5.5: Employment rates (%) by educational attainment in 1995 (30-59 year olds)

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Source : Labour Force Survey, Eurostat.

Figures on educational attainment reveal the magnitude of efforts in Member States to increase the stock of human capital during the last twenty five years. In 1996, 44% of EU citizen aged 30-34 had attained the upper secondary level, compared with only 30% of the 55-59 year-olds, who were educated 25 years earlier. Similarly, 21% in the 30-34 age class attained a tertiary education degree, compared with only 13% in the 55-59 class. Moreover, women's attainment levels are very close to men's in the 30-34 age-class, whereas they are much lower than men's in the 55-59 age class.

Human capital accumulation also greatly increases the chances of employment. Higher education and literacy levels improve the citizen's prospects on the labour market. As shown in graph 5.5, there seems to be a positive correlation between educational attainment levels and employment rates. Similarly it can be shown that there is a direct relationship between estimated literacy and educational attainment levels on the one hand and unemployment rates, vulnerability to unemployment and earnings on the other.

The challenges ahead call for a deep assessment of the role of governments in enhancing human capital accumulation. Where the provision of education is concerned, although nobody questions the need for public intervention, a reflection is needed as regards the boundaries of intervention. Overall, while there seems to be a broad consensus that free and compulsory primary and secondary education is needed, direct and free provision of tertiary education should be assessed in the light of possible mismatches between the available study courses, labour market opportunities and student preferences.

Addressing such mismatches does not imply a withdrawal of the public sector or lower public spending, but rather a change in the way public money is spent and in the form of public intervention. Some countries are introducing new financing approaches in the form of tuition and loans rather than of free provision and grants. Such schemes try, at the same time, to influence student behaviour in order to optimise spending, while ensuring the participation of low-income households is not discouraged.

But education is not the only means to increase human capital accumulation. Continuing training in enterprises constitutes one of the main elements of human capital development, and is paramount in times of fast technical progress. Information on labour market training, largely including non-formal training, is scattered and less reliable. Government support is provided both by direct financing of education and training and through various incentives, including tax incentives, to enterprises and individuals. An indication on private financing for labour market training is channelled mainly through employer's contributions to company related training. Estimates on employers' expenditure in 1993 accounted for only 1.6% of total payrolls costs for the EU 12. Such an average value hides wide variations among Member States from 0.7% in Portugal to 2.7% in the UK, due to diverging training intensities and unit costs.

Most Member States have increased their efforts since then, and training has become a key element in the European employment strategy, as set up in the Employment Guidelines where vocational training and a comprehensive approach to life-long learning is a major goal. Such efforts are assessed every year in the Joint Employment Report. Although the shift from passive to active labour market policies is a reality, further efforts are needed on both sides, public and private, to promote life-long learning and ongoing upgrading of professional skills.

Table 5.2. Participation rates in education and training for age group 25-64

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According to the 2000 Joint Employment Report, there was a growing emphasis in 1999 on active labour market policy in most Member States, while the numbers of registered unemployment declined. In this context, evidence from the National Employment Action Plans shows that all Member States increasingly promote education and lifelong learning activities. Several Member States point out existing education and training deficits and recognise the need for adapting training provisions and undertake specific measures to improve qualifications. Available statistics on participation in labour market related training and education activities give a rather disappointing picture. In particular participation rates among adults (25-64 years old) remains very low in the EU, although it has somewhat increased in recent years from 6.5% in 1997 to 8% in 1999. The highest participation rates was achieved in SW, DK and UK with an average of 20.8% in 1999 (see table 5.2).These data indicate that only a small proportion of GDP was allocated to labour market training. Such programmes are more developed in the Nordic countries with S and DK allocating respectively 2% and 1.9% in 1998 (table 5.3).

Table 5.3. Total active expenditure 1990-1998

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5.4 R&D and innovation

As in the case of education, public expenditure on research and development (R&D) is classified as current spending, whereas it actually contributes to capital accumulation in the form of knowledge, as well to productive processes and outputs. Table 5.4 presents figures on R&D executed by the public sector as a percentage of GDP (column II), and government R&D spending as a percentage of total public spending (column III). The EU is well behind the US in terms of the percentage of general government expenditure accounted for by R&D, 1.7% compared with 2.9%. However, in terms of GDP, the amount of R&D executed by public sector is relatively similar, although government budget appropriations have declined in real terms more noticeably in the EU compared than in the US over the past decade.

Table 5.4 Public spending on R&D

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Source: European Commission, DG Research "Towards a European Research Area - Science, Technology and Innovation Key figures 2000".

Note: p = forecasts, e = estimates

(1) 1993-1999: (2) 1991-1999: (3) 1992-1998: (4) 1995-1999; (5) Government Intramural Expenditure on R&D + Higher Education Expenditure on R&D; (6) Government Budget Appropriations or Outlays for R&D (GBOARD) in % of General Government Expenditures; (7) of GBOARD

Nevertheless, and according to the Communication from the Commission on Innovation in a Knowledge-Driven Economy (COM(2000) 567), the differences in terms of private expenditures on R&D are much more striking and relevant for the development of the "new" economy. The industrial research effort in the EU is only 60% that of the US, and the Federal Government funds 13% of the R&D expenditure of American companies, while in the European Union only 9% of private R&D expenditure is publicly funded. The total research effort in the US is close to 3% of GDP, whereas the corresponding figure in the EU is lower than 2%.

Where the situation across Member States is concerned, only in F, the NL, FIN and S is public spending on R&D higher than in the US. At the opposite extreme, in countries such as EL, E, IRL and P, public spending on R&D is below half a percentage point of GDP.

The importance of innovation has been unambiguously highlighted in the European Council of Lisbon as a response to the challenges of globalisation and the knowledge-driven economy.

In January 2000 the Commission proposed the creation of a European Research Area (COM(2000) 6). The Commission recalled the importance of sustained research and technological development for economic growth, competitiveness and employment through the creation of new products, processes and markets and the modernisation of European companies.

Conceived in order to help establishing strong partnerships among the Member States and between them and the Union, the orientations presented by the Commission at the beginning of October 2000 to implement the European Research Area (COM(2000) 612) foresee in particular the following: using new instruments such as the Union participation in national research programmes jointly implemented, as well as networks of excellence and large scale targeted projects allowing to build critical masses of competence; increasing and diversifying the actions at Europe