Communication from the Commission to the Council and the European Parliament : the contribution of public finances to growth and employment: improving quality and sustainability.
Date: 2000-12-21
Institutions: European Commission
Subjects: economic growth, economic support, employment aid, public finance

COMMISSION OF THE EUROPEAN COMMUNITIES

Brussels, 21.12.2000
COM(2000) 846 final

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 ............................................................................................................ 7

2. HOW DO PUBLIC FINANCES AFFECT GROWTH AND EMPLOYMENT? .......... 9
2.1 OVERVIEW OF EU PUBLIC FINANCES AT THE START OF THE 21ST ENTURY............................ 9
2.2 THE IMPACT OF PUBLIC FINANCES ON GROWTH AND EMPLOYMENT.................................... 14

3. MAINTAINING SOUND PUBLIC FINANCES IN STAGE 3 OF EMU .................... 18
3.1. NEW BUDGETARY CHALLENGES ARE COMING TO THE FORE .............................................. 18
3.2 THE WAY AHEAD AND THE RESPONSE BY MEMBER STATES .............................................. 19

4. TOWARDS MORE EMPLOYMENT-FRIENDLY TAX AND BENEFIT SYSTEMS22
4.1. THE STRUCTURE OF TAX/BENEFIT SYSTEMS IN THE EU ................................................ 22
4.2 THE WAY AHEAD AND THE RESPONSE BY MEMBER STATES .......................................... 27

5. PUBLIC FINANCES FOR THE KNOWLEDGE-DRIVEN ECONOMY................... 34
5.1 COMPARING THE STRUCTURE OF THE GOVERNMENT SPENDING.......................................... 34
5.2 PHYSICAL CAPITAL (INFRASTRUCTURE)............................................................................ 36
5.3 HUMAN CAPITAL INVESTMENT......................................................................................... 39
5.4 R&D AND INNOVATION................................................................................................... 44

6. LONG-TERM SUSTAINABILITY OF PUBLIC FINANCES .................................... 47
6.1 OVERVIEW OF THE BUDGETARY IMPLICATIONS OF AGEING POPULATIONS .......................... 47
6.2 THE WAY FORWARD AND THE RESPONSE BY MEMBER STATES .......................................... 55

ANNEX A: REFORMS OF TAX SYSTEMS ................................................................... 62
ANNEX B: REFORMS OF BENEFITS SYSTEMS......................................................... 68
ANNEX C: REFORMS OF HEALTH CARE SYSTEMS ............................................... 73
ANNEX D: REFORM OF PUBLIC PENSION SYSTEMS ............................................. 83

ii

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 report1 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,

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.

1 ECFIN 586-00-EN.rev1

iii

• 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

iv

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
labour market
programmes. However, these efforts in shifting the balance from passive to active labour
market policies must be speeded up, reinforced and intensified.

thereby supporting participation in active

conditions,

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.

increase the investment necessary to facilitate the
Greater efforts are needed to
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

v

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.

vi

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 report2 prepared by the Commission services which
draws upon the DG ECFIN report Public finances in EMU-20003. 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.

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 variety of policy measures
The Commission-Council report can help ensure that
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

2

3

ECFIN/586/00-EN.rev1
ECFIN/339/00-EN, May 2000, published in European Economy, Reports and Studies, No 3, 2000.

7

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
investment in physical capital (infrastructure),
contains detailed assessments on public
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.

8

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

0
0
1
=
S
U

;

S
P
P
n

i

c
p
P
D
G

73

72

71

70

69

68

67

66

65

64

0
7

2
7

4
7

6
7

8
7

0
8

2
8

4
8

6
8

8
8

0
9

2
9

4
9

6
9

8
9

0
0

2
0

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

9

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.

10

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

55

50

45

40

35

P
D
G

f
o
%

Total expenditure

Deficit

Revenues

30
70 72 74 76 78 80 82 84 86 88 90 92 94 96 98

2000 02

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.

11

Graph 2.3. Budgetary imbalances in the EU 1977-2002

)

P
D
G

f
o
%

(

t
i

c

i
f
e
D

7

6

5

4

3

2

1

0

-1

-2

Positive output gap

Deficit

debt

75

70

65

60

55

50

45

40

35

30

)

P
D
G

f
o
%

(

t
b
e
D

7
7

7
9

8
1

8
3

8
5

8
7

8
9

9
1

9
3

9
5

9
7

9
9

0
1

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 20004.

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).

12

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

46

48

46

36

Other

Investment

Consumption

Social transfers

Subsidies

Interest

60

50

40

30

20

10

0

1970

1980

1990

2000

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.

13

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

42

44

46

37

Other

Social security contr.

Indirect taxes

Direct taxes

60

50

40

30

20

10

0

1970

1980

1990

2000

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.
is
Moreover, where the impact of the size of spending on growth and employment
concerned,
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.

comparisons may be misleading. Simple

international

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.

14

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. 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.

investment and attract

further

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.
the
Therefore, mounting debts can reduce overall capital accumulation and prevent
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

15

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
is also
protection also plays a redistribution role which, by reducing social conflict
conducive to growth and employment. A well designed social protection and assistance
system can raise economic efficiency. Programmes, such as, for instance, unemployment
integration, can
insurance or family allowances, as well as policies promoting social
increase participation and labour supply, while enhancing the social acceptance of structural
reforms.

labour. For

However, these positive effects could be counterbalanced by a negative impact on the
supply and demand 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.

16

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.

it may foster stable inflationary expectations,

Budgetary discipline also indirectly affects growth and employment by contributing to
macroeconomic stability. First,
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.

17

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
that could make an important contribution to raising
the tax burden, a development
potential output and employment. This process is already under way. However,
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.

it

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

18

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-

19

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
is maintained. While
expenditure reductions so that progress towards the SGP goal
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

20

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.

21

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.

22

Overview of tax and benefit systems

As measured by the implicit tax rates5 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.

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

45,0

40,0

35,0

30,0

25,0

20,0

EU

US

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

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.

5

6

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.
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.

23

Table 4.1. The tax burden on low and middle wages

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

(1)

(2)

(3)

(4)

32,6
14,5
32,3
34,3
29,5
32,7
-1,2
35,7
8
22,4
19,8
22,4
27,9
40,9
15,1
15,6

40,8
31,3
35,6
36,2
33,7
39,5
23,8
43,3
13
33
32,2
26,8
40,8
45,2
24,8
15,6

49,5
41,7
47,7
35
34,8
41,6
24,9
48,8
29,7
38,8
41,1
30,8
44,2
49,2
28,4
19,4

52
41,7
47,7
35,9
37,5
44,3
28,2
49,4
27,1
39,3
43,4
32,6
46
50,2
26,4
19,6

B
DK
D
EL
E
F
IRL
I
L
NL
A
P
FIN
S
US
JAP

(1) single individual with two children, earning 67% of
the APW (Average wage of production workers)
(2) married couple with two children and a single earner
at the APW.
(3) single individual with no child, earning 67% of the
APW.
(4) married couple with two children and two earners,
with earnings split between the two
two partners at 100% and 67% of the APW

From the perspective of incentives to increase labour supply and especially to assess the
risks of “poverty traps”, marginal tax rates7 are more relevant than average rates. Over the
period 1997-99, most Member States (D, L and S excluded) succeeded in lowering

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.

24

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.

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
including normal cyclical evolution of economic growth and
unemployment developments, and benefit reforms to a lesser extent.

factors,

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

All transfers

Transfers to
working age
people (1)

Change
1993-97
-1,2
-1,1
0,6
0,7
-2,3
0,2
-2,3
0,9
n.a.
-2,9
-0,6
0,7
-4,3
-3,5
-1,3
-0,4

Change
1997-99 (2)
-0,4
-1,1
-0,3
0,1
-0,8
-0,3
-0,6
0,1
-0,2
-1,2
-0,5
0,1
-1,9
-0,7
-1,0
-0,5

1997
5,4
6,8
4,6
1,7
4,2
3,7
3,7
1,9
n.a.
7,4
3,3
3,4
7,4
6,2
3,7
4,0

Change
1993-97
-0,7
-2,1
-0,1
-0,1
-2,3
-0,3
-0,6
-0,4
n.a.
-1,2
0,3
-0,1
-2,5
-1,2
-0,8
-0,6

Disability

Unemployment

1997
1,5
2,3
1,6
1,2
1,5
1,0
0,8
1,5
n.a.
4,1
2,0
2,3
3,4
2,6
2,8
1,8

Change
1993-97
-0,3
0,1
0,1
-0,1
-0,1
-0,1
0,0
-0,2
n.a.
-0,7
0,4
-0,2
-0,9
-0,4
0,0
-0,1

1997
3,3
3,5
2,4
0,5
2,7
2,3
2,6
0,4
n.a.
3,2
1,2
1,0
3,5
2,9
0,9
1,9

Change
1993-97
-0,4
-2,0
-0,3
0,0
-2,2
-0,3
-0,7
-0,2
n.a.
0,2
-0,1
0,0
-1,6
-0,8
-0,8
-0,5

B
DK
D
EL
E
F
IRL
I
L
NL
A
P
FIN
S
UK
EU-15 (3)

1997
20,0
18,9
20,0
15,2
15,0
19,8
10,3
19,4
n.a.
21,0
19,8
12,7
19,6
19,6
17,8
18,8

Source: Eurostat, Social protection database, ESSPROS

(1)

Includes unemployment + disability benefits + social assistance.

(2) Source: Ameco, DG ECFIN, European Commission.

(3) Weighted by real GDP share 1997, excluding L.

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

25

replacement rates8 for low-paid workers are relatively high in several countries (see table
4.3) and this may lead to unemployment traps9. 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.

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

Married couple, 2
children,1st month
of unemployment

Single earner, 1st
month of
unemployment

B
DK
D
EL
E
F
IRL
I
L
NL
A
P
FIN
S
UK
US
Source: OECD: "Benefit Systems and Work Incentives", Paris, 1999

75
95
74
48
78
86
73
52
87
90
79
86
94
90
83
51

84
89
69
55
70
83
45
36
82
92
57
87
72
77
73
59

Married couple, 2
children, 60th
month of
unemployment
79
92
61
5
61
60
73
75
91
94
76
86
100
100
95
61

Single earner, 60th
month of
unemployment

61
67
75
0
35
55
45
39
67
84
54
61
79
84
73
10

8

9

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.
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.

26

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
the demand for labour.
human capital accumulation,
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

increase participation and boost

27

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 activities10.
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”

y reducing simultaneously pollution and unemployment. Shifting taxes on consumption is expected to
generate positive employment effects

28

Table 4.4. The long run GDP, Employment and Investment Effects of Tax Reforms (1% of

Tax Experiment

(1) Reduction of Labour, Corporate and Value Added Taxes *)
(2) Reduction of Labour and Corporate Taxes only *
(3) Reduction of Labour Taxes only (*)

(4). Tax shift from Labour to VAT (**)
(without compensating transfer recipients)
(5). Tax shift from Labour to VAT (***)
(with compensating transfer recipients)

GDP

Labour

Investm
ent

.54
.65
.81

.66

.37

.54
.57
.97

.82

.48

1.28
1.88
1.24

.73

.32

(*) The simulations in row (1) – (3) are conducted under the assumption that unemployment benefits
are kept constant in real consumption terms, i. e. the reservation wage is assumed to remain constant.
In this case the labour tax reduction is partly shifted onto firms in the form of lower wage costs.
Under the assumption that unemployment benefits are linked to net wages, the real output and
employment effects of a labour tax reform would be less strong and could even be absent.
(**) The experiment reported in row (4) assumes that unemployed workers (and other transfer
recipients) are not compensated for the increase in consumer prices, i. e., the reservation wage is
assumed to fall by an amount equivalent to the rise in consumer prices.
(***) Unemployed workers (and other transfer recipients) are compensated for the increase in
consumer prices.

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

29

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 gains11. 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.

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
tax co-ordination at the EU
a driving force for lower taxes on capital. In the absence of
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.

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

30

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
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.

tax rates. However, overall

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 NL12. 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.

31

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

3
2
1
0
-1
-2
-3
-4
-5
-6

B D
K

D E E
S

F I
R
L

I L N
L

A P F
N

I

S U
K

E
U
-
1
1

E
U
-
1
5

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.

32

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

Changes over 1997-1999

A
RI
T
S
U
A

M
IU
G
L
E
B

K
R
A
M
N
E
D

D
N
A
L
FIN

E
C
N
A
R
F

Y
N
A
M
R
E
G

E
C
E
E
R
G

D
N
A
L
E
IR

Y
L
A
IT

G
R
U
O
L'B

S
D
N
A
N'L

L
A
G
U
T
R
O
P

N
E
D
E
W
S

N
AI
P
S

N
A
P
A
J

S
U

K
U

4

2

0

-2

-4

-6

-8

SINGLE4

MARRIED1

SINGLE1

MARRIED4

Source: OECD, Taxing wages 1998-1999

33

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

100%

80%

60%

40%

20%

0%

Other

Investment

Consumption

Social transfers

Interest

B D E F

I

R
L

I L N
L

A P F
N

I

E
U
-
1
0

D
K

E
L

S U
K

U
S

J
P

E
U
-
1
4

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.

34

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

30

25

20

15

10

5

0

-5

-10

Other

Investment

Consumption

Social transfers

Interest

B D E F

I

R
L

I L N
L

A P F
N

I

E
U
-
1
0

D
K

E
L

S U
K

U
S

J
P

E
U
-
1
4

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,
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.

in particular those which support

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

35

structure for private agents is at least as important as direct public sector intervention13. 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.

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 challenge brought about by the new economic,
technological and institutional setting.

the EU can meet

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.

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 3 rd generation mobile licences
have been a source of public revenues.

36

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

8

7

6

5

4

3

2

1

0

B D E F

I

R
L

I L N
L

A P F
N

I

E
U
-
1
0

D
K

E
L

S U
K

U
S

J
P

E
U
-
1
4

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

:

(%ofGDP)

0.8

0.6

0.4

0.2

0.0

-0.2

-0.4

B DK D EL E F

IRL I L NL A P

FIN S UK

EUR-11

EU-15

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

37

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.

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 wasteful15. 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:

14

15

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.
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.

38

• 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 period16, 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.

39

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

Total 1995 Total 1996

n.a.
8,0
4,8
2,9
4,9
6,0
5,2
4,7
4,4
5,2
5,6
5,8
7,3
7,8
5,2
5,2
* Includes public institutions and government-dependent private institutions.

B (1)
DK
D (2)
EL (3)
E
F
IRL
I
L
NL
A
P
FIN
S
UK
EU-15

n.a.
8,8
4,7
3,1
4,8
6,0
5,0
4,9
4,3
5,3
6,5
5,7
7,4
8,0
5,1
5,3

Pre-
primary +
Not
allocated
0,7
1,2
0,6
:
0,3
0,7
0,1
0,5
0,0
0,4
0,6
0,6
0,8
0,5
0,4
0,5

1997

Primary Secondary Tertiary

Total

1,2
1,8
:
1,1
1,2
1,2
1,6
1,1
1,9
1,2
1,3
1,7
1,6
2,1
1,1
0,9

2,7
3,2
3,0
1,3
2,2
3,0
2,0
2,2
2,1
1,9
2,9
2,4
2,3
3,2
2,1
2,5

1,2
1,8
1,1
0,8
0,9
1,1
1,3
0,7
0,2
1,4
1,7
1,0
2,0
2,1
1,1
1,1

5,7
8,0
4,7
3,2
4,6
6,0
4,9
4,5
4,1
4,8
6,4
5,7
6,7
7,9
4,7
5,0

Source: Eurostat, UOE data collection.

(1) The data for B are for 1994.

(2) The data for D include primary and secondary combined.

(3) The data for EL include pre-primary and primary combined.

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
the
initiatives undertaken towards this direction include the Employment guidelines,
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.

40

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

100

50

0

B Dk D El E F Irl

It

L Nl A P FIN S Uk EU

Lower Secondary Upper Secondary

Tertiary

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

41

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

B

DK

D

GR

E

F

IRL

I

L

NL

A

P

FIN

S

UK

EU-15

1998

4,4

19,8

5,2

1,0

4,1

2,7

~

4,8

5,1

12,8

~

3,0

16,1

10,9

11,1

6,0

Source: European LFS

1999

6,9

19,8

5,3

~

4,9

2,6

~

5,5

5,3

13,6

~

3,2

17,6

24,1

18,5

8,0

42

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

1990

1998

B (1997)

DK

D

GR (1994)

E

F (1997)

I (1996)

IRL (1996)

L (1997)

NL

A

*P

FIN

S

**UK

1,21

1,13

1,04

0,36

0,85

0,82

1,43

1,44

0,30

1,28

0,31

0,62

1,01

1,68

0,61

1,29

1,89

1,27

0,30

0,72

1,37

1,08

1,66

0,31

1,76

0,44

0,87

1,23

2,01

0,37

* Total active expenditure for Portugal is from 1997

** For Sweden year 1990 refers to 1990-1991

** For UK year 1990 refers to 1990-1991, year 1998 to
1997-1998

Source: OECD, Labour Market Expenditures,1999.

43

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

I

Latest

Year

p 1997

e 1998

e 1998

1997

1998

p 1998

1997

p 1998

1997

1993

1998

p 1998

1997

1998

e 1998

p 1998

1998

II

III

IV

As % of GDP

As % of Gen.

(5)

0,5

0,7

0,7

0,4

0,4

0,8

0,4

0,5

0,9

0,7

0,4

0,9

0,9

0,6

0,7

0,6

0,7

Gov. expenditure
(6)

1,36

1,44

1,86

0,80

1,82

1,964

0,89

1,38

1,88

1,32

1,39

2,28

1,45

1,85

1,73

2,90

1,80

Annual avg. real
growth in 1990-
1999 (7)

3.3

5.4 (1)

-1.2 (2)

4.8

5.3

-3.1 (3)

8.0

-1.5

1.4

3.4

8.7

6.6 (4)

-7.2 (4)

-1.2

-0.7 (2)

-0.4

5.2

B

DK

D

EL

E

F

IRL

I

NL

A

P

FIN

S

UK

EU

US

JP

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

Note: p = forecasts, e = estimates

44

(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
the differences in terms of private
Knowledge-Driven Economy (COM(2000) 567),
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 European level on infrastructure, mobility and at the interface
between research and innovation;
concentrating the Union efforts on selected priority
themes and areas with a clear European added value.

The Commission Communication on Innovation in a Knowledge-Driven Economy has
extensively assessed the trends in European innovation policy and has set the broad policy
lines for enhancing innovation in the Union.

In order to offer an environment supportive of innovation, the Commission has highlighted
the relevance of the regulatory, administrative and financial environment to research and
innovation, while putting emphasis on the need to improve the interfaces in the research and
innovation system. This will allow firms to have access to knowledge, skills, financial
banking, sources of advice and market information.

Such a policy strategy explicitly acknowledges that a major problem resides in institutional
and regulatory arrangements which do not provide adequate incentives for the private sector
to innovate and invest in R&D. Nevertheless, as mentioned previously, in some Member
States the provision of publicly financed R&D is very low, while the involvement of the

45

private sector is far from optimal by international standards. In addition, in most countries
public and private efforts go hand in hand. Therefore, such institutional and structural
reforms should be complemented by strengthened cooperation between the public and the
in R&D spending. It needs to be
private sector in order to increase the total effort
investigated whether tax systems in the EU are conducive to investment
in intangible
capital, such that Europe can compete with the US in the high-tech sector.

46

6. LONG-TERM SUSTAINABILITY OF PUBLIC FINANCES

6.1 Overview of the budgetary implications of ageing populations

Many factors will affect the long-term sustainability of public finances

The Lisbon European Council called for the report to the contribution of public finances to
growth and employment to assess whether concrete actions are being taken to “…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”17.

The mandate recognises that factors other than ageing populations affect the long-term
sustainability of public finances. For example, changing household structures and increased
female participation will affect public spending and taxation. Also, as economic integration
deepens, governments may find it increasingly difficult to raise tax revenues on mobile tax
bases due to tax competition. This Communication concentrates on the budgetary impact of
ageing populations, in particular on public pensions and to a lesser extent on health care
spending. As such, it does not address other equally important policy implications of ageing
populations, such as the implications for the adequacy of social protection systems which
are being examined by the High Level Working Part on Social Protection.

Demographic developments

In the coming decades, the population of EU Member States will continue to change due to
continuing trends of low fertility rates below the level needed to achieve a natural
replacement of the population and increasing life expectancy. One particularly significant
factor affecting the balance between working-age and retired people will be the fact that the
large cohorts born after World War II will be reaching retirement age. Updated Eurostat
population projections for the period 2000 to 2050 show that
the EU working age
population (aged between 20 and 64) will stay broadly stable at some 230 million until
2015. Thereafter, it will decline to 224 million by 2025 and 192 million by 2050. At the
same time, the numbers of elderly persons aged 65 and above will rise from 61 million in
2000 to 86 million in 2025 and 103 million by 2050. The largest increase will take place
amongst the very old (aged 85 and above), whose numbers will almost triple from 7 million
in 2000 to 19 million in 2050.

17

As part of goal of modernising social protection, the Lisbon European Council requested “…the High Level
Working Party on Social Protection, taking into consideration the work being done by the Economic Policy
Committee, to support this co-operation and, as its first priority, to prepare, on the basis of a Commission
communication, a study on the future evolution of social protection from a long-term point of view, giving
particular attention to the sustainability of pensions systems in different time frameworks up to 2020 and
beyond, where necessary”. A progress report should be available by December 2000.” . The High Level
on The future evolution of social
Working Party on Social Protection has prepared progress report
protection – pensions for the European Council of Nice in December 2000 (Council Document 2949/00 of
06.1100). This progress report was prepared the basis of a recent a Commission Communication The
Future Evolution of Social Protection from a Long-Term Point of View : Safe and Sustainable Pensions
(COM(2000) 622 final).

47

Overall, the size of the total population can be expected to start to fall after 2020, see table
6.1. The total population in the EU is forecast to increase from its 2000 level of 376 million
to 386 million in 2020, after which it gradually declines to 364 million by 2050. However,
considerable differences are forecast between Member States. Large population falls are
forecast for I, D and E, whereas it is expected to grow in F, UK, NL, IRL and P.

Table 6.1 Total population in EU Member States 2000-2050

(millions)

2000

2010

2020

2030

2040

2050

B

DK

D

EL

E

F

IRL

I

L

NL

A

P

FIN

S

UK

10.2

5.3

82.1

10.5

39.4

59.2

3.8

57.6

0.4

15.9

8.1

10.0

5.2

8.9

59.5

EU-15

376.2

10.4

5.5

83.4

10.8

39.9

61.4

4.1

57.3

0.5

16.7

8.1

10.3

5.3

9.0

10.5

5.6

83.3

10.8

39.5

62.8

4.4

56.0

0.5

17.3

8.2

10.5

5.3

9.1

10.5

5.6

82.0

10.7

38.6

63.7

4.6

54.0

0.5

17.7

8.1

10.7

5.3

9.3

10.4

5.6

79.6

10.6

37.3

63.5

4.7

51.5

0.5

17.9

7.9

10.8

5.1

9.2

10.1

5.6

76.0

10.2

35.1

62.2

4.8

48.1

0.6

17.7

7.6

10.7

5.0

9.2

60.9

383.4

62.2

386.0

63.2

384.6

62.9

377.6

61.8

364.5

Source: Eurostat, baseline scenario

The old-age dependency ratio (defined as persons aged over 65 as a percentage of working
age population 20-64) will rapidly increase from some 27% in 2000 to 39% in 2025 and to
53% in 2050 for the EU, see graph 6.1. Increased immigration could stabilise the total
population, but to mitigate some of the increase in the old-age dependency ratio, it would
have to reach unprecedented (and possibly politically unacceptable) levels to maintain ratios
at or close to their current levels.

Again, there are sharp differences between the Member States. In terms of starting position
in 2000, IRL has the lowest old-age dependency ratio at 19% compares with ratios of close
to 30% in B, EL, I and S. The timing of the demographic changes also differs. Steep
increases in the old-age dependency ratio start to occur after 2005 in D, EL, I, NL and A,
and somewhat later around 2010 in B, E, F, FIN and S. In most Member States, the old-age
dependency ratio will reach a new plateau around 2040, with the highest ratios in 2050

48

forecasts for EL, E and I. The scale of the changes are impressive, with the old-age
dependency ratios increasing by nearly 40 percentage points in I and E.

Graph 6.1 Old age dependency ratio 2000-2050*

75%

65%

55%

45%

35%

25%

15%

Year 2050

Year 2025

Year 2000

B D
k

D G

r

E F I
R
L

I L N
L

A P F
N

I

S U
K

E
U

There is uncertainty with long-term demographic projections. However, demographic
projections over the medium term are broadly reliable for people who are already born as is
the case with pensioners in the next 30 to 40 years. From the perspective of public finances,
there are two particular down-side risks. Firstly, the anticipated rise in fertility rates from
their historically low levels may not materialise, which would imply fewer entrants to the
labour market in coming decades. Secondly, a significant increase in life expectancy above
current predictions, due to say advances in medical technologies or medicines, could further
raise old-age dependency ratios and add to the pressure on public pension and health care
systems. These risks suggest the need for careful monitoring of demographic developments
and their implications for public finances.

How ageing populations affect public finances

Pensions18: ageing populations will cause a fall in the ratio of contributors to pensioners
between now and 2050. Public pension schemes account for the largest share of retirement
income in Member States. However, there are considerable difference between Member
States as regards the nature and financing of public pensions, see table 6.2. Public pensions

18

The Treaty provides a number of safeguards which prohibit the liabilities of one Member State being
passed on to other EU countries. In particular, Article 103 has a no bail-out rule which states "The
Community shall not be liable for or assume the commitments of central governments, regional, local or
other public authorities, other bodies governed by public law, or public undertakings of any Member
State...".

49

are normally financed on a pay-as-you-go (PAYG) basis, i.e. they are directly paid from the
contributions of the current working population and employers. In some Member States, the
PAYG pensions only provide a minimum pension to cover basic needs. It is left to the social
partners or individual employers and employees to supplement these with occupational and
private pension provision, which normally are full funded. In other Member States, the
PAYG pensions operate on an insurance basis, with pensions linked to past earnings.

There are large differences in the size of current public spending on public pensions. It is
highest in A and I accounting for some 15% of GDP, which compares with levels of 5% of
GDP in IRL, NL and the UK. In other Member States, spending on public pensions is in the
order of 10% of GDP. There are also marked differences in the size of pension fund assets
across countries; they are highest in the NL (87% of GDP), the UK (75%), DK (75%) and
IRL (45%). In contrast, pension fund assets are low, well below 10% of GDP, in a majority
of Member States including the four largest economies of the euro area.

Table 6.2: Overview of pension systems in EU Member States

Statutory
retirement age

Indexation

Public
pensions %
1998 GDP1

Pension
fund assets
as % 1996
GDP2

B

DK

D

EL

E

F

IRL

I

L

NL

A

P

FIN

S

UK

Men Women

65

678

65

61

67

603

55/655

55/60

65

60

65

60

Prices

Wages

Net wages

Wages

Prices

Prices

65/66

65/66

Discretionary

65

65

65

65

65

65

656

65

60

65

65

60

65

65

65

60

Prices

Wages/prices

Wages/prices

Net wages

Discretionary

Wages/prices

Other

Prices

9.5

11.8

12.44

12.1

9.6

12.7

3.0

14.2

10.6

5.0

15.0

9.8

11.5

11.1

5.3

4.1

75

5.8

12.7

3.8

5.6

45.0

3.0

19.7

87.3

1.2

9.9

40.8

32.6

74.7

Source: Report of the EPC working group on ageing populations

Notes: (1) Definitions of public spending on pensions dare not
identical, and hence not strictly
comparable. For IRL, the figures are set of social insurance contributions: (2) Source OECD, except
DK which comes from national authorities. .In some countries these funds usually do not form part of
the public pension system: (3) Will be 65 as of 2005: (4) General statutory and special civil servants
regime: (5) Public sector: same applies for women: (6) The retirement age is 61 and flexible upwards.
The system is contribution defined so every additional working year increases pension benefits

50

accordingly. The guarantee pension has the requirement age of 65: (7) Formula based on nominal GDP
growth: (8) 65 as of 2004.

Making long-term budgetary projections requires a number of assumptions on variables
such as interest rates, productivity growth and labour market developments. Whereas
projections should be able to identify serious budgetary imbalances, the results should be
treated with caution. A further difficulty is that national projections are usually not
comparable as they use different demographic and economic assumptions along with
different model specifications and definitions. International organisations have overcome
some of these problems by using standard demographic and economic assumptions, but at
the cost of less accuracy in the modelling of the institutional detail of national pension and
social security systems.

This
trade-off between comparability/transparency prompted the Economic Policy
Committee to take a new approach in a report on the budgetary implications of ageing
populations examined by the ECOFIN Council on 7 November 2000.19 National authorities
were invited to run their national models using standard EUROSTAT demographic and
economic assumptions. These assumptions provide some flexibility to cope with specific
national circumstances.20 The results presented below are not strictly speaking comparable,
but nonetheless represent an important advance in producing quasi-comparable estimates of
long-term pension projections.

The starting point was a so-called “current policy scenario”, which aimed at projecting
pension expenditures on the basis of legislation already enacted. Various sensitivity tests
and policy simulations have been also been conducted, which are set out in full in the EPC
report.

19

20

Report of the impact of ageing populations on public pension systems, EPC/ECFIN/581/00-EN. The work
of the EPC is proceeding in parallel with an exercise underway in the OECD (Working Party 1). The
demographic and economic assumptions were drawn up in collaboration with the OECD Secretariat to
ensure consistency between the two exercises.
For example, participation rates were based on ILO projections, but adjustments to 2010 were allowed to
reflect cross-country differences in labour markets policy reforms and legislated reforms to social
institutions. Unemployment is assumed to fall to its structural level by 2005 as defined by the OECD and
held at that rate to 2050. However, this rate could be adjusted to reflect reforms to the labour market
already enacted, provided the adjustment does not exceed one third of the estimated structural rate of
unemployment in 2005. Labour productivity should converge towards 1.75% annually between 2020 and
2030

51

Table 6.3 Pension expenditure projections 2000-2050 (as % GDP, before tax)21

2000

2005

2010

2020

2030

2040

2050

B

DK

D

EL

E

F

IRL

I

L

NL

A

P

FIN

S

9.3

10.2

10.3

NA

9.4

12.1

4.6

14.2

NA

7.9

14.5

9.8

11.3

9.0

8.7

11.3

9.8

NA

9.2

12.2

4.5

14.1

NA

8.3

14.4

10.8

10.9

8.8

9.0

12.7

9.5

NA

9.3

13.1

5.0

14.3

NA

9.1

14.8

12.0

11.6

9.2

10.4

14.0

10.6

NA

10.2

15.0

6.7

14.9

NA

11.1

15.7

14.4

14.0

10.2

UK

4.9
Source: Report of the EPC working group on ageing populations

5.1

4.7

4.4

12.5

14.7

13.2

NA

12.9

16.0

7.6

15.9

NA

13.1

17.6

16.0

15.7

10.7

4.7

13.0

13.9

14.4

NA

16.3

15.8

8.3

15.7

NA

14.1

17.0

15.8

16.0

10.7

4.4

12.6

13.2

14.6

NA

17.7

N.A.

9.0

13.9

NA

13.6

15.1

14.2

16.0

10.0

3.9

Change
2000-peak
year

3.7
4.522

4.3

NA

8.3

3.9

4.4

1.7

NA

6.2

3.1

6.2

4.7

1.7

0.0

The simulations show that public pension expenditure as a percentage of GDP is predicted
to rise substantially in all Member States over the next few decades, except in the UK.
However, the size and timing of the increases in expenditure differ across Member States.
Only two Member States are projected to have increased spending on public pensions of
less that 2% of GDP over the period 2000 to 2050, namely I and S.

In the majority of cases the effects of ageing will add between around 3 to 5 per cent of
GDP to pension expenditure, i.e. B (3.7%), DK (4.5%), D (4.3%), F (3.9%), IRL (4.4%), A
(3.1%), and FIN (4.7%).Even higher upwards pressure on public pension spending is
projected for P, NL (6.2% of GDP) with the highest increase projected for E (an additional
8.2% of GDP over the forecast period). As regards timing, public pension expenditure in
DK, F, I, A, P and S should reach its peak around 2030. The peak will be reached around
2040 in B, NL and FIN, and in the remaining countries around 2050. Overall, it is also
worth noting that although the projected rise in public expenditure is a significant challenge,
it remains below the expected increase in dependency ratios. This suggests that reforms

21

22

Estimates for Greece and Luxembourg will be provided by national authorities in January 2001
For Denmark, net of the supplementary, semi-funded scheme, ATP, the increase from 200 to the peak year
is only 3.1 % of GDP

52

undertaken in the 1990s have gone some way
populations on public pension schemes.

to addressing the impact of ageing

However, other factors should be borne in mind apart from the size of the increase in
spending on public pensions. Account needs to be taken of the starting level of spending on
public pensions, which in 2000 ranges from some 5% of GDP in IRL and UK to over 14%
of GDP in I and A. It is also necessary to take account of taxes on pension income, i.e. net
public expenditure on pensions. Another relevant factor is that contributions to funded
pension schemes, such as in NL, are usually tax deductible i.e. deferred until entitlements
are paid out. This means that of the increased spending on public pensions in such countries
will be offset by increased tax revenues on income from funded pensions.

Health care: on average, public spending on health care in the EU is just over 6% of GDP,
which accounts for approximately three quarters of all spending on health care. It is a major
component of all public spending, and is central to the debate on the budgetary implications
of ageing populations.

Studies on the pattern of health expenditure for different age-groups reveal that as people
In fact, profiles of
age they generally tend to spend increasing amounts on health care.
average health expenditure for persons of different age groups tend to be U-shaped, with
high levels of expenditure characterising childhood and old age. The projected increase in
the number of older people therefore fuels concern about rising health care expenditures.

However, measuring the impact of demographic changes on overall health expenditure is
not as straightforward as it might first appear. Some recent studies suggest that as life
expectancy (as well as the number of elderly people) increases in the future, individuals will
enjoy a higher number of years in good health than previous generations. That is to say that
although there will be increased numbers of elderly people in the future, this might not lead
to a proportional increase in health expenditure. Moreover, a significant proportion of health
care services are consumed in the final months of life prior to death, and are therefore not
directly age related .

Over the past three decades, ageing has not been a significant driving force in the increase in
health expenditure in Member States. As reviewed in annex C, OECD studies on the
evolution of health expenditure between the 1960s and the 1990s suggest that the following
factors have been more important: increased coverage of public provision of health care or
health insurance; increased demand/consumption of health care in line with increased
prosperity; and supply-side factors such as the increased use of new and more expensive
technology, and medical price inflation higher than overall price inflation. There is little
consensus as to whether these factors will continue to be important in the future. Other
factors, might also start to play a role in increasing the demand for formal health provision,
such as increased household fragmentation as a result of increased female participation in
the labour force. On the other hand, an increased awareness of the link between individuals’
behaviour and their health status, or more importantly the effect of past reforms in the health
sector, might serve to contain pressures for increases in health expenditure.

The existence of many different factors driving health care expenditure considerably
complicates the process of projecting future trends in health expenditure and of predicting
the particular role of demographic changes. Moreover, cross-country projections for

53

expenditure for health expenditure are further complicated by the nature of health systems.
Health systems by their very nature are extremely complex and their structure can vary
considerably between different countries. However, the detailed organisational structure of
health systems, and the incentives that they create for different types of agents, can have an
extremely important
role to play in determining supply and demand pressures for
expenditure. As a result, similar trends in medical technology or in medical prices, might
lead to very different implications for the evolution of health expenditure in different
Member States.

Despite these difficulties, there have already been some attempts to project health care
expenditures. The OECD estimate that the direct effects of ageing on public expenditure on
health will be an increase of 3% of GDP in the EU and in Japan, and 2% in the US. Several
Member States have attempted to quantify future increases in public expenditure on health
associated with ageing populations. These point to an increase in public spending in the
order of 2 - 3% of GDP. On balance therefore, there is a consensus that health care
expenditure will rise, but there is still some debate as to the scale of the increase. This
underlines the need for effective cost-containment measures, a review of which is contained
in annex C.

One important issue in the budgetary impact of ageing is the issue of long-term care for the
elderly. This type of expenditure will be one of the key sources of increased public
expenditure due to ageing. However, in many Member States, long-term care is no longer a
formal part of the health sector – this spending is often covered by social budgets.
Projections of health care expenditure excluding this type of care are likely to seriously
underestimate the impact of ageing populations on overall public expenditure.

Education: The scope for any reduction in public spending on education on account of
fewer young people is likely to be modest, and probably much smaller than increases in
spending on pension and health care. Increased per-capita spending may be required to
increase investment in human capital and to promote lifelong learning which enables elderly
workers to return to or remain in the labour force.

Overall assessment of the implications for public finances

While caution must be exercised in interpreting the above projections, the combined impact
of ageing populations on public pension and health care systems suggests, in the absence of
further reforms, an increase in public spending of between 5 to 8 percentage points of GDP
in most Member States, and possibly larger amounts in less favourable scenarios. Although
this pressure will emerge over several decades, it nonetheless represents a major challenge
to the sustainability of public finances. The budgetary challenge of ageing populations will
be most acute in countries having a large stock of outstanding public debt and that rely on
PAYG pension systems.

Clearly, such large expenditure increases could not be financed by running up large
structural deficits and public debt. A return to large structural deficits would undermine all
the fiscal consolidation efforts undertaken in the run up to EMU, and would be contrary to
the Stability and Growth Pact. Unsustainable public finance positions would complicate the
implementation of the single monetary policy by the ECB and undermine confidence in the
EMU process possibly resulting in interest rates being higher than they otherwise would be.

54

Addressing the challenge simply by raising additional finance for increased pension and
health care spending may run contrary to the conclusions of the Lisbon European Council.
For example, raising contribution rates to public pension systems (which are already very
high in many Member States) would widen the wedge between labour costs and net wages,
and create disincentives to hire workers and participate in the labour market. Moreover, it
tax burden
would widen inter-generation imbalances. Similarly increasing the overall
could exacerbate disincentives towards employment and investment, which could over time
worsen rather than improve the sustainability of public finances. Finally, cutting back on
other essential public expenditure items such as infrastructure , education and training,
information technology and R&D could be counter-productive as such expenditures
contribute to raising the potential output of the EU.

the same time as pressure mounts to increase age-related expenditure, economic
At
integration may ‘erode’ mobile tax bases, i.e. tax competition. Governments may find it
increasingly difficult to support higher tax burdens necessary to finance increased age
related expenditures. Alternatively, governments may have to shift the tax burden way from
mobile tax bases (e.g. on capital) towards immobile tax bases (e.g. labour), a development
which could distort the functioning of the labour market.

6.2 The way forward and the response by Member States

A comprehensive reform process is required to address these challenges. It should include
steps to further consolidate public finances prior to 2010 when the budgetary impact of
ageing takes off, labour market measures to increase employment and participation rates
especially amongst elderly workers, and reforms to place public pensions on a sound
financial footing. 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.

Further consolidation of public finances

Member States should take advantage of the current favourable economic climate to pursue
fiscal consolidation and reduce public debt levels at a faster pace. This will enable them to
meet the changing demographic situation with a smaller public debt and a lower interest
burden. Illustrative calculations in table 6.4 show what would happen to public debt in 2010
and 2020 if Member States stick to the medium-term targets for 2003 set down in their
1999/2000 stability or convergence programme.23 It clearly shows that sticking to the
medium-term target would allow countries to substantially reduce their stock of debt and
achieve a fall in the interest burden: this would partly cover the extra budgetary costs of
ageing. This effect is particularly strong for high-debt countries. Maintaining budgetary

23

Several Member States have already submitted their updated stability and convergence for 2000/2001.
However, the medium-term targets in the table have not been modified accordingly. It will be possible to
include a revised table in the Commission-Council report taking on board the targets contained in
2000/2001 programmes of all countries. These calculations are based on an assumption of a growth rate-
interest rate differential of some 2.25%, which is close to the long-run solution of the Commission’s
QUEST model.

55

positions at the 2003 target levels would bring about a fall in their interest burden by 2020
of around 3 percentage points of GDP.

A further lasting improvement of the structural balance by 1% point of GDP over these
targets would bring about an additional reduction in public debt of some 12 percentage
points of GDP by 2010 and 2020 in most Member States. All countries would be below the
60% Maastricht threshold and, in the case of Nordic countries, the debt would be turned into
an asset. The new debt levels imply an additional fall in the interest burden by 0.4% of GDP
by 2010 and 0.6% points of GDP by 2020. All countries would have a lower burden of more
than 1% of GDP compared with their 2000 level, and in eight Member States the reduction
would be above 3% of GDP. These significant savings highlight the contribution that strong
fiscal discipline can make in pre-empting the budgetary consequences of ageing
populations. However, in light of the projections above, the potential saving are unlikely to
fully compensate for additional age-related expenditures.

Table 6.4. Pre-empting ageing: reduction in interest burden

(% of GDP)

"Medium
term

Targets"

(def:+;

surpl: -)

-0.2

-2.5

0.5

-0.2

-0.2

0.5

-2.6

0.1

1.1

1.3

0.3

-4.7

-2.0

0.3

B

DK

D

EL

E

F

IRL

I

NL

A

P

FIN

S

UK

Medium term targets

Medium term targets – 1%

Debt

Debt Change

Debt Change

Debt Change

Debt Change

in

in

in

in

ratio

2000

112

50

61

103

63

59

46

112

62

64

57

43

59

44

ratio

Interest

ratio

Interest Ratio Interest

ratio Interest

2010

burden

2020

burden

2010

burden

2020 Burden

69

12

40

64

37

43

1

73

38

52

41

-7

20

24

-2.1

-1.9

-1.0

-2.0

-1.3

-0.8

-2.3

-1.9

-1.2

-0.6

-0.8

-2.5

-2.0

-1.0

44

-12

26

38

22

32

-20

48

29

45

28

-45

-3

18

-3.4

-3.1

-1.7

-3.3

-2.1

-1.4

-3.3

-3.2

-1.6

-0.9

-1.5

-4.4

-3.1

-1.3

63

5

33

58

30

36

-6

66

31

45

34

-14

13

17

-2.5

-2.2

-1.4

-2.3

-1.6

-1.2

-2.6

-2.3

-1.6

-0.9

-1.2

-2.9

-2.3

-1.3

31

-25

14

26

9

19

-33

36

17

32

16

-57

-16

5

-4.1

-3.8

-2.4

-3.9

-2.7

-2.0

-3.9

-3.8

-2.3

-1.6

-2.1

-5.0

-3.7

-1.9

Medium term targets correspond to the budget balances in 2003 (EL, F, A & S: in 2002) projected in

the 1999 Stability and Convergence Programmes.

Source: Commission Services.

56

Reforms to raise employment levels

An increase in employment rates would help offset the negative impact of demographic
developments on the size of the labour force. From a public finance perspective, it would
raise income tax receipts and contributions to PAYG pensions, lower expenditure on public
pensions and other entitlements, and raise the overall level of output. For these reasons, the
recent Commission Communication on safe and sustainable pensions and the report of High
Level Working Party on Social Protection (HLWPSP) has drawn attention to the imperative
of raising overall employment rates, especially amongst older workers, as a key part of the
strategy to deal with ageing populations. The report calls for mobilising society's full
potential as proposed in the Lisbon European Council which implies vigorous reform as
regards economic, social and labour policies.

An essential question for the financial equilibrium of pension systems is the early departure
from the labour market of the older workers. Currently,
in most Member States, the
effective retirement age is appreciably lower than the statutory retirement age provided for
by the obligatory pension schemes. This translates into a rapid fall in employment rates
beginning with the age of 55 in most Member States (see table 6.5). One of the principal
reasons for this trend has been poor age management practices in labour markets, whereby
early retirement schemes were used for dealing with redundancies. There is clear evidence
from EU Member States that incentives embedded in pension systems, together with early
retirement packages (see chapter 4.1), have served to lower the effective retirement age well
below the statutory retirement age. Reforms are required to introduce neutrality back into
the retirement incentives.

Table 6.5: Employment rates by age group in 1999

B DK D EL

E

F IRL I

L NL A

P FIN S UK EU15

50-54 60.3 80.4 73.4 60.1 57.2 74.1 62.1 57.2 64.6 70.2 72.7 71.4 78.9 84.2 75.9 69.2

55-59 36.9 70.9 55.1 47.4 44.8 46.8 50.5 36.6 38.2 49.6 41

59.1 54.6 77.8 62.1 50.7

60-64 12.9

34 19.6 30.4 24.7 10.1 35.9 17.9 12.9 18.6 11.7 43.6 22.2 47.9 35.6 22.3

65-69 3.8

6.2

5

11.5 3.9

2.1 14.3 6.2

n.a.

5.2

4.9 24.8 4.4 10.7 11.6

6.5

Source: Survey on work forces – Eurostat, Reproduced from report of HLWPSP

If effective retirement ages are to be raised to achieve higher employment rates amongst
older workers, a variety of actions are required. It will be necessary discourage early
retirement (except where justified, for example, on account of dangerous or heavy work),
and to improve opportunities for older workers in labour markets. On one hand, barriers and
disincentives to working longer must be removed. On the other hand older workers must
have equal access to lifelong learning and upgrading of skills and to keep attractive working
conditions in work place and to well-targeted active employment measures in the general
labour market. Making pension schemes employment friendly entails limiting the access to

57

early retirement, introducing more flexible rules governing the transition into retirement,
and ensuring that labour market policies for older workers are turned truly active. Resources
that have been used to take workers out of labour markets should instead be committed to
retaining and reintegrating them into employment.

In many Member States, an increased participation by women in the labour market
constitutes another route for improving the employed/retired ratio. To this end, however, it
is necessary to facilitate the relationship between professional life and family life, such as
the provision of affordable child care facilities. The lack of support services for families acts
as a brake on women staying in the labour market. It may also lead to a reduction in fertility
rates, further aggravating the problem of ageing in the long term.

Evidence of the need to raise employment rates to address the budgetary impact of ageing
populations is found in the report of the EPC working group on ageing populations. Pension
projections were made on the basis of a macroeconomic scenario consistent with the
conclusions of the Lisbon European Council which called for the EU to “.. raise the
employment rate from an average of 61% today to as close as possible to 70% by 2010 and
to increase the number of women in employment from an average of 51% today to more
than 60% by 2010.”24 The results of this so-called “Lisbon scenario” projections show that
pension expenditures in some countries (P, DK, UK, S, F) would be below those described
in table 6.3 based on a “current policy scenario”. Achieving a higher employment rate will
require appropriate policy measures to be taken and alone cannot fully compensate for the
economic and budgetary consequences of ageing populations. In many Member States,
some adjustments to the benefit/contribution formula in public pension systems may also be
needed.

Reform of public pensions systems

Reforms have been under way in many Member States for several years. Essentially they
involved modifications to eligibility, contribution and entitlement rules. At the same time,
this has left more scope for private pension provision, the development of which have been
such as granting tax exemptions on
encouraged through public policy measures
contributions, making private provision compulsory and encouraging social partners to
conclude agreements on occupational pension provision. Annex D provides an overview of
pension reforms currently under way at Member State level. Progress is uneven across
Member States and negotiations are at a key juncture in several countries. A number of
common features of the reform process can, however, be identified:

24

The assumptions provide for both male and female participation rates gradually converge to 83 per cent by
2045, and for male and female unemployment rates to 4 per cent by 2045, the projections for working age
population being taken from the high scenario provided by EUROSTAT, and productivity levels and
productivity growth converging across European countries and to the level and growth registered in the
US by 2050.

58

• most Member States are gradually equalising the retirement age for men and women, and
in some cases have raised the mandatory retirement age, although they have been less
successful in raising the effective retirement age.

• in some countries, the overall benefits of pensions has been reduced by increasing the
number of years used to assess entitlement derived from the contributory records of an
individual (e.g. pension benefit based on life-time earnings rather than final salary),
altering the accrual factor, increasing the number of years required in work to receive a
maximum pension rights, and indexing pension benefits to price inflation rather than to
net wages.

• changes have also been implemented to improve actuarial fairness of pensions,

i.e.

establish a closer link between contributions and entitlements.

• in some Member States (UK, NL, IRL, DK), funded pension schemes play a relatively
important role in the provision of income to older people. In others, measures are under
consideration to encourage the development of private provision.

These reforms have undoubtedly improved the sustainability of public pension systems.
However, as discussed above, spending on public pensions in many Member States is still
expected to grow significantly in the coming decades, so further reforms will be needed.
Reforms must take account of the expectations of people who may have paid contributions
over several decades, and require a large consensus in order to avoid future governments
undoing the reforms carried out by their predecessors.

A wide consensus exists on the need for a comprehensive approach to retirement income
provision. The responsibility of policy makers is not limited to a first pillar PAYG schemes.
Public policy also influences the development of second pillar occupational schemes that
provide a link with earnings during a persons working life, and third pillar private savings.
Moreover, it is important to bear in mind that the living standards of older people are also
determined by other policies in areas such as housing, health and long-term care or the
provision of free or subsidised services (transport, culture etc.).

In many EU Member States funded pension provisions will be expected to play a greater
role in light of ageing populations. In the face of a requirement to curb the growth of public
pension spending the promotion of occupational and personal pensions can help ensure the
adequacy of income during retirement. A transition to greater funding can improve the
sustainability of public finances in the long-term, and make an important contribution to the
important to put in place a
development of capital markets in the EU. This makes it
legislative framework that guarantees high standards
such that supplementary pension
schemes are widely accessible and well adapted to the needs of an increasingly mobile
workforce. The EU is playing a role in this process, with the adoption in October 2000 of a
proposal for a Directive the activities of institutions for occupational retirement provision25.
Further measures are required to co-ordinate national rules on the taxation of supplementary

25

COM(2000)507 of 11 October 2000

59

pension products. Obstacles to the mobility of workers arising from supplementary pension
schemes are being examined in the European Pensions Forum.

The contribution at EU level

Ageing populations pose a wide range of social, economic and budgetary challenges. This
chapter has focussed on the budgetary impact of ageing populations on public pensions and
to a lesser extent on health care spending. Measures to address the long-term sustainability
of public finances must form part of a comprehensive reform package along the lines set
down by the Lisbon European Council.

As a first step, the ECOFIN Council has invited the EPC working group to extend its
analysis to cover the impact of ageing on health care. The Commission will actively
participate in this work. At the same time, work will continue in the High Level Working
Party on Social Protection along the lines proposed in the Commission Communication and
the Group’s progress report to the Nice European Council.

Secondly, the work of the EPC illustrates the diversity of possible approaches when it
comes to analysing the impact of ageing populations. A wide variety of models (e.g. CGE
models, generational accounts) and indicators are available, and projections differ in the
time span they cover. Some Member States produce reports of pension spending regularly
and present these to legislative bodies, whereas others only do so on an ad hoc basis. The
Commission proposes to promote an exchange of views on methodologies used to simulate
the future evolution of pension and other age-related expenditures.

Thirdly, as proposed in the Commission Communication on sustainable pensions of 11
October 2000, European statistical surveys could be used,
to gauge public
awareness and expectations as regards the modernisation of social protection systems.

inter alia,

Fourthly the analysis above has illustrated the increased role which supplementary pension
schemes may have to play as public pension schemes are adapted in light of the budgetary
pressure of ageing population. This underlines the need for the rapid adoption of the
proposed Directive on the activities of institutions for occupational retirement provision.

Further reflection is required as to how sustainability could be introduced into the Stability
and Growth Pact. The BEPGs and Council opinions on the stability and convergence
programmes already contain general recommendations on the need to prepare for the future
burden on the budget of demographic developments. However, the scale of the challenges
highlighted and potentially large cross-border spillover effects in EMU suggest that the
implications of ageing populations on public finances need to be addressed more
systematically at European level. In its report to the Helsinki European Council on the co-
ordination of economic policies, the ECOFIN Council called for “a broadening of the scope
of public finance issues covered in the stability and convergence programmes and more
emphasis on medium to longer-term sustainability issues.” It is now time to implement this
conclusion. Member States
agreed to ensure that future stability and convergence
programmes contain a section on the long-term sustainability of public finances. It should
outline the overall strategy of the government to address the budgetary consequences of
ageing populations, and present long-term budgetary projections.

60

Finally, the Commission will examine the possibility of establishing, in cooperation with
Member States, a European Longitudinal Ageing Survey.26 This would provide essential
data necessary for the design of effective policies in fields such as health care and social
protection systems which cater for the changing needs of an ageing population. The utility
of longitudinal ageing survey has already been demonstrated by the Health and Retirement
Survey in the US and the English Longitudinal Ageing Survey (ELSA). There would be
significant benefits in organising a longitudinal ageing survey at European level, both in
terms of cost saving and ensuring that data is of high quality and comparable across
countries. Moreover, it would mark an important step in promoting the process of open co-
ordination advocated by the Lisbon European Council on the basis of comparable data and
indicators.

26

Such a survey would focus on a representative sample of older persons, say aged over 50, and encompass
data on health, economic status (such as income, education, employment, pension rights etc. ) as well as
information on social support (assistance within families, transfers of assets etc..).

61

ANNEX A: REFORMS OF TAX SYSTEMS

Social security contributions

Personal income taxes

Corporate and capital taxes

Consumption taxes

Others

B

DK

by

Lowering of SSC, specially
for
the low-paid in 2000
(lump sum reduction of SSC
paid
and
employees). Aligning of the
regime
white-collar
workers to that of blue-collar
workers.

employers

of

(Labour

The temporary contribution to
Market
ATP
Pension),
Supplementary
corresponding to 1% of the
made
wage
sum
permanent with effect
from
1999. Increased contribution
to early retirement scheme.

was

From 1999 onwards a full
indexation of tax brackets has
been restored. Crisis levy to
be eliminated by 2004.

Gradual reduction of marginal
tax rates, in particular for low
and middle income earners
(1999-2002). For low wage
earners, marginal tax rates are
being reduced by up to 8
percentage points.

for

proposal

A
lowering
corporate tax rates (from 32% to
30%) included in the budget for
2001.Simplification of tax-rules
on shareholdings for individuals.
Introduced a 5% tax on stock-
return
funds.
Reduction of tax deductions for
interest payments (1999-2001).

pension

to

D

Reduction of SSC to the
pension system by 1 pp.
between 1998 and 2000

Across-the board reduction of
taxes: Minimum
income
rate from 22.9%
marginal
(2000)
15% (2005);
to
maximum from 51% (2000)
to 42% (2005). Minimum
exempted income will be
raised.

Corporate tax rate cut to 25%
(from 40% and 30% for non-
distributed
and
distributed
profits,
from
respectively,
2001 onwards.

No taxes on capital gains
when shareholdings are sold
between
(from
2002 onwards).

companies

62

Lowering of VAT on labour-
intensive services.

(Energy. environment)

Increase in energy taxes in
1999-2000.

and will

Ecological taxes introduced in
gradually
1999
increase to finance reductions
in SSC.

Social security contributions

Personal income taxes

Corporate and capital taxes

Consumption taxes

Others
(Energy. environment)

GR

Reduction of employers' SSC
(50%) on new staff.

Increased income tax allowances,
for
tax
increase
of
abolition
children,
presumptive criteria.

credits

in

E

F

in

cuts

General
SSC for
permanent contracts (0.2 pps for
the employers and 0.05 for the
employees in 2000)

Targeted cuts in SSC for new
permanent contracts since 1997.

Employers’ SSC cuts at the lower
end of
(in
the wage
association with the reduction of
working week).

scale

.

Thorough reform of the personal
income tax in 1999:

A new single tax rate schedule
was established; minimum and
maximum marginal tax rates cut
by 2 and 8 pps respectively. The
concept of taxable income was
redefined, which is obtained after
tax-free
the deduction of
personal allowance.

a

General tax cuts between 2001-
2003 (0.5% of GDP; FRF 22bn
in 2001).

(“contribution
and

CSG
sociale
généralisée”)
CRDS
(“contribution
le
pour
remboursement
la
dette
gradually
sociale”) will
reduced in the next three years
for workers earning up to 1,3
times the minimum wage.

de
be

Tax relief
for venture capital.
Lowering of tax rates for general
receipts
partnerships.
from corporate bonds taxed in the
same way as interest
receipts
from government bonds

Interest

No withholding tax on securities.
Tax
venture
capital.

incentives

for

Reduction of withholding tax on
dividends

Lowering of VAT on labour-
intensive services. Reduced VAT
rate on electricity.

Adjustment to the average rates
in the EU of indirect taxes on
cars and heating oil.

Lowering of VAT on labour-
intensive services: hairdressers
and small house repairs.

incentives

Tax
innovative companies.

for

young

General cut in the VAT rate (1
percentage point)

Progressive
environmental taxes.

rises

in

Removal of
corporate profits in 2000.

the surcharge on

Creation and extending of a tax
to finance the reduction of the
working week.

Reduction of taxes on dwellings.

Gradual reduction of corporate
tax rates from 36.6% to 33,3%
between 2001 and 2003.

Reduced VAT rates on household
repairs and services.

Reduction of excises on petrol
products in some sectors.

Elimination of the “vignette” for
non-business cars.

small

and
reduction

medium
For
companies,
the
of
corporate tax rate to 15% for the
first 250,000 francs of SMSEs

63

IRL

I

Social security contributions

Personal income taxes

Corporate and capital taxes

Consumption taxes

Others

New National Training Fund
Levy payable by employers
from 2000 onwards. This is
offset by cuts in the employer
PRSI contribution rates (from
12% and 8.5% to 11.3% and
7.8%).

Reduction of the standard (24
to 22%) and top rates (46 to
44%). Increase in the standard
rate band. Generalisation of
standard-rating and increase
in personal allowances.

Reduction of
the standard
corporate rate from 28% in
1999 to 24% in 2000 and
further to 12.5% by 2003.

Abolition

Increase in indirect taxes on
of
tobacco.
transport taxes on air and sea
travels
overseas
to
destinations in 2000.

Housing market: introduction
of a new anti-speculative tax
of 2%.

(Energy. environment)

in

Cut
excise
kerosene in 2000.

duty

on

Total SSC relief for new jobs
in the South introduced in
1999 for a duration of three
the
years. SSC rebates at
lower end of the wage scale.
SSC cuts: 0.82% in 1999,
0.70% in 2000, additional
cuts planned for 2001.

of

the

With the 1998 tax reform,
revision
personal
income tax (reduction of tax
brackets from 7 to 5, increase
in the minimum rate from 10
to 19%, decrease of
the
maximum rate from 51 to
46%). In 2000, reduction of
the rate on the second bracket
from 27 to 26%. Reduction of
lower
tax
in
pensions.
poorer
allowances
households. Adjustments
in
tax rates and further increases
in
planned in
2001.

on
Increase
for

allowances

pressure

on

tax

Regional
production
activities (IRAP) with a flat rate
of 4.25% and Dual Income tax
(DIT), both introduced by 1998
tax reform. DIT initially applied
only to corporate taxpayers;
in
2000 extended to insurance and
banking
implementation
accelerated; further extension to
other types of businesses planned
in 2001. Reorganisation of tax
rules on capital gains in 1998,
broadening tax base and reducing
rates to two (12.5% and 27%);
further fine tuning planned in
2001.

and

1998
in

tax
the
Following
reform,
the
increase
minimum VAT rate to 20% ,
intermediate VAT rate of
16% abolished.
1999,
reduction of VAT on labour-
intensive
(home
services
renovation,
etc.), measure
extended to 2000.

In

excise

Some
duties were
reclassified as CO2 taxes in
1999. The CO2 tax was
in
suspended
2000. Possible freeze also in
2001.

temporarily

64

Social security
contributions

L

Personal income taxes

Corporate and capital taxes

Consumption taxes

Others

(Energy. environment)

Between 2001 and 2002, reduction
from 16 to 14.
in tax scales
Marginal rates cut by 2 (2001) and
4 pps
Increase in the
(2002).
minimum taxable income

Reduction of
the effective
from
taxation of business
37.5% to less than 35% in
2002. Elimination of the local
business tax.

Reduced VAT rates on some
labour-intensive services.

NL

Reduction
workers above 65.

of SSC for

P

Harmonisation of SSC for
the self-employed and the
employed.

Reduction of direct taxes on all income
brackets by 2001. Top rate down from
60% to 52%, intermediate rate down
from 50% to 442%, lower rate down
from 4.5% to 2.8%. Changes in the tax
brackets.
Increase in the minimum
exempted income.

Employment tax rebate (max 803 euro
for minimum wage).

Conversion of deductible allowances
into tax credits (since 1999). In the
2001 budget project: new simplified
regime for the self-employed; general
reduction of tax rates; lower tax rates
low work incomes; minimum
for
collectable income
consolidated;
is
spouses can be taxed separately; more
favourable tax credits
savings,
housing and health and education
expenses. Equal treatment for personal
taxes on capital gains

for

Capital gains tax (with flat 30%
tax on imputed rate of return of
4%) will replace existing tax on
net wealth by 2001. Income from
substantial business interest will
be taxed at 25%.

ncrease of payments on account
on income taxes (from 75% to
85%) in 2000. In 2001, reduction
of
tax rates on firms’ profits
(from 32% in 2000 to 30% in
25% in
2006)
and
2002
Introduction
simplified
a
of
regime for small firms (volume
sales below 150,000 euro –20%
tax rates). Elimination of double
taxation over dividends.

Increased tax credits for R&D
related investments. Property tax
reform to be presented to the
Parliament by end 2000

65

The standard VAT rate will be
raised from 17.5% to 19%.

Increase of environmental levies.

Reduced VAT on some labour-
intensive services.

the

subsidised
Review of
mortgage lending scheme as to
favour housing investment during
downturns.

Environmental tax reform to be
presented to the Parliament in the
1st quarter of 2001.

Social security contributions

Personal income taxes

Corporate and capital taxes

Consumption taxes

Others

(Energy. environment)

Hikes in tobacco and vehicle
insurance taxes in 2000. VAT flat
rate turnover tax scheme changes
for farmers.

Taxes and duties on cars
alcohol and tobacco may be
reduced in the medium term
as
restriction
related to EU
exemptions
accession expire.

trade

Taxes and duties on alcohol
and tobacco will be reduced
because
in
2004, of exemptions related to
EU membership.

expiration,

of

A

FIN

S

A pension reform is scheduled to
take effect in 2001. It will lead to
a 0.8% rise in the pension
contributions made by active and
retired civil servants.

Increase in family allowances.
Reduction of tax rates on low and
middle incomes.

Assistance for business start-ups.
Reduction of taxes on business
transfers

adjustment

Downwards
contributions
unemployment and pensions.

of
to

revision

of
Neutral
employers’ SSC: Old age
retirement fees up by 3.8 pps
to 10.21%; health insurance
fees up by 1 pps. General
wage fees down by 4.95 pps.
Tax rebate of 25 per cent of
the employees’ contribution
from 2000

Rates increased from 28 to
29% in 2000.

Reductions in corporate taxes
in 2000. Coupon tax on
dividends
foreign
to
companies partly abolished in
2000. New tax relief in 2000-
2001. Rise in taxes on real
state in 2001.

1997.

Rates reduced by 1.7 pps
since
Cumulative
reductions for 2000-2001 for
all income brackets, but lower
incomes focused through the
abolition of the lowest income
tax bracket

Increasing

Lowering of income tax rates
at the bottom and the middle
of the income distribution in
1999.
the
minimum exempted income
income
(the proportion of
earners paying national
tax
expected to fall from 18% to
15%).

Further reductions planned for
2001-2002.

66

Increase
environmental taxes.

of

energy

and

Increase in energy taxes on
diesel oil and electricity from
nuclear power in 2000.

Social security contributions

Personal income taxes

Corporate and capital taxes

Consumption taxes

Others

UK

Abolition of the NIC entry
fee. Increase in the threshold
above which employees pay
NICs
in
employers NIC rate by 0.3%
and 0.1% in 2001 and 2002
respectively.

and Reduction

and

credit

Working
in
Increases
Families Tax Credit, under 16
income
child
related benefits
from June
. Employment Tax
2000
from 2003.
(ETC)
Credit
Lowering of income tax rates:
starting tax rate down from
20% to 10% on the first
income.
£1520 of
Basic rate down from 23% to
22%.

taxable

gains

tax reform.
Capital
Permanent first year capital
allowances for SMEs at 40%.

Increases in stamp duty on
above
property
£250,000

transfers

5% real increase in tobacco
duty

Levy on aggregates.

(Energy. environment)

Introduction
graduated
of
vehicle excise duty for new
cars from 2001.

Introduction
change levy.

of

a

climate

67

ANNEX B: REFORMS OF BENEFITS SYSTEMS

benefits:
Unemployment
benefit
duration,
eligibility and job availability
rules

level,

Means-tested schemes: housing
allowances,
social assistance,
child care subsidies

B

Introducing an allowance
for
training attendance to young job
seekers (1999).

Adapting unempl. benefit rules to
take into account new provisions
related to temporary unempl. and
voluntary work (1999).

DK

the duration of
Reduction of
unemployment benefit from 5 to
4 years (1999)

Tightening the eligibility rule on
“guaranteed minimum (social
assistance)” for under 25 (1998).

Strengthening of job availability
requirements (1999)

Extension of the right and duty to
activation to all people in receipt
of social assistance (1999)

Older workers :
early retirement schemes

disability,

Employment-conditional
benefits

Employment subsidies

long-term

Transferring unemp. benefits to
employers for promoting hiring
other
of
unemployed and exempting the
whole salary from SSC payments
(1999).

and

for

Increase in the minimum age (to
58 years)
full-time early
retirement and extending part-
time early retirement schemes
(1999).

Introducing an income support
threshold for employed under
back-to-work scheme (1998).

in back-to-
Enabling workers
work scheme
and young in
training to receive allowances
Insurance
paid from unemp.
(1998).

Providing lump-sum payments to
long-term unemployed
lone
parents or compensate moving
costs when taking up jobs (1999-
).

Modifying the early retirement
law to be less attractive for under
62 and increasing incentives to
remain longer in work through
more flexible combinations of
retirement and part-time work
(1999) .

Softening the reduction of the
basic pension when pensioners
have earnings from professional
activity (1999).

68

benefits:
Unemployment
benefit
duration,
eligibility and job availability
rules

level,

Means-tested schemes: housing
allowances,
social assistance,
child care subsidies

Older workers :
early retirement schemes

disability,

Employment-conditional
benefits

Employment subsidies

D

Making the unemployed eligible
for active measures (subsidised
jobs) after 6 months (instead of
12 months before) (1999) .

Increase in child benefit and
allowance
after
ruling of constitutional court.

(1999-2001),

Tighter means-testing of the part-
time work in the social security
system (so-called 630 DM law),
1998.

Promoting empl. of age 55 and
older up to 5 years in New
Länder and regions with high
unempl. (1999).

Introducing the “Act on Part-time
Work in Old Age” allowing older
workers to halve their working
time without high income losses
(2000-).

subsidies
above

to
Extending
unemployed
for
encouraging training and job
search in a fixed-term program
(1998-2000).

20

GR

E

F

Introducing parental leave with a
right of transferring 10 weeks to
the father and drawing up rules
for work contract termination to
avoid dismissal due to pregnancy
and family-care leaves (1999) .

Tightening rules
for making
elderly employees redundant by
increasing fine for
lay-offs of
over 50.

Enabling workers to keep certain
allowances during the 1st 12
months. of regular empl. (1998-).

69

Some projects include subsidies
for social charges of employers to
improve the incentives for the
recruitment of the low-skilled.

Providing bonuses and incentives
for recruiting unemployed young
(under 30), older (45 or more) or
long-term (1999) .

Unemployment
benefits:
duration,
benefit
eligibility and job availability
rules

level,

Means-tested schemes: housing
social assistance,
allowances,
child care subsidies

Allowing the retention of Rent
and Mortgage Supplement
for
those who are in the Community
Employment Scheme, Back to
Work Allowance Scheme and
Revenue Job Assist (99).

leave and
Introducing parental
leave on family grounds with a
guarantee
re-employment
(1999-)
Setting up scheme for expanding
child care facilities (1999).

of

IRL

I

L

NL

Older workers :
early retirement schemes

disability,

Employment-conditional
benefits

Employment subsidies

Back-to-Work
Extending
Allowance
long-term
to
unemployed taking up self-empl.
(98)
Enhancing Back to Work Scheme
(e.g., travel allowance, bonus for
starting training, 1999).

Speeding up the increase of
retirement age from 53 to 57 as
from 2002,
instead of 2008
(1998-).

unempl.

Introducing co-payment scheme
for
for
employees laid off after 57.5
years old.

benefits

Reintegrating the Work-Disabled
Act for promoting employment
of persons with disability (1998).
Introducing
premium
differentiation for first 6 months
of unempl. Benefits to discourage
short-term/seasonal empl.

P

Creating a partial unempl. benefit
to promote part-time jobs (1999).

Appointment of
recipients of
Minimum Guaranteed Income to
(refusal
match job vacancies
implies
the
of
discontinuity
subsidy

Creation of an “extra solidarity
complement” to reinforce older
workers’ pensions.

70

benefits:
Unemployment
benefit
duration,
eligibility and job availability
rules

level,

Means-tested schemes: housing
allowances,
social assistance,
child care subsidies

Older workers :
early retirement schemes

disability,

Employment-conditional
benefits

Employment subsidies

A

Deducting only a portion of
income from temporary work
from unempl. benefit/assistance
(1998-).

allowances

Introducing
for
elderly workers taking up part-
time jobs (2000-2001).

FIN

Improving
unempl.
partial
benefits for taking up part-time
jobs (1997-).

Modifying the Social Assistance
Scheme to reduce the wage floor
(1998).

Providing a safeguarded pension
amount for taking up lower paid
jobs (1998-).

Providing subsidies to employers
to hire long-term unemployed
(1997-).

Tightening of empl. Condition
from 6 months to 10 months for
insurance-based unempl. benefit
(1997-).

S

Increasing requirements in terms
of occupational and geographical
mobility in umempl.
Insurance
(2000-)

Cutting unempl. Pension by 4%
and raising early retirement age
from 58 to 60 (2000-).

employers’
Increasing
responsibilities for unempl. &
disability pension costs (2000-).

Increasing the age for elderly
long-term unemployed to be
entitled for receiving allowances
during an additional period from
55 to 57 (1997-).

employer

Providing
tax
reductions corresponding to 75%
of wage costs over 2 years for
recruiting persons 57 or older
(2000-).

71

employers

Providing
tax
reductions for hiring long-term
unemployed (1999-).

benefits:
Unemployment
benefit
duration,
eligibility and job availability
rules

level,

Means-tested schemes: housing
allowances,
social assistance,
child care subsidies

Older workers :
early retirement schemes

disability,

Employment-conditional
benefits

Employment subsidies

UK

Introducing
interview to
(ONE, 1999-)

a

work-focused
system

benefit

the

Introducing
minimum wage to support
“make work pay” policy (99).

national
the

Introduction of a 10p rate/£ of
income tax on the first £ 1500 of
taxable income (1999).

Providing the tax-free allowance
and in-work training grant
for
unemployed aged 50 or over as a
New Deal initiative (2000-).

Linking the receipt of benefits
more strictly to participation in
New Deal
initiatives for young
(18-24) unemployed, disabled,
lone parents and spouses of
unemployed.

to

Offering
cover
subsidy
payments up to 6 months (and
training costs for taking on young
unemployed) for hiring those in
the New Deal initiatives.

tax

credits
children

for
Introducing
and
families with
disabled to provide guaranteed
minimum
when
employed (1999).

income

Sources: Joint Employment Report 2000 (2000-07-28), MISSOC INFO: Evolution of social protection in the Member States of the European Union (2/99, 2/2000, DG EMPL),
National Action Plans for Employment 1998, 1999 and 2000

72

ANNEX C: REFORMS OF HEALTH CARE SYSTEMS

Introduction

In analysing the overall evolution of public expenditure and in evaluating its quality and
contribution to growth, it is essential to consider the health sector. As well as providing
an essential public service, the provision of health care in Member States is important
from an economic perspective. Data from the OECD suggest that the total expenditure
on health care in 1998 ranged from 5.9% of GDP to 10.6% of GDP for EU Member
States. The average share of health care expenditure in GDP in Member States has been
around 8% throughout the 1990s. Similarly, public expenditure on health is one of the
most important expenditure items for public budgets. The average share of public
expenditure in GDP is around 6%. Moreover, the health sectors of Member States are
generally important sources of employment.

National health care systems: similarities and differences

Health care systems in Member States differ considerably as regards the methods of
provision of services, the means of financing the overall system, and payment systems
for hospitals and doctors. Other differences not reported in this annex are the supply of
doctors, the provision of out-patient care and dental care, the extent of patient choice, and
the regulation systems.

Financing systems27: Essentially, there are two philosophies guiding the financing of and
provision of health care. One group of countries has chosen general taxation as a main
source of financing whereas some other countries rely primarily on social insurance.
Additionally, in all EU countries, there exist supplementary financing systems such as
voluntary health insurance and user charges.

General taxation is the principal source of financing in eight countries (DK, UK, S, IRL,
I, FIN, E, P). Earmarked taxes represent a significant share only in Italy. Other Member
States rely more heavily on insurance, notably F, NL, D, A and L. These are compulsory
social insurance systems, except in the Netherlands where there is a mixture of social and
private insurance. In Belgium, both taxes and social insurance are equally important
sources of financing. In Greece, the largest share is financed by user charges and the rest
by general taxes and social insurance.

Over the last 15 years, there have been some significant changes in financing systems. In
Spain, general taxation has replaced social insurance as the dominant source of funding.
In most countries the role of voluntary health insurance has increased somewhat, and
user charges have increased significantly in many countries (B, FIN, S and P).

Provision of services: in the past tax-financed systems tended to be characterised by
mostly public providers of services. In these countries the public sector still generally
acts as the principal agent of service delivery in some areas, such as hospitals, primary
care centres and ambulance services. However, many of these countries have introduced

27

Source: Mossialos and Le Grand (1999)

73

and continue to experiment with models of contracted services, most notably the UK.
This means a separation of purchasers from providers including more independence for
public providers, and greater use of private and non-profit providers operating in market.
In this sense, the pattern of service provision is approaching that applied in insurance-
based systems.

Payment systems: The methods of financing hospitals in Member States have changed
significantly over the last 15 years. There is a clear move from open-ended retrospective
funding of hospital activities to the establishment of prospective budgets and purchaser-
provider contractual agreements. The main types of hospital financing are prospective
budgets mainly based on historical spending (DK, EL, F); prospective budgets based on
hospital activities or functions (D, IRL, L, NL, P); prospective budgets combined with
activity-related payments (B, E, A); and activity-related payments with case-mix-based
payments (S, I) and purchasing packages of hospital services (UK, FIN). There are also
different methods for paying doctors including: capitation, i.e. payment per numbers of
patients (IRL, I, UK); a salary (EL, P, FIN and S); and /or a fee-for-service (B, D, F and
L). In some countries payment for doctors is characterised by a mix of the above three
payment systems. Payment systems may be applied differently to general practitioners
from specialists; capitation or salary are more often applied to general practitioners
whereas fee-for-service payment systems apply more often to specialists.

Trends in health expenditure

Since 1960 expenditure on health care in Member States has generally shown a steady
upward trend; health expenditure as a share of GDP roughly doubled over the period
1960-1990. Moreover, public expenditure on health grew at an even faster rate as a result
of increased coverage by public insurance.

More recent data for the 1990s reveal that growth of total health expenditure as a share of
GDP generally continued in Member States up until the mid-1990s albeit at a slower
pace than in earlier years. However, in the second half of the 1990s, health expenditure
(See Table C.1.)
as a share of GDP has either been stabilised, or been reduced.
Unfortunately, there is no comparable data since 1999, and so it is not possible to see
whether policies have changed in the light of the most recent economic upturn.

74

Table C.1 Total expenditure on health as a share of GDP

1990
7.4
8.4
8.7
7.6
6.9
8.8
7
8.1
6.6
8.8
7.2
6.4
7.9
8.8
6
7.6

1993
8.1
8.7
9.7
8.3
7.6
9.7
7.8
8.6
6.7
9.4
8.1
7.5
8.3
8.9
6.9
8.3

B
DK
D
EL
E
F
IRL
I
L
NL
A
P
FIN
S
UK
EU*
* unweighted average
Source OECD Health Data 2000

1996
8.6
8.3
10.6
8.3
7.1
9.7
7.2
8.1
6.4
8.8
8.9
7.7
7.7
8.7
7
8.2

1998
8.8
8.3
10.6
8.3
7.1
9.6
6.4
8.4
5.9
8.6
8.2
7.8
6.9
8.4
6.7
8.0

Nominal health spending per capita (in Euro PPS - see Table C.2) also reveals an upward
trend for the 1990s. Between 1990 and 1998 nominal expenditure per capita increased in
all countries, with growth rates ranging from 2.1% to 9.2%. The trend for expenditure
for Sweden and Finland is somewhat different from that of other Member States, as these
two countries saw a decline in nominal terms in health expenditure per capita in the early
1990s.

Table C.2 Total expenditure on health per capita Euro PPS (nominal prices)

1990
1177
1360
1515
667
769
1457
752
1246
1402
1329
1137
581
1217
1409
904
1128

B
DK
D
EL
E
F
IRL
I
L
NL
A
P
FIN
S
UK
EU*
unweighted average
Source OECD Health Data 2000

1993
1496
1600
1709
855
941
1724
1040
1429
1750
1558
1440
815
1242
1405
1119
1342

avg. %
growt
1991-98
6.7
5.1
5.4
6.6
5.2
3.9
8.0
4.0
5.2
5.0
6.5
9.2
2.1
2.1
5.5
5.4

1998
1974
2023
2298
1108
1151
1968
1377
1691
2099
1965
1863
1172
1425
1654
1378
1676

1996
1761
1850
2111
1028
1034
1860
1223
1560
2011
1779
1818
1002
1371
1583
1289
1552

75

Table C. 3 Public expenditure on health as % of GDP

1993
7.2
7.2
7.5
4.8
6

1990
6.6
7
6.7
4.8
5.4
6.7
5
6.3
6.1
6.1
5.3
4.2
6.4
7.9
5.1
6.0

B
DK
D
EL
E
F
IRL
I
L
NL
A
P
FIN
S
UK
EU*
unweighted average
Source OECD Health Data 2000

5.7
6.3
6.2
7
6
4.7
6.3
7.7
6
5.9

1996
7.6
6.8
8.3
4.9
5.5
7.4
5.2
5.5
5.9
6
6.3
5.1
5.8
7.4
5.9
6.2

1998
7.9
6.8
7.9
4.7
5.4
7.3
4.8
5.7
5.4
6
5.8
5.2
5.3
7
5.6
6.1

Table C.3 contains data on public expenditure on health care as a share of GDP
throughout the 1990s, and Table C.4 contains data on the share of public spending in
total spending. In most countries, the share of the public sector in health expenditure has
been falling throughout the 1990s. The decline of the public share has been most marked
in Italy, where it fell by 10.1% between 1991 and 1998. However, some countries have
shown an increase in the public share of health expenditure – this is notably the case for
Ireland where expenditure increased by 4.1% between 1991 and 1998.

Table C.4 Public expenditure on health care as a share of total expenditure %

1993
88.7
82.6
77.5
58.2
79.7

1990
88.9
82.6
76.2
62.7
78.7
76.9
71.7
78.1
93.1
68.7
73.5
65.5
80.9
89.9
84.2
78.1

B
DK
D
EL
E
F
IRL
I
L
NL
A
P
FIN
S
UK
EU*
*unweighted average for EU-14 excl. F for 1991-1994
Source OECD Health Data 2000

72.8
73.1
92.9
74.7
74.2
63.0
76.1
85.7
85.9
77.5

1996
88.8
82.4
78.3
58.7
78.5
76.3
72.5
67.8
92.8
67.7
70.5
66.7
75.9
84.8
83.7
76.4

1998
89.7
81.9
74.6
56.8
76.9
76.4
75.8
68.0
92.3
70.4
70.5
66.9
76.3
83.8
83.7
76.3

76

Factors affecting the evolution of health expenditure

There are a number of different demand and supply factors which have driven the
increase in health expenditure per capita over the last years, although it
is unclear
whether these same factors are likely to continue to drive health expenditure. On the
demand side, several factors have influenced the evolution of health care expenditure:

• Increases in income levels: as income levels rise consumers demand more health care.
Empirical analysis reveals that the income level for different countries are significant
determinants of overall levels of health expenditure per capita. However, there is little
consensus on the value of the income elasticity of health expenditure - some studies
estimate it to be greater than unity and some less.

• Extensions of health cover:

extended
significantly in past decades. By the end of the last century, universal coverage of
populations was practically achieved in almost all Member States. However, certain
types of treatment are usually excluded from this coverage.

compulsory insurance

coverage was

• Ageing populations: people tend to consume more health care as they get older.
Studies of past expenditure indicate that ageing did not play a significant role in
driving health expenditure in the last century. However, population projections
suggest this is likely to change during the first half of this century. Nevertheless, the
likely impact of population ageing on health expenditure is not completely clear as
some literature suggests that as life expectancy increases people can expect to enjoy a
greater number of years in good health. The overall impact of population ageing on
public expenditure will depend crucially on policies for long-term care of the elderly.

On the supply side, several factors affect the evolution of health care expenditure:

• Technological change: advances in medical technologies covering drugs, equipment
and medical procedures have generally led to increases in medical costs. Some
advances have been cost-saving, but others have led to the introduction of more
expensive technologies (usually with improved benefits for the patient), or to the
treatment of previously untreatable conditions.

• Supply–induced demand: many health systems in Member States have experienced an
over-supply of physical capital such as beds. This over-supply, combined with
inappropriate payment systems, may well have led to the supply-induced use of
facilities (e.g. longer hospital stays).

• High medical price inflation: many countries have seen medical inflation consistently
higher than general price inflation, leading to an increased share of health expenditure
in GDP. High levels of medical price inflation generally reflect a low level of
competition in the provision of health care.

77

Cost containment reforms28

Cost containment has been a dominant theme for most Member States since the mid-
1970s. Almost all Member States have introduced measures aimed at directly or
indirectly containing public expenditure on health care, but the emphasis of these reforms
has changed considerably over time. From the mid-1970s to the mid-1980s, the emphasis
of reforms was on direct and indirect controls on health expenditure. These included:
control over facilities such as hospital beds and staff; control over investment decisions
in capital and technology; as well as control over the entry to medical education.

From the mid-1980s, the emphasis shifted to budget setting measures.
Initially this
involved budgetary ceilings and targets for different sectors, but later this evolved to
setting budgets for individual providers which were often combined with activity-related
payments. Payment systems for doctors were also often changed Direct and indirect
control measures continued during this period, but evolved into price controls
(pharmaceuticals, reference price systems, alternative models for reimbursement of
pharmaceuticals) and into providing incentives for alternatives to hospital care.

Since the 1980s, Member States have also used budget shifting measures. These
primarily consisted of an increased use of cost sharing (e.g. user charges) and voluntary
health insurance. Additionally, restrictions in treatments (through priority setting and
through limiting reimbursement for certain types of service such as dental care) and on
reimbursements for certain types of pharmaceutical products have been introduced. A
few countries have also adapted public budget shifting, above all, by shifting costs of
long-term care of the elderly to the social services budget.

rationing, and on evidence-based purchasing decisions.

From the mid-1990s onwards, the emphasis of health care reforms has been on budget
Indirect control
shifting,
mechanisms such as assessment of health technology, and the introduction of
management and information systems, have also been used increasingly in the 1990s.
The reforms carried out between the 1970s and the early 1990s29 have had some success
in containing overall costs. However, there is insufficient information to be able assess
the long-term effects of the measures taken. Notably, macro measures to contain costs
can often have important repercussions for the micro-level efficiency of health care
provision. Nor is it possible to distinguish the effects of individual measures either
because new measures have quickly followed previous ones, or because many countries
have implemented packages of reforms made up of a number of individual measures.

28

29

The information contained below on reforms is taken from Mossialos E. and J. Le Grand (eds., 1999):
Health Care and Cost Containment in the European Union, The London School of Economics and
Political Science
There is little information about more recent reforms. The Commission has requested this information
from Member States.

78

Budget setting measures appear to have been the most effective way of controlling
these measures have been most
public expenditure on health care.
successful in countries where the health care is mainly tax-financed and where there is
monopsony power through single purchasers of health care. Insurance-based systems on
the other hand, have usually succeeded better in controlling costs when regulating
providers’ fees and implementing direct controls. However, the overall result seems to be
less uniform and inferior to countries with tax-financed systems.

In particular,

79

Overview of reforms to health are systems

MID-1970s/MID-1980s

MID-1980s/MID-1990s

LATE 1990s

Emphasis: Direct and indirect controls

Emphasis: Budget setting

Purchasing/provision of services: Public integrated
model dominant
in systems mainly financed by
taxation (Beveridge type); public contract model
dominant in systems financed by statutory insurance
(Bismarck type). Payers gradually transformed into
purchasers in some social insurance-based systems.

Purchasing/provision of services: Public contract model
replaces the public integrated model in Denmark, Sweden
and the UK. Also the predominant model for the hospital
sector in Finland and in Italy. Purchasers in some insurance-
based systems set budgets for each of the contracted sectors,
negotiate doctors' fees, prices and volume of services.

Emphasis: Budget shifting, rationing and evidence-based
purchasing decisions

Purchasing/provision of services: Public contract model
dominant in most countries. The role of private finance,
but not necessarily private provision, increases.

Budget shifting
• Role of cost-sharing still small
• Voluntary health insurance negligible except in
the Netherlands, Germany, Austria and France
• Exclusion of services from reimbursement limited
but spa treatment excluded in Italy. Elsewhere,
negative lists for drugs introduced and parts of
dental care no longer covered in several countries

Budget shifting
• Significant increases in co-payments
•

Increasing role of voluntary health insurance

• More drugs included in negative lists and even more

switched to over-the-counter (OTC) status

Budget shifting

•

Increases in user charges

• More pharmaceuticals switched to OTC status
• Reduction in the number of those exempted from

paying co-payments (e.g., wealthy pensioners)

• More services excluded from reimbursement (mainly

• Reduction in the number of diseases exempted from

dental care, cosmetic surgery, ophthalmic care)

co-payment

• Explicit rationing decisions
• A greater role for voluntary health insurance
• Alternatives to hospital care and long-term care
coverage schemes are further developed, but mainly
financed by private sources

80

MID-1970s/MID-1980s

MID-1980s/MID-1990s

LATE 1990s

Budget setting
• Budget ceilings for hospitals (prospective global budgets

in France, historical budgets in Denmark)

Budget setting

•

Introduction of fixed or target budgets for overall or
public expenditure on health

• Target budgets for each contracted sector (Germany and

• Sectoral budgets for health services, mainly for hospitals

the Netherlands)

and pharmaceutical care

• Relative value scales for payment of doctors (Germany)

or hospital services (diagnostic tests in Belgium)

• Changing doctor payment systems (capitation payments
in Italy, salaried GPs in Portugal, salaried specialists in
Irish hospitals)

•

Individual fixed or target budgets for doctors (UK,
Ireland)
• Relative

doctors
for
(Luxembourg and the fee-volume trade-off payment
system in France)

payment

scales

value

of

Budget setting
• Fixed budgets replace target budgets
• Budgets are combined with activity-related

payments

• Sectoral budgets are replaced by budgets for

individual providers

• More

countries

introduce

capitation

for

payment of first contact doctors

• Fee-for-service payments are introduced in capitation-
to encourage preventive medicine

based systems
(immunisations, screening) and day surgery

• Performance-related payment systems for hospitals are
introduced in several countries (Diagnosis Related Group
(DRG) type or activity-related)

81

MID-1970s/MID-1980s

MID-1980s/MID-1990s

LATE 1990s

Direct and indirect controls
• Controls of hospital staff numbers (Ireland, Spain)
• Controls on prices (pharmaceutical products, per

day payments in hospitals)

• Controls on volume (e.g. maximum number of

items per prescription)

• Controls on hospital beds (most countries)
• Controls

investment

capital

on

and

new

technology

•

Incentives to develop alternatives to hospital care
(Northern European countries)

• Manpower controls (numerous clauses in medical
entry to

controls over

schools,

and dental
specialist training)

Direct and indirect controls
• Price control systems for pharmaceuticals in all countries

Direct and indirect controls
• A greater role for Health Technology Assessment in

except in Germany and the UK

coverage and purchasing decisions

• Reference

price

non-patented
systems
pharmaceuticals in Germany, Sweden and Denmark and
for all pharmaceuticals in the Netherlands and Italy
• More incentives to develop alternatives to hospital care

for

(mainly in Belgium and Denmark)
• Further reduction in hospital beds
• Practice guidelines

for

office-based doctors with

financial penalties (France and Austria)

• Technology Assessment Institutions were established in

several countri²es

• Further controls on capital

investment and new

technology

• Further reduction in hospital beds
• Development and use of sophisticated information

systems

• Further manpower controls (mainly doctors)
• More

investment

in

developing management

competence

• Sanctions for excess prescribing

Source: E. Mossialos and J. Le Grand “Health Care and Cost Containment in the European Union”, London School of Economics, 1999.

82

ANNEX D: REFORM OF PUBLIC PENSION SYSTEMS

30

B

Building on important reforms introduced in 1997 for private sector employees, the government
together with social partners is reflecting upon further reforms to cover for public sector
employees and the self employed. Consideration is also being given to the promotion of private
funded pensions.

DK

D

EL

E

The transformation of a largely unfunded system to one with a much higher degree of funding
has been under way for some years. 1999 saw a temporary contribution to the ATP (Labour
market supplementary pension) amounting to 1% of the average wage made permanent and a
tightening up of early retirement rules.

Pension reform is still high on political agenda. A tax reform package was agreed enabling
increased revenues from energy taxes to partially offset a reduction in the contribution rate to
pensions by employees and employers. Changes were also agreed for 2000 and 2001 linking
increases in public pensions to inflation rather than the rise of net wages; in the ongoing
discussions on pension reform, the federal government has, however, offered to link the rise in
public pensions due on 1 July 2001 to net wages again (adjustment for the increase in net wages
due to income tax reform). A planned pension reform has the target to restrict the increase in
social charges due to demographic changes so as to secure an appropriate level of pensions to
2030 and beyond. An additional capital funded pension is being envisaged. Pending these
reforms, the reforms agreed by the preceding government in 1998 and suspended by its successor
would take effect.

A two phase reform strategy was announced in 1998. The first phase was largely organisational,
involving for example the introduction of a single social security number. The second phase will
require a major overhaul of public pensions, and could involve the consolidation of retirement
ages in different pension regimes, adjusting contribution and eligibility rates to sustainable
levels, and the introduction of compulsory occupational pension scheme. Announcements on the
second phase are still being awaited.

Important reforms were introduced in 1997 (based on the 1995 Pacto de Toledo) which placed
public pensions on a more sustainable footing. Further reforms are scheduled for 2000. They will
need to address measures to increase the effective retirement age and discourage early
retirement, and special pension regimes (e.g. covering self-employed, agricultural workers).
During 1999, a disagreement broke out between the Central Government and the regions as to
whether the latter’s non-contributory pensions should be increased by above the inflation rate. In
2000 a Social Security fund reserve has been created to address the problem of the ageing
population . The initial fund amounts to 0.1% of GDP and there is a commitment in the Updated
Spanish Stability Programme to further increase this fund reserve

30 The table is based on the report on the implementation of the BEPG. The process of updating the table is not yet

complete.

83

F

After postponing reforms adopted in 1997, a report was presented in 1999 to serve as a basis for
dialogue between authorities and social partners which is now taking place. Prime Minister
announced in March 2000 broad reform guidelines, including boosting the assets of the pension
reserve fund, the establishment of a monitoring body on pensions (Conseil d’Orientation des
Retraites) and, for civil servants, the possible extension of the minimum contribution period
needed to receive a full pension.

IRL

I

In May 1998, the Government outlined its plans for creating a fully developed pension system.

On foot of a government decision in July 1999, an annual provision of 1% of GNP is made to
pre-fund future public pension costs. Part of the proceeds from the privatisation of the State
telecom company will also go into the National Pensions Reserve Fund (to be established 2000;
legislation pending). Part of the proceeds were also used to buy-out the State's future pension
liabilities to pre-privatisation staff.

A series of reforms were undertaken in the 1990s, the last in 1997. Although these reforms have
succeeded in bringing down the rate of growth of pension outlays to GDP compared to the pre-
reform situation, public pension expenditure remains high and might weaken long-term public
finance sustainability. The main shortcomings of the present system are an excessively long
transition period and rather generous benefits from an actuarial point of view. Moreover, there is
still a high degree of uncertainty about future reforms. No changes to the system were made in
1999 and in 2000. A revision of the parameters of the system is scheduled to take place in early
2001.

L

Reforms were introduced in 1998 to align the pension regime for new public servants with that
applying in the private sector.

NL

With a large proportion of pensions already funded, the impact of ageing populations is being
addressed via the reduction of public debt and measures to increase employment rates.

A

Large reform packages were adopted in 1993 and more recently in 1998. The latter reform
addressed incentives for early retirement, tightened up eligibility for disability pensions, and
aligned the pension system for civil servants to the general system. Also an annual adjustment
formula was introduced making an adjustment for the financial
impact of increased life
expectancy. This however was suspended in 1998 and 1999 and must be addressed in 2000.

P

A new framework law was approved by Parliament in July 2000 in response to a White Paper
presented in 1998. It should be implemented in the near future. The novelties are: the retirement

84

age will be made more flexible, the pension formula will be altered (instead of using the best 10
out of the last 15 years, the whole contribution history will be used) making the system much
less generous, and the Stabilization Fund will be engrossed to almost 50 per cent of the current
annual private sector pension outlays. The Fund, at the end of 1999, had about 3 per cent of GDP
accumulated assets

FIN

S

UK

During 1999, agreement was reached between labour market organisations on measures to
postpone retirement and extend active participation. Together with a large primary balance, this
will make it easier to meet increased age-related expenditures in coming years. However,
questions remain about the long-term sustainability of existing public pension schemes, and
further reforms may be required to tackle imbalances at source.

Reforms adopted in 1998 are currently being phased in. They are increasing the degree of
funding of pensions. They also establish a closer link between contribution paid and benefits
received, i.e. taking into account the full working career, and indexation clauses were adjusted.

Estimates released in 1999 show that the public finance implications of ageing populations for
the UK are relatively favourable. Extensive reforms proposed in late 1998 were adopted in 1999.
They provide for a ‘minimum income guarantee’ and a replacement of SERPS (state earnings
related pension scheme) with a second flat rate pension.

85