JCMS 2009 Volume 47. Number 1. Pp. 153–174

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Bringing Macroeconomics into the EU BudgetDebate: Why and How?

SEBASTIAN DULLIENFHTW Berlin

DANIELA SCHWARZERStiftung Wissenschaft und Politik

Abstract

The EMU has been designed without an instrument for automatic fiscal stabilization

on the European level. This article highlights the seriousness of this lacuna by newempirical data, which suggest that fiscal stabilization at the national level has also

worked insufficiently. This situation will hamper the EU’s efforts to achieve the

targets set by the Lisbon Agenda: recent theoretical contributions suggest that a

positive macroeconomic environment is a prerequisite for productivity growth and

structural reform which form the centrepiece of the Agenda. There are thus strong

economic arguments for rethinking the set-up for fiscal stabilization policies in the

EMU. We suggest three remedies for the underperformance of the automatic stabi-

lizers: making EU expenditure sensitive to the cyclical situation of the recipient

country, introducing an EU corporate tax upon the upcoming revision of the EU

budget before 2013 and/or setting up a European unemployment scheme.

Introduction

This article examines whether fiscal stabilization in the EU works satisfac-torily. As our econometric analysis suggests it does not, we discuss theconsequences and conclude that stabilization elements have to be introducedat the EU level. With its empirical analysis and the specific proposal for betteradjustment mechanisms, our article contributes to the literature on the bud-getary performance of the Member States, the EU budget reform debate and

JCMS 2009 Volume 47. Number 1. pp. 153–174

© 2008 The Author(s) Journal compilation © 2008 Blackwell Publishing Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148,USA



on EMU governance as well as linking older literature on possible fiscalstabilization schemes with more recent macroeconomic contributions.

The current academic debate about budgetary policy in the EU and EMU

has several strands, three of which are principally relevant for our analysis:(1) The first focuses on the reform of the EU budget , coupling this question

of reform in particular to the success of the Lisbon goals. This strand of analysis describes a debate that has arisen each time a new budgetarypreview has been negotiated. Indeed, this debate intensified in 2005 dueto the tensions that emerged after the EU Constitutional Treaty hadbeen rejected and before a compromise for the 2007–13 budget wasfound. The ‘rendez-vous clause’ included in the Conclusions of the

European Council of December 2005 was key to this compromise. Itprescribes a profound reform debate on the EU public finances, includ-ing on previous taboos such as the British rebate. The European Com-mission has already launched the review with a consultation paper anda public and expert consultation process, and will deliver conclusions inspring 2009 at the latest. Yet, the fact that the 2005 compromise couldonly be reached with the perspective of fundamental reform fathomedby the rendez-vous clause has led many analysts to conclude that thedecision-making process requires change due to the growing number

and heterogeneity of participants and the increasing salience of nationalpreferences. The reform debate focuses on three related issues.1 Firstly,as regards the expenditure side, the question is how to reform the rel-evant EU policies given the shortcomings on the national and Unionlevels. On the national level, the room for allocative policies is con-strained by the Stability and Growth Pact (SGP); the allocative expen-diture of the EU budget is meanwhile generally judged to becompletely out of step with the tasks the EU has assigned itself (Butiand Nava, 2003; Sapir, 2003). Secondly, as regards the income side,

analysts want to replace the horse-trading culture between net contribu-tors and net recipients with a transparent system of EU public finances,possibly including an increased amount of the EU’s own resources, inorder to allow for more forward-looking budgetary decisions. The thirdissue comprises the twin questions of how a new EU budgetary systemcan be afforded legitimacy and subjected to scrutiny, and how the man-agement of the EU budget might be improved.

(2) The debate on national fiscal policies under E(M)U institutions has

developed relatively independently from that on the EU budget. It mostly1 See for instance Sapir et al. (2004), Buti and Nava (2003), Becker (2007), Begg (2005), Enderlein et al.

(2005), Collignon (2003) and the contributions in Lefebvre (2004).

154 SEBASTIAN DULLIEN AND DANIELA SCHWARZER

© 2008 The Author(s) Journal compilation © 2008 Blackwell Publishing Ltd



focuses on the adequacy of the EU rules (notably the SGP and theExcessive Deficit Process) for national budgets. Many economic contri-butions deal with the question of whether the targets for budgetary policy

are conducive to certain objectives such as sound public finances andlong-term sustainability. The political economy view studies the applica-tion of rules, the functioning of soft co-ordination, the chance to imple-ment sanctions and so on. Recently, the quality of public finances has alsogained importance in the academic debate on national fiscal policyco-ordination in the EMU. In addition to the objective of reaching thenominal targets defined in the excessive deficit procedure, the debate nowfocuses on the question of how to improve the perspectives for growth-enhancing policies in line with the Lisbon Agenda as well as on how to

ensure the long-term sustainability of national public finances.(3) The debate surrounding the need for macroeconomic stabilization

mainly concerns the functioning of stabilization mechanisms in the EUunder certain given constraints (the existence of a single monetarypolicy for 13 Member States, the limits on national fiscal autonomyimposed on all EU countries through Art. 104 TEC and the SGP, andthe incomplete functioning of markets). It strongly interrelates with thesecond discussion mentioned above, notably when analysts of the SGPturn to the question of whether the rules are likely to promote anti- orpro-cyclical fiscal policies. Notably, this debate is gaining attentionamong economists: the political economy of structural reforms and theinteraction between a positive macroeconomic environment and produc-tivity growth are increasingly well understood and clearly highlight theimportance of a stable macroeconomic environment for microeconomicpolicies (see Galí et al., 2005; Mabbett and Schelkle, 2007; Aghion andHowitt, 2006).

Our article links these three debates. Section I argues that the issue of

macroeconomic stabilization, and in particular the role of fiscal policy, shouldbe taken into account more strongly in the debate on EU and EMU budgetaryreform in order to contribute to the development of a coherent and efficientbudgetary system. We argue that there are growing indications that a bettermanagement of economic fluctuations helps to increase the long-term growthpotential and that thus a better fiscal management is a necessary complementof the Lisbon Agenda. In section II we show that, under the current set-up,national stabilization policies have underperformed considerably. We provide

new evidence that budgetary policy, for instance in Germany and Portugal,became pro-cyclical when automatic stabilizers were less evident. Theempirical data presented here support one important conclusion reached by

BRINGING MACROECONOMICS INTO THE EU BUDGET DEBATE 155




theorists of fiscal federalism, namely that economic stabilization should occuron the highest possible level in a monetary union, and not in its sub-units.Against this background, the third section assesses the major weaknesses of

the current EU and EMU budgetary systems and suggests a way to include thestabilizing function: by making EU-expenditure more sensitive to the cyclicalsituation in the recipient country, by introducing a European corporate tax tofund a substantial part of the EU budget and/or by setting up an EU orEMU-wide unemployment scheme. This final section includes a discussionof the institutional and legitimatory requirements of these new budgetarymechanisms.

I. The Importance of Fiscal Stabilization

Interdependencies and Spillovers: Fiscal Backing for the Lisbon Agenda

While macroeconomic stabilization policies have long been regarded as sub-

stitutes for policies to promote microeconomic productivity and efficiency,there is new evidence – both from a political economy perspective as well asfrom an economic point of view – that they should be seen as complementary.From the political economy side, it is increasingly argued that a long periodof low economic growth and high unemployment in spite of painful economic

reforms might undermine the population’s support for further reforms. Thisargument has even been picked up by the OECD which usually focuses onsupply-side policies. In its Economic Outlook (2005, p. viii) it concludes that‘more robust domestic demand may also help avert a stalling of economicreforms, in a context where their potential deflationary impact raises appre-hensions in many segments of public opinion’ (2005, p. viii). Hence, a bettermanagement of short-run macroeconomic fluctuation might help to improvepublic support for microeconomic reforms.

From an economic point of view, it is well known from the theory of monetary integration that Europe might need a stronger centralization of fiscal policy (Baldwin and Wyplosz, 2006, p. 358). According to the text-book arguments, handing over autonomy in monetary policy requires alter-native adjustment mechanisms for asymmetric shocks. If a high degree of labour mobility or wage flexibility cannot be attained to bolster shocks,alternative mechanisms might be necessary. One possibility is fiscal policywhich can bolster regional demand by increased expenditure, transfers orindeed by lower taxes. According to this argument, fiscal stabilization

requirements in EMU are actually bigger than in other federal entities suchas the USA, as labour mobility in Europe is lower and wages are lessflexible.





While this argument has been widely discussed in the early debate on howto structure economic governance for a monetary union,2 it fell into disregardafterwards. Belief in the effectiveness of fiscal policy faded with the ascent of

New Classical Economics in the late 1980s. Meanwhile, the political realitiesof the early 1990s made any closer political union with a larger budgetunthinkable.3 That said, the view on this issue has again turned. One centralproposition of the New Classical Economists was ‘Ricardian Equivalence’,the notion that an increase in budget deficits would be without effect aseconomic subjects would rationally expect higher taxes as a pay-back in thefuture and would accordingly already cut their private expenditure. Sincethen, a number of empirical indications have emerged to support the argumentthat Ricardian equivalence does not hold in its absolute form (Ricciuti, 2003).

In addition, extensions of modern micro-founded models have provided anew rationale for improving the effectiveness of fiscal policies. A number of models now show that fiscal stabilization policy can be effective if householdsare liquidity-constrained and have limited access to unsecured loans or if individuals use rules-of-thumb for their consumption decisions.4

In addition, recent economic research has presented fundamentally newarguments to strengthen the case for counter-cyclical fiscal policy, Galí et al.

(2005) finding that business cycle fluctuations distort the efficiency of aneconomy if price rigidities or other market frictions exist – the cost of whichcan be quite substantial. According to these scholars, major recessionaryepisodes in the US have been related to welfare losses of up to 8 per cent of annual consumption – a figure well above that quoted by Lucas (2003) in hiscritique of stabilization policies. In a further paper, Galí (2005, p. 7) arguesthat these results reinstate the old Keynesian proposition that it might be‘require[d] that appropriate fiscal and monetary policies are undertaken toguarantee that a higher level of activity is attained’.

In a New Growth Theory framework, Aghion and Howitt (2006) go even

further, arguing that macroeconomic fluctuation might hinder companiesfrom conducting an optimum level of research and development, especially if financial markets are underdeveloped and firms may thus be unable to bridgeperiods of low earnings with fresh credit. Aghion and Marinescu (2006) showeconometrically that this effect is significant at a macroeconomic level. Sincethe approaches adopted by both Galí et al. as well as Aghion and Howitt show

2 See the special Reports and Studies Issue No. 5/1993 of the European Economy. The issue was also raisedbefore and during the Maastricht negotiations, e.g. by then Bundesbank President Hans Tietmeyer who

insisted a currency union should be complemented by a political union.3 Note for instance the failure of the Intergovernmental Conference on the political union to accompany theEMU-project.4 See for a survey Andersen (2005).





that the benefits from stabilization policies grow with market imperfections,the two approaches would lead us to the conclusion that Europe needs moremacroeconomic stabilization than the US.

The Case for Automatic Stabilizers

It is now well established that this stabilization should not be attemptedthrough discretionary policy, but rather through automatic stabilizers.5 One of the criticisms regularly made against discretionary fiscal-stabilization policyis that it involves long time lags from the initial economic slow-down until achange in the policy stance actually leads to changes in output and employ-ment. First, in order to enact appropriate expansionary policies, a macroeco-nomic shock needs to be detected early and the type of shock analysedaccordingly. As most economic data are only available with a significant timelag (in most European countries, GDP data are only published six weeks afterthe end of a quarter) and are subject to large volatility and revisions, there isa danger that fluctuations are only detected with a significant delay (detection

lag). In addition, budgetary processes in most industrialized countries resultin a long lag between the first idea and the implementation of fiscal policymeasures (decision lag). Finally, economic agents have to adjust to fiscalpolicy measures (such as tax cuts) and might take time to adjust their expen-

diture ( policy lag). Automatic stabilizers get around this problem as theirpay-outs are usually linked to some directly observable high-frequency datasuch as unemployment and as they are automatic, they are not subject to adecision lag.

Moreover, economic considerations in modern models hint that stabiliza-tion policy is most effective when it is limited to a short period of time(Andersen, 2005). A permanent increase in deficits leads to an adjustment of the public sector towards the expected higher tax rates, while a temporaryincrease might just provide additional income to households, of which a share

is liquidity-constrained. If fiscal policy is set in a discretionary manner, theremight be reluctance to cut back public spending or increase taxes again evenafter the need for stabilization has ceased. Thus, there is a broad consensusthat fiscal stabilization works best via automatic stabilizers, and not throughdiscretionary spending.

II. Stabilization Policy: The Experience of the First Years of EMU

In principle, one should think that western Europe’s welfare states are wellpositioned to use their fiscal policy as a stabilizing tool. With a relatively high

5 Andersen (2005).





government-revenue-to-GDP ratio and a progressive tax system as well as arather generous social security system, automatic stabilizers should be strong.In an analysis of tax and welfare systems, Van den Noord (2000) finds that in

most EMU countries, a change in GDP by 1 per cent actually changes thegeneral government’s budget balance by 0.5 per cent of GDP, compared toonly 0.25 per cent for the US. In a simulation with the cyclical fluctuation of the 1990s, he finds that these automatic stabilizers have thus erased roughly25 per cent of the fluctuations in GDP in the larger EMU countries.

However, as Van den Noord also notes, for the overall stabilizationoutcome, it is important to look beyond automatic stabilizers. After all, it ispossible for one country to manage to counteract cyclical fluctuations througha discretionary fiscal policy, even if automatic stabilizers are rather small.

Similarly, it is possible for a government to counteract automatic stabilizerswith a pro-cyclical discretionary fiscal policy, thus dampening or even elimi-nating their positive effects completely. This was exactly what some critics of the SGP had warned about: if countries with a budget deficit close to the limitof 3 per cent of GDP were hit by a recession, they would be forced to cut back spending or increase taxes in the downturn, thus eliminating the stabilizationeffect exerted by the automatic stabilizers.

So far, most authors who had attempted to model the effect of EMU inempirical terms concluded that overall fiscal policy has not become morepro-cyclical after the beginning of European Monetary Union, but rather thatit was acyclical to pro-cyclical even before the start of EMU (Galí and Perotti,2003). This is in contrast to the US where it has been counter-cyclical.6

However, previous studies do not always include the time after 2002 when theexcessive deficit procedure was applied to Portugal and Germany7 or the longperiod of very slow growth after 2001 which has brought many EMU coun-tries into conflict with the SGP. To overcome this deficiency, we have con-ducted a new analysis in the spirit of Galí and Perotti, but using additional

data-points.8

The results for the time before EMU mirror those of Galí and Perotti.Overall, discretionary fiscal policy in the run-up to EMU seems to have beenslightly pro-cyclical, especially in Belgium and Italy, but also in France andSpain (albeit to a degree which is not statistically significant).9 This probablyreflects the governments’ resolve to reduce their budget deficits to meet theMaastricht criteria for joining EMU.

6 See also Lane (2003) and Aghion and Marinescu (2006).7 The Commission started the Excessive Deficit Procedure against Portugal with its report in September

2002 and against Germany in November 2002.8 For the econometric analysis, see Tables A1 and A2 in the Appendix.9 Note that negative coefficients denote pro-cyclical fiscal policies while positive coefficients showcounter-cyclical fiscal policies.





Since the beginning of EMU, discretionary fiscal policy seems overall tohave been acyclical – as Galí and Perotti too have found. However, ourconclusions differ in an important manner from theirs: in the two countries

which were first subject to the excessive deficit procedure, Germany andPortugal, fiscal policy turned strongly pro-cyclical after the introduction of the euro (although in the case of Portugal the coefficient is not statisticallysignificant, sitting, as it does, at the 10 per cent level). This shows that theconcerns of those who warned that the SGP might hinder the working of theautomatic stabilizers and might thus have prolonged the economic downturnwere right. In fact, in Germany, the Schröder government with its Hartz

labour market reforms cut unemployment benefit duration and benefit levelsfor the long-term unemployed during this time, thus actively reducing the

possible effect of the automatic stabilizers. In Portugal, VAT was increasedamidst an economic slump.

The results for EMU are even more interesting if one compares them withthose of other major OECD economies – the US and Japan. Of the actorsincluded in this international comparison, the euro area shows the leastevidence of a counter-cyclical discretionary fiscal policy both prior to andafter 1999. In the US, discretionary fiscal policy has always been stronglycounter-cyclical, and this period was no exception. Japan ran a stronglycounter-cyclical fiscal policy prior to 1999, but no subsequent systematicreaction to the cycle can be detected.

Yet, even though discretionary fiscal policy has been pro-cyclical in someEMU countries, this does not necessarily imply that overall fiscal policycannot be counter-cyclical. In order to ascertain whether the overall policystance has been counter-cyclical, we have thus run a number of additionalregressions of the actual (headline, not cyclically adjusted) deficit on theoutput gap. On the basis of an analysis of both discretionary fiscal policy andautomatic stabilizers, over the whole period from 1991 to 2006, but for two

small EMU countries alone (Austria and Finland), a statistically significantreaction of fiscal policy towards the output gap can be detected. In all theother EMU countries, the coefficients are mostly small and none are statisti-cally significant. Thus, discretionary fiscal policy in EMU obviously coun-teracted the automatic stabilizers to the degree that no significant stabilizingeffect of overall fiscal policy remained.

Again, this contrasts with the US and Japan:10 In these countries, fiscalpolicy reacts in a strongly counter-cyclical manner towards the output gap,

10 It should be noted here, however, that the Durbin-Watson test statistics for the US as well as for someEMU countries point towards misspecifications in the equation. However, as re-specifying the equation foreach country would lead to a loss in comparability, they are reported nevertheless. For EMU as a whole aswell as for Japan and Great Britain, the equation seems well specified in the form reported.





with coefficients as high as 0.9 in the US and 0.6 in Japan, meaning that anincrease in the output gap by one percentage point causes the overall deficitto widen almost by one per cent of GDP in the US and by more than half a per

cent in Japan.

Explaining Europe’s Failure to Stabilize

Against this background, the question arises why Europe fails to use fiscalpolicy to stabilize even though economic theory tells us that it has more needto do so than the US. A possible explanation might be that the nationalgovernments in EMU responsible for stabilization policies have reasons toavoid them. As Goodhart and Smith (1993, p. 423ff) note, the smaller and themore open a country, the fewer incentives a government will have to use fiscalstabilization policies. If a country is very open as is the case with the indi-vidual members of the single market, a large part of the stabilization effortcan be expected to result in higher imports and thus beneficial effects for thetrading partners, and not for the home economy. Thus, fiscal stabilizationpolicy has positive external effects. The costs of stabilization policy in theform of higher government debt, however, have to be completely borne by thenational government which undertakes it. If a single government weighs itsown benefits from stabilization against its own costs for such a policy, it will

rationally decide for a degree of stabilization which is significantly lower thanwould be optimal for the currency union as a whole.11 As stabilization policythus has a public-goods character for a currency union, fiscal stabilizationshould take place on the highest possible level of government in a currencyunion.12

Deducing the Requirements of a Coherent System

Against the background of these findings as well as, of course, the economic

goals outlined in the preamble of the Treaty on the European Union (‘toachieve the strengthening and the convergence of their economies’ as well as‘to promote economic and social progress for their peoples, taking intoaccount the principle of sustainable development’) there is an argument for asignificant shift in the way the EU both raises revenue as well as spends themoney, especially under the conditions of a single currency. Three mainprinciples are apparent:

11 This is nothing other than Samuelson’s (1954) seminal analysis, that the private provision of goods withpositive externalities leads to an under-provision of these goods.12 See the literature on fiscal federalism, as well as recently Collignon (2004), Begg (2005) and Buti andNava (2003) for their ways to integrate this argument in the current debate on budgetary policies in the EU.





1. Expenditure should enhance the productivity of the European economy

and thereby work towards the Lisbon targets. After all, total factorproductivity is the single most important determinant for incomes and

thereby for ‘economic progress’. Moreover, by spending money forproductivity enhancement both at the EU level as well as in individualcountries which lag behind in productivity (and hence have lower percapita incomes than the average), convergence in incomes across theEU is fostered.

2. Both EU revenue and expenditure should be raised and spent in a way

that does not contribute to boom and bust periods in the business cycle.

Today, EU expenditure in infrastructure is paid and spent even if anational economy is overheating, thus aggravating the cycle and

increasing the risk of a sharp downturn later. As the stability of thebusiness cycle is a supplement to structural reforms in the process of increasing productivity, this leads to a sub-optimal outcome.

3. An explicit mechanism to stabilize the business cycle at the EMU- or

even EU-wide level should be introduced to complement stabilization

policies at the national level. As the structure of the EMU leads to asub-optimal degree of stabilization when the decision is left to nationalgovernments, the EU budget should have an explicit stabilization targetand additional mechanisms for EMU should be considered.

The following sections analyse the revenue and expenditure side of thecurrent EU budget and suggest changes to come closer to fulfilling theseefficiency criteria.

III. The Structure of a New Budgetary System

With regard to the principles defined above for a coherent budgetary systemwhich enhances the growth potential of the European economies, the EUbudget broadly fails. Neither the way in which revenue is raised nor the meansof its dispersal do anything to stabilize regional and EU-wide business cycles.Indeed, at worst, they even amplify existing fluctuations and misalignments.

The Income Side

The EU budget is currently funded through four kinds of ‘own resources’:agricultural levies, customs duties, value-added tax and the GNP-based ownresource which covers the difference between planned expenditure and the

amount yielded from the other three resources. This latter source of financecontributes more than 50 per cent of the revenue, as agricultural and otherimport duties have considerably decreased in the last decades.





The question of whether the EU needs a new system of own resources hasbeen up for debate since the European Commission launched its 2007 con-sultation paper (Commission, 2007). From an economic point of view, this

new system would be one which better takes into account the wealth in theMember States than the current system does (and which is additionallydistorted by various factors including the UK rebate). This debate had alreadyraged during the European Convention, where France, Germany, Austria,Belgium, Luxembourg and Portugal identified such a system as being in theirinterest.

Tax-based own resources are usually defended with the following argu-ments: increased transparency, increased EU autonomy, a more direct link to EU citizens and more scrutiny of EU public finances, the need for an

increased democratic legitimization and justification of public expenditurein the EU.13 To this, from the EMU experience, we would add the cyclicalstabilization function of a trans-European tax.

Unlike the tax systems of most modern countries, the EU revenue processis geared to have no stabilization effect whatsoever. National budgets usuallyfinance themselves from a combination of different taxes, some of which,such as capital gains taxes, progressive income taxes or profit taxes, are,cyclically, highly sensitive. If there is an unexpected shortfall of revenues, thegap is filled by increased government borrowing in most countries.

In principle, the VAT and the tariff part of EU revenue could work in asimilar manner. However, VAT and tariffs are amongst the least sensitivesources of revenue in cyclical terms, as consumption is relatively smooth overthe business cycle. Moreover, as any shortfall in VAT revenue is automaticallyfilled via ‘own resources’ which are extracted from the Member States, thissmall effect can be completely counteracted by the logic of the EU budget.Without the possibility of going into debt or at least drawing upon reservesaccumulated earlier, the EU budget cannot act as an overall stabilizer for the

European business cycle.

The Expenditure Side

The EU’s expenditure is currently concentrated on two major areas: thecommon agricultural policy (almost €680 billion) and structural and cohesionpolicy (€308 billion). Both areas together make up 70 per cent of the bud-getary outline 2007–13.14 The bulk of EU public expenditure hence goes into

13 One interesting contribution with references to the most important positions in the debate is Le Cacheux(2007).14 The figures are taken from the interinstitutional agreement with the European parliament of 4 April, 2006which is based on the Council decision of 17 December 2005.





redistribution, and large parts of the budget actually support the status quoand hinder change, as e.g. the expenditure for agriculture provides a perma-nent transfer to certain rural regions without bringing any advantages with

regard to social or economic progress or development.15

Allocative expendi-ture is comparatively minor, totalling up to €74 billion for the Lisbon Agenda(improvement of competitiveness), the financing of the EU’s citizenshippolicies and co-operation in justice and home affairs (€10.7 billion), the EU’sinternational role (€49.4 billion) and administrative costs of €49.8 billion.

There is currently no expenditure devoted to stabilization purposes. Thestructure of the EU budget as such prevents any money flowing into automaticmacroeconomic stabilization. The main reasons are the structure of theincome and expenditure sides coupled with the organization of the EU budget

process in six-year programmes which leave no room for reaction to cyclicaldevelopments. All expenditure is distributed or allocated along multi-annualprogrammes which follow objectives other than cyclical stabilization (e.g.redistribution to underdeveloped regions or uncompetitive market segments,allocation of means to create infrastructure, to finance research etc.).

From the country-by-country perspective, the situation is even worse,because for some of the countries, transfers from Brussels are much moreimportant relative to GDP and affect a much smaller sector of the economythan the revenue side. For example, structural funds alone amounted onaverage to almost €10 billion for Spain each year from 2000 to 2006 (morethan 1 per cent of GDP), with most of this money going into an alreadyoverheating construction sector, the now excessive size of which is consid-ered to be one of the main vulnerabilities of the Spanish economy. Oneproblem is that the money is spent at a predetermined speed without anyconsideration of the situation of the national business cycle. It is thus morethan possible that the structural funds will first amplify a national boom andthen expire exactly at a moment when the economy slumps.

In order to solve these problems, one could condition the speed of dis-bursement for investment-spending around the position of the business cycle.Under such a regime, work on infrastructure projects would be delayed whenthe national economy in question is growing above trend and expedited whengrowth falls below trend. The idea is not to suddenly reduce funding withoutprior notice, but rather to extend or speed up the funding period if need be. Inmost cases, this should be a measure appreciated by the contractors in theprojects (and could even be negotiated in agreement with them). In a periodof overheating in the construction sector, contractors may be happy to delay

certain projects to a time when their order books are less packed and they have

15 See for instance Becker (2007), Begg (2005), Buti and Nava (2003).





spare capacities to do the job.16 Without additional costs, the existing struc-tural funds could thus be brought to a secondary use of stabilizing nationalbusiness cycles. This principle could also be applied when some of the

expenditure is shifted from traditional cohesion and structural-fund expendi-ture towards areas which are more compatible with the Lisbon Agenda suchas research and development or higher education, with higher disbursement intimes of economic slump and lower disbursement in times of rapid growth.While for the capital expenditure part of R&D (construction of laboratories orbuildings) the mechanism described above could be applied, for large parts of R&D, such as the hiring of personnel, one would need a different approach asit is not feasible to delay a project once it has started. One possibility wouldbe to start certain subsidized R&D projects at the beginning of a downturn

when unemployment among scientists and engineers too is rising.A shift towards a more cyclically sensitive tax than VAT would likewise

improve its stabilization properties. A progressive personal income tax wouldprobably provide the best stabilization properties (Goodhart and Smith,1993). However, as introducing such a tax on the European level would beextremely complicated given the huge differences in the national preferencesand tax bases for personal income taxes, a European Union corporate taxseems to be the second best solution. Introducing a common EU corporate taxwould not only have the advantage of shifting from an acyclical to a morecyclical revenue source, but would in addition allow for the introduction of aminimum level of taxation which would limit the excesses of harmful taxcompetition. As is the case with the federal states in the US, introducing anEU corporate tax would not impair the single countries’ power to levy anadditional corporate tax on profits in their jurisdiction, thus still allowing fora certain degree of tax competition.

In principle, the whole EU budget beyond the revenue from tariffs couldbe financed with a Union-wide corporate income tax without increasing the

overall tax burden for corporations. On average, taxes on corporate incomeamounted to 3.2 per cent of GDP in 2004, with corporate income taxes in allsingle EU countries exceeding 1.5 per cent of GDP (see OECD, 2006, p. 76).The whole EU budget of 1.27 per cent of GDP could thus be financed by acommon corporate tax, leaving all countries ample room for an additionalnational corporate income tax. Shifting taxation to this new source would beneutral for national budgets as well as for taxpayers. Since the EU would befinanced with corporate income taxes, the revenue now allocated to the EUbudget from VAT and the national budgets would be available for national

16 Another idea, which would be yet more complicated to implement, is to vary national co-paymentsaccording to the cyclical condition of the economy (yet again, not altering the overall amount of money thecountry receives, but only the time span in which the sum is paid out).





expenditure, allowing the countries to lower their own corporate income taxesby the amount of the new EU-wide tax.

In order to allow for the stabilization of the business cycle not only across

regions, but also across time, the EU would need to be allowed to build upreserves in an economic upswing and draw upon them in a downswing – astark change from the current practice. If the new budget system were to bephased in at a favourable point of the business cycle (and thus at a point of high tax revenue), this could work without allowing the European Union to gointo debt. The EU would thus first build up reserves from which it could drawafterwards, thereby avoiding the politically sensitive debate on whether theEuropean level should be allowed to issue debt titles of its own.

Introducing an Explicit Pillar for Stabilization in the EMU or EU

All the same, as the primary goal of most of the current expenditure as wellas any additional expenditure aimed at reaching the Lisbon targets is toimprove the structure of the economy, not to stabilize the cycle, the effectsfrom these changes might be limited. In order to reach a stabilization closerto those of other advanced countries, an explicit pillar for stabilization poli-cies in the EU would be desirable. In the early 1990s, there was a lively debateon possible stabilization schemes (Goodhart and Smith, 1993; Majocchi and

Rey, 1993; Italianer and Vanheukelen, 1993; Pisani-Ferry et al., 1993). Morerecently, Dullien and Schwarzer (2005 and 2006) and Nevin (2007) havepicked up the argument. Perhaps the most interesting result from this discus-sion has been that expenditure need not be large in order to provide significanteffects. According to Italianer and Vanheukelen, a quarter of all country-specific GDP fluctuation could have been stabilized with an average cost of only 0.2 per cent of GDP. In their model, single countries would be paid avariable amount should national unemployment rise significantly faster thanunemployment in the rest of the Union.

However, these proposals do not address the political economy problemsof stabilization policies in very open economies such as those in the EMU.Even if national governments were given money in a downturn, it is not clearwhether they would use it right away for expenditure increases or tax cuts. Inparticular, countries constrained by very high deficits might use the additionalfunds for budget consolidation to have room for additional spending or taxcuts just before the next elections, which would not stabilize the cycle.

An alternative solution would be the introduction of basic unem-

ployment insurance on the European level. This could conceivably beapplied to all EU or EMU countries just as well as it could to only a group of countries. For all employees in participating countries, a certain payroll tax





(back-of-the-envelope calculations propose that roughly 2 per cent wouldsuffice) on wages paid up to a certain limit (possibly the national medianwage) would be collected. From this money, employees who have paid

contributions for more than a year would be allowed to draw benefits of half their last salary up to a limit (possibly half the median wage) for a period of six to 12 months. This basic unemployment insurance would replace only partof the national system. Each nation would still have its own national unem-ployment insurance. This would reflect the national choice for social securitysince it would top up the payments from Europe (either in the monthly benefitamount or in the duration of benefits)17 without raising the overall burden onemployers and employees. Importantly, it would not threaten to eliminatenational specificities because national governments would still define the

level and duration of benefits and bear the costs for very ambitious schemes.Such a system would fit very neatly with existing unemployment insur-

ance schemes, as all EMU countries (with the exception of Ireland andGreece) have unemployment insurance systems which are financed by payrolltaxes and which pay benefits relative to past earnings. By retaining the overallbenefits paid to the single unemployed, changing the source of funding alone,there would be no deterioration in the incentives to look for new work.

Such a scheme would stabilize the business cycle by draining purchasingpower from countries in which the economy booms as unemployment in thesecountries falls. If a country goes into crisis, purchasing power and thusdomestic demand would automatically be shored up. By funnelling themoney directly to the unemployed, it is guaranteed that the money is actuallyspent. The system would only explicitly compensate for cyclical unemploy-ment and not therefore for structural unemployment as only those who havebeen regularly employed for a certain period prior to unemployment canreceive payments. Short-term unemployment is an excellent indicator for theoutput gap: those who have recently become unemployed are by definition

unused potential of the national economy in question. In addition, by reactingto unemployment, the mechanism would not induce transfers caused byquarter-to-quarter fluctuations in GDP growth figures, but only if an economyexperiences a protracted upturn or downturn of the kind that could beexpected to have effects on the long-term growth path.

As the need for a common stabilization policy is larger inside the EMUthan in the rest of the European Union (since EMU countries have no nationalmonetary policy left), an option would be to introduce this kind of basicunemployment insurance at first only for the EMU (or even only part of the

EMU), with a voluntary option for other EU countries to join. This might be

17 Dullien (2007) provides an overview.





politically more feasible than trying to get all EU members to agree to sucha scheme, given the position of the British in particular (but also some centraland eastern European countries’ preferences) not to strengthen the social

dimension of European integration. The overall amount of money required toachieve meaningful stabilization effects via unemployment insurance neednot be large. According to Chimerine et al. (1999), US unemployment insur-ance has roughly stabilized 15 per cent of fluctuations in GDP, even though itonly moves about 0.4 per cent of GDP each year.

Of course, as these proposed measures only use instruments designed forpurposes different from macroeconomic stabilization (poverty alleviation forthe case of the unemployment insurance and productivity enhancement forthe case of R&D and infrastructure expenditure), there will be no perfect

stabilization of the business cycle. However, this approach would allow usingthe instruments in question for partial stabilization without jeopardizing theirprimary purpose, bringing the economy closer to its optimum.18

Institutional and Legitimatory Requirements

The introduction of an EU tax would raise the procedural requirements fordeciding on a democratically legitimate EU budget. Moreover, the Europeanunemployment scheme would need a transparent and efficient governance

system, which, if not all EU members participate, would have to have its ownmechanisms either as part of or outside the EU budget.

As has been pointed out by Enderlein et al. (2005) in an ECB DiscussionPaper, a further development of the EU’s public finances has to go hand inhand with the development of the EU as a political entity. Today, the mainsource of legitimacy runs through the national governments. As these gov-ernments find it difficult to justify the benefits of EU integration and of thepolicies financed through the EU budget (at least for the net contributors) totheir electorates, the basis of legitimacy for the current EU budget is com-

paratively low.Even if the budget as such were not fundamentally changed, budgetary

compromise in the EU-27 would remain extremely difficult to achieve. As thenegotiations on the Financial Framework 2007–13 have shown, this can be

18 According to the Tinbergen principle, one needs at least as many independent economic policy instru-ments as one has economic policy variables that one wants to target exactly. However, if one allows forinexact targeting, one can do so with fewer instruments. A real-world example would be the use of combined heat-and-power production for heating the housing in a power plant’s vicinity. In these cases,there might not be perfect temperature control of the houses by adjusting the level of energy production

alone. However, using the waste heat in this way improves the energy efficiency greatly. Hence, one wouldhave two targets (the electricity production and the heating of the houses), but would use only oneinstrument (the production level). In the absence of additional heating in the house, this would greatlyimprove the comfort of the house, even if one cannot control temperature perfectly.





traced to the sheer number of negotiators and the heterogeneity of theirpreferences. The lack of trans-European legitimization mechanisms providesa bias against reasoning in terms of European public goods. Collective action

problems and temptations for free-riding prevent coherent action with theEU’s resources. Log-rolling is a problem in this context as Member States aremore likely to find a compromise if they trade different policies and financialflows against each other (Collignon, 2003). Meanwhile, the ‘no-taxation-without-representation’ rule remains valid for the EU. If EU taxes are raised,their imposition has to be based on a democratically legitimate and transpar-ent process, giving voters the chance to sanction those who have imposed thetaxes, and giving newly elected majorities the chance to change the directionof socio-economic policies reflected both in the income and expenditure side

of the EU budget.A modern approach based on individualistic/liberal principles would rec-

ommend redistribution to citizens as reflected in a tax system which is basedon the individual’s ability to pay for the provisions of public goods (such asthe European corporate tax or a common progressive income tax system) – aswell as in the European unemployment scheme suggested in this article.Regional policies should continue to supplement the distribution policies onthe individual level (Collignon, 2003).

Conclusion

Assuming that the guiding principle of any future EU budgetary systemshould be the added value generated by EU expenditure in terms of Europeanpublic goods, our proposals are in line with political economy considerationsof national governments’ incentives. Their implementation would not onlyimprove the functioning of the EMU, but would also be a quantum leap in EUbudgetary policy and in European integration as such, given the need for the

new mechanism to enjoy democratic legitimacy.Our starting point was the analysis of the newly identified efficiency

requirements that budgetary policies would have to meet if stabilization wereto be achieved – and which they do not meet under the current design of theEMU. Since the introduction of the euro, not only have problems with theimplementation of the Lisbon Agenda surfaced, but economic tensions withinthe EMU have also grown with excessively prolonged boom and bust cyclesin individual countries leading to dangerous imbalances (see Dullien andSchwarzer, 2005; 2006). These problems are likely to aggravate as EMU

is being enlarged. Both problems could be at least mitigated by a moreintelligent use of funds. Combining a relocation of expenditure towards





productivity-enhancing goals such as research and development withstability-enhancing revenue and spending and an additional explicit stabili-zation pillar in European Union finances could provide a triple benefit. As the

solutions proposed in this article are aimed at providing additional stabiliza-tion without reducing the funds’ impact on productivity, productivity growthcould be boosted, bringing the EU closer to its target of becoming morecompetitive. The economic workings of the euro area would be improved.Together, these moves can reduce the risk of political backlash against Euro-pean integration.

Correspondence:

Daniela Schwarzer

Stiftung Wissenschaft und Politik Ludwigkirchplatz 3–4

D-10719 Berlin, Germany

Tel +49 172 640 97 12

Fax +49 30 880075217

email [email protected]

Appendix: Econometric Estimates

In order to evaluate how far fiscal policy in the euro area and in otherimportant industrialized countries has reacted to the business cycle over pastyears, we have broadly followed the approach chosen by Galí and Perotti(2006). However, unlike this original work which only uses data up to 2002,we have used time-series which include all years until 2006. In contrast toGalí and Perotti, we do not differentiate the time periods before and after thesignature of the Maastricht Treaty in 1992, distinguishing instead the periodfrom the early 1990s until the actual start of EMU in 1999 from the subse-quent period.

Table A1 shows the results from a number of estimated equations of theform:

d c E x E x d b ut BEMU t t EMU t t lag t t t * *= + + + + +− − − −φ φ φ φ1 1 1 1

with d t * denoting the cyclically adjusted primary government balance, d t -1*denoting the lagged deficit, xt denoting the output gap and b denoting the debtto GDP level. The two coefficients f EMU and f BEMU allow for different reactionsfor the time before EMU and in EMU, with the first one being applied for the

years until 1998 and the second one for the period starting in 1999. The ideabehind this analysis is as follows: the cyclically adjusted primary deficit is thecurrent deficit adjusted for the workings of the automatic stabilizers and the



mailto:[email protected]

mailto:[email protected]



debt service. As the deficit beyond the automatic stabilizers and beyond theinterest service can be seen as the discretionary fiscal policy variable, itsreaction to the output gap shows how far policy-makers are reacting to thebusiness cycle. Including the debt level into the equation simply mirrors theassumption that policy-makers are nevertheless concerned about the overalllevel of public debt and aim at attaining a certain debt-to-GDP-ratio. As thereis the problem of endogeneity between the cyclically adjusted budget deficitand the output gap, the equations have been estimated by a two-stage-least-square procedure with the use of instruments following Galí and Perotti (in

addition to the lagged deficit and the debt level, the output gaps of othercountries have been used as instruments).19

In a second step, an additional analysis is run in order to evaluate whetheroverall fiscal policy has reacted systematically to a change in output gap. Tothis end, for all of the countries, an estimation of the following form has beenestimated (without differentiating between pre- and post-1999 periods):

d c d x b ut lag t x t b t t = + + + +− −φ φ φ1 1

with d t denoting the headline deficit and all other variables defined as above.The results are presented in Table A2.

19 Details on the instruments used can be obtained from the authors on request.

Table A1: Reaction of Structural Primary Deficit on the Output Gap

Country c (t) F lag (t) F BEMU (t) F EMU (t) F debt (t)

Aut -8.44 (-0.75) 0.54 (1.93) 0.47 (0.56) 0.04 (0.09) 0.14 (0.80)Bel 1.76 (0.61) 0.48 (1.86) -1.04 (-1.71) 0.71 (0.88) 0.01 (0.26)

Deu 2.09 (0.80) 2.07 (2.43) 1.01 (1.31) -1.52 (-1.91) -0.04 (-0.97)

E12 -17.35 (-3.20) 0.31 (1.48) -0.30 (-1.63) -0.04 (-0.35) 0.26 (3.20)

Esp 7.58 (2.85) -0.06 (-0.17) -0.17 (-0.52) -0.38 (-0.99) -0.09 (-2.38)

Fin -1.04 (-0.39) 0.58 (2.22) 0.21 (0.87) 0.85 (2.27) 0.05 (1.43)

Fra -1.23 (-0.87) 0.74 (3.13) -0.38 (-0.93) -0.08 (-0.17) 0.02 (0.74)

Gbr -7.36 (-4.13) 0.76 (6.48) 0.20 (0.57) 0.74 (0.79) 0.17 (4.32)

Irl 1.14 (0.75) 0.65 (2.08) 0.32 (0.97) -0.49 (-1.84) 0.02 (0.64)

Ita -2.74 (-0.32) 0.36 (0.97) -1.02 (-1.52) -0.02 (-0.05) 0.04 (0.48)

Lux -0.87 (-0.05) 0.50 (1.22) -0.18 (-0.12) 0.06 (0.05) 0.29 (0.10)

Nld -1.63 (-0.46) 1.11 (1.27) 1.47 (1.03) -0.88 (-1.14) 0.03 (0.60)

Prt 17.00 (0.69) 0.14 (0.23) 0.39 (0.73) -1.25 (-0.95) -0.29 (-0.69)

Swe -1.71 (-0.28) 0.67 (2.97) -0.68 (-0.45) 0.20 (0.28) 0.05 (0.53)

Jpn -3.16 (-2.60) 0.64 (4.35) 0.59 (1.88) 0.09 (0.32) 0.01 (1.10)

Dhe -2.10 (-0.82) 0.26 (0.81) 0.59 (1.75) 0.14 (0.29) 0.06 (1.11)

Can -5.54 (-1.90) 0.88 (5.08) 0.16 (0.46) -0.94 (-1.67) 0.08 (1.89)

USA -11.39 (-3.34) 0.73 (8.71) 0.60 (1.84) 0.67 (2.34) 0.19 (3.36)





The data for the econometric estimations have been taken from the EUCommission’s AMECO database (autumnFall 2006) for all EU countries andfrom the OECD Economic Outlook (autumnFall 2006) for Japan, the US,Canada and Switzerland.20 Budget deficits for EU countries are corrected forproceeds of the sale of UMTS mobile phone network licences as they can beseen as one-off-events that did not figure in the general consideration fordiscretionary fiscal policy (in fact, the EU finance ministers had agreed inadvance to pay back public debt with the windfall revenue) and can also be

assumed to have rather limited immediate effects on the business cycle. Formost countries, the time-series runs from 1991 to 2006. However, for a smallnumber of countries (i.e. Spain, Euro-12), the time-series only starts in 1996.

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20 While data for 2006 still have been estimates, they can be considered to be already reasonably accurateas final data for the first half of the year have already been available to the institutions at the time of theforecasts.

Table A2: Reaction of Total Deficit on Changes in the Output Gap

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