The economics and politics of social policy in Europe’s EMU

By: Guiseppe Bertola, University of Turin

 

Protecting citizens from terrorism, war, job loss, poverty is a crucial task of every government. Which  institutions should be in charge of such protection in the European Union? The 2006 special Eurobarometer survey on The Future of Europe finds that ‘The fight against terrorism’ and ‘The promotion of democracy and peace in the world’ receive most support for decision making at the European level (with over a 70% ‘more’ minus ‘less’ differential).  This is sensible. Towards external threats, all citizens of Europe may have the same attitude, favour the same policies, use their collective force together.

Is it as sensible to find at the bottom of the list ‘The fight against unemployment’ (at 14%) and ‘The protection of social rights’ (at 24%)?  

 

Heterogeneity and integration  

EU-level institutions currently have practically no policymaking power on social and labour market issues, that are entrusted instead to country-specific regulation, tax, and subsidy policies. If such policies really need to be tailored to each country’s different circumstances, this can be a good arrangement. We see in the Chart that countries around the world impose very different tax rates on their workers, and have very different employment rates and per capita incomes. 

 

 

 

We teach students that taxation reduces incentives to trade, so we would expect employment to be lower where taxes are higher.  But one would have to look very closely to see some such negative relationship in the cross country data plotted in the chart. Countries are different, and differences explain why German and Japanese working-age people have very similar employment rates when Germany’s taxes take up 55% of total labour costs compared to only 30% in Japan, or why a 43% tax rate comes with 44% employment in Turkey and 76% in Denmark.

 

Taxes do reduce employment, all else equal. But countries do not tax labour in order to reduce employment. They use the revenue of taxes for a variety of different purposes, and the impact of taxes on labour demand and supply differs according to structural features, including the ease with which production may move across nation borders in reaction to taxation. All else is clearly not equal in reality, and there is a lot of relevant heterogeneity across the EU. Denmark is often touted as an example for other countries because it famously combines high employment with heavy taxes, as the Chart shows, and a generous Welfare State. But the Danes spend their tax money in peculiar ways, devoting some 5% of GDP to employment policies. Their policies are decided and implemented in a political and economic environment that is really not the same as, say, Italy’s and Spain’s. Taxes and subsidies are less affordable for poorer countries; the political appeal of redistribution is scarcer in larger and less socially homogeneous nations; their implications for employment and incomes differ across countries with differently elastic market supplies and demands. Maybe countries should indeed be left free to choose the policies that best fit their own circumstances.

 

Or maybe not. Not all heterogeneity implies that policies should be different. The effects of social and labour market policies, after all, are different across regions, cities, villages, families, within countries and within any entity that engages in redistribution. And since redistribution policies unavoidably operate across the borders of such entities when they are economically integrated, international economic integration makes it doubtful that policy should be made at the level of countries. Policies interact with individual choices in the market. If markets are not restrained by the borders of countries, taxes and subsidies no longer just affect the choice of whether to work and produce, they also influence where employment and production are located. Within each EU country, taxes are high and redistribution is intense: in the chart, old and new EU members have higher tax rates than similar OECD countries around the world. As in the enlarged EU overall income inequality reaches US levels, how can social and labour market policies not be debated and implemented at the European level?

 

They cannot. Eurobarometer finds that support for European-level labour and social policy action is low relative to other policy fields. But there is support. More than half those polled (and a majority in every country except the UK and Scandinavia) favour more EU involvement in these two areas. Two thirds would favour harmonization of social welfare systems across the EU (with slightly less than a majority in favour only in the UK and Finland).  And ‘A European social welfare system’ is cited by a third of respondents as one of the two best ways to strengthen feelings of European citizenship.

 

People want protection, and are justifiably reluctant to release control of policies that reflect their own history and social peculiarities. In an economically integrated EU, however, the uncoordinated national welfare systems that aim (in heterogeneous ways) at controlling income inequality within each country are challenged by international competition and by inequality of income across countries. The problem is that markets cannot be integrated efficiently unless policies meant to correct market outcomes are agreed and run collectively. Competition across the borders of constituencies that choose such policies independently undermines their effectiveness. Whether for good or for bad reasons, people feel that some aspects of their life should not be left completely to markets. And when markets need to be controlled, then their integration is difficult, as shown most clearly by the fate of  the Services Directive.

 

People’s welfare and the future of the EU

The economics of the choices facing Europe is clear. If market interactions are allowed to spill over countries’ borders, so will policies’ effects, and protection and market regulation should be pursued at the European level as well as within countries’ borders. Integration of markets and integration of policies are complementary processes that have to steer a path between two dangers. The danger of insufficient market-correcting policies, due to the uncoordinated decisions about policies that need to be chosen and enforced collectively. And the danger of excessive regulation, decided centrally on the basis of insufficient information, and uniform across very different situations. A path was found for integration of product markets, harmonizing product specifications, and adopting a single currency.

 

As regards social policy, two dangers are perceived to be differently threatening by different people and in different countries. Those that are happy to rely on markets see economic integration as an opportunity to foster efficiency and abolish protectionist regulation. This is a common attitude in the UK, while in countries like France people see the extension of government powers to the economically integrated area as necessary condition for economic integration. And countries where redistribution is supported by strong national solidarity and low inequality, like Sweden, suspect that integration with poor and socially complex countries would threaten their own system’s viability. From all perspectives, “protection” tends to be cast (as the villain, or as the hero) as the opposite of “integration” in political discussions within and between countries.

 

But protection and integration can and should be reconciled so as to pursue in new ways the traditional protective goals of National social policies. Europe has seen many wars and revolutions and has adopted economic integration as a tool to foster resource sharing and prevent further fighting, as well as to promote efficiency and growth. Delivering protection is key to political success in this continent. Promising protection is clearly a top priority in the French presidential campaign. National politicians find it easier to blame foreigners than to seek European solutions aimed at reconciling integration and protection, at allowing citizens to access wider well-functioning markets as well as at sheltering them from malfunctioning markets.

 

Uncoordinated deregulation and excess centralization are more present dangers in wider markets. The fact that welfare policies are more difficult to run in continent-wide markets may explain why they cannot be as extensive in the US as in EU countries. But it also explains why financial and other markets play a larger role in American people’s lives than they do in Continental Europe. Larger economies are more difficult to control for governments, so they need better-working markets. Financial markets can provide some of the protection from competitive shocks that used to be provided by trade barriers, and of the protection from life risk that health, old age, unemployment insurance schemes find it increasingly difficult to provide in the face of tax base erosion and competitiveness constraints. To stabilize consumption and prevent poverty, household access to financial markets is at least as important as traditional tax-and-transfer schemes. The US does have a Federal welfare policy, however, and markets - especially financial markets - have to be appropriately regulated and supervised.

 

Europe needs to find new ways to pursue social policy goals. Just as some of its countries found a way to forego monetary sovereignty, so they will have to find ways to coordinate and harmonize private and social insurance. Welfare policy instruments are even nearer people’s hearts than currencies and monetary policy, and this makes it even more important to ensure that they are implemented consistently with economic integration.  For the same reason, however, they are harder to harmonize. It has been an amazing feat for  many sovereign European nations to adoption of a common currency and accept an  independent monetary policy. Social policy is even more political than money because it's more important to people’s daily life. It is rooted in local politics, and in old, life-shaping traditions. While giving up monetary policy was not so bad for citizens who had experienced inflation and instability, many of every country’s citizens still think social policy is useful. When they feel that social policies are threatened by integration, they will sooner forego integration than social policy.

 

Reforming social policy is always difficult, because Welfare States are to some extent prisoners of their own history: redistribution policies can hardly change without disrupting life plans. In Europe, reforms are also difficult because some of the problems span countries’ borders, and the necessary solution would have to be more political and less technical than those found at previous stages of EMU and those possible in the current setting. During its first few decades, the process of European integration could use economic tools to achieve such political goals as the pre-emption of further wars. In the future, it will need to develop political tools to solve such economic problems as the development of suitably harmonized social protection systems. Progress on the economic policy reform front will only proceed at the pace allowed by development of the European media and political space needed to discuss and mediate difficult issues.

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