Is the EU an optimal fiscal area?

In 2006, years before the issue became acute, Professor George Halkos and I published a paper examining the issue of tax competition and if the European Union is an Optimal Tax (or Fiscal) Area.

The issue of an OFA follows the discussion of Optimal Monetary Areas, which predated the establishment of the European Monetary Union. Some authors then had doubted that the European Union in its present state (and membership) was an Optimal Monetary Area, and developments after 2009 seemed to prove them right.

Under the issue of an OFA we propose some criteria for a discussion in order to avoid mistakes as those predating the formation of EMU. Now that the weaknesses of EMU have become clear and the discussion on a fiscal union at European level is “ante portas” this discussion is of major importance.

OFA is a benchmark area satisfying the following:

First, countries participating into it should have relatively similar economic structures, as to GDP per head, sectoral contribution to GDP, etc. two countries like Germany and the Netherlands could more easily form an OFA than say, Luxembourg and Turkey, which present very dissimilar structural characteristics. These structural differences imply great differences in the fiscalities of the two states, i.e. their revenues and expenditures, and, taxation. Countries with such differences should (and cannot) belong to the same OFA.

Second, what we call, similar “tax cultures”; It is a well known issue in institutional economics that customs and norms are slow to change. Laws may be changed but they may not be implemented if they encounter strong resistance in society due to encounter strong resistance in society due to established customs. Today’s Greece, with continuing tax evasion, black economy etc seems to be a case illustrating this. “Tax culture” in particular shows the citizens attitude towards fiscal (and government) administration, varying from trust to total mistrust. Northern European countries (like the Scandinavian, Germany, etc) are characterized by high trust while Southern European ones by mistrust. Obviously countries with very high different “tax cultures” cannot form an OFA.

Third, “fiscal stance” a point that captures the fact that today’s situation is dependent on past fiscal decisions. Countries with similar fiscal stances can easily form an OFA, but countries with divergent ones, have difficulties seen again with the great problems of adaptation of southern European countries.

Fourth, the effectiveness of fiscal administration, which combines two elements, first tax collection costs, total government cost, corruption and fraud, etc, that may be labeled the “quality” of the administration and second, the effectiveness of fiscal policy itself, i.e. the degree to which policy aims are achieved, the “ correctness” of the aims, etc.

Here again, the diversity among member states are great. The cost of government in Greece for example was 6.5 percent of GDP (it has gone a bit down) compared to an EU average of 3.5 percent which is a measure of wastefulness. Each 1 percent reduction of this corresponds to about 2 billion euro. This again means that if the cost of government in Greece reaches the EU average, then we would have achieved a saving of 6 billion more than double the revenue collected by the wealth tax on property.

Second, the degree of achieving mainly long-term policy aims is very variable. In general, Northern countries are better in this respect too. Taking the recent Greek example again, fiscal policy has failed in part to achieve its aims, creating substantial costs, both concerning unemployment (26.7 percent in January) and “collateral damage” to the environment. Here, the increase of taxation on heating fuel (by about 20 percent) to reach the level of transportation fuel, resulted according to estimates to a reduction of 80 percent in demand which makes clear that total revenue out of this source will be lower than before the tax increase. Since consumers have switched to less clean sources of heating (wood, pallets, coal, etc) pollution has increased (by six times in Athens for some days) creating long-term health problems which will be translated in the future in higher health care costs. This is a dismal failure of fiscal policy.

Lastly, and perhaps the most important point for a modern democracy, are citizens preferences as to the size of the public sector and resulting necessary taxation to finance it. If preferences diverge, the OFA becomes an impossibility. Scandinavian countries citizens are in general satisfied with a relatively big and efficient public sector coupled with relatively high taxation; citizens of southern countries less so, because they consider the services etc provided by the public sector of low quality, inefficient etc. Recent opinion polls in Greece for example showed that 62.5 percent were in favour of privatization of public owned corporations, which may be taken as an index of dissatisfaction and mistrust of the public sector.

Related to this is a moral ethical issue, as to the limits of taxation. If taxation gets too high it surpasses ethical limits. In a representative democracy, it is not easy to calculate these limits and preferences but in direct democracy it is easier. A famous example is California’s Proposition 13 that set limits to taxation on wealth through a referendum.

Thus, if the so called “democratic deficit” characteristics of many modern European states and the EU is to be reduced and the true preferences of citizens are to be followed, elements of direct democracy (referendums after citizens initiatives) should be used also concerning fiscal matters, as for example the size of the public sector, the height of taxation linked to the provision of public services etc.

In practical terms, the issue of fiscal union is not clear even in its definition. What is really meant by it? The application of formal fiscal criteria (like the two Maastricht Treaty ones) coupled to strong monitoring and the right of the EU to introduce sanctions against deviating states? Or/and the setting of specific fiscal targets binding to all, for example austerity measures for all? Or/and the introduction of common fiscal instruments, like harmonized tax rates on income, corporation tax etc (a very unlikely outcome due to the existence of tax competition in order to attract investments)

From the short discussion of an OFA above, it becomes clear that at the present situation it becomes unlikely ad it would even if introduced, not prove beneficial to the fiscally weaker EU members. A thorough discussion of the issues and the clarification of what is the meaning of a fiscal union must precede political decisions to avoid the mistakes that were made when the EMU was formed.

*Nicholas Kyriazis, has received a Ph.D. from Bonn University, has been a visiting scholar at Harvard University and is currently professor at the university of Thessaly. He is also a writer.

1. George Halkos and Nicholas Kyriazis (2006) “Is tax competition harmful and is the EU an optimal tax area?” in European Journal of Law and Economics, Vol.21, 163-177

2. The issue of the ethical limits of taxation came to the foreground after J.Buchanan’s “The ethical limits of taxation” in “Liberty, Market and State”, Harvester Press 1986, 165-177