Europe needs a coordinated mix of fiscal and wage policies

Austerity policies coupled with rising inequality in Europe have resulted in a long period of economic stagnation. To end the vicious circle of chronically low demand, a slowdown in investment and productivity and economic, social and political instability we need coordinated action to develop sound fiscal and wage policies in all the EU Member States.

The effects of income distribution and fiscal policy on growth, investment and budget balance: the case of Europe (to read the full research paper, click here) is a piece of research which we carried out at the Greenwich Political Economy Research Centre. The research presents the impact of a coordinated policy mix of increased public spending together with more progressive taxation and labour market policies to improve growth and income distribution in Europe.

Based on a model developed for 15 individual European Union member states, we simulated a policy scenario of a simultaneous increase in public spending by 1%-point of Gross Domestic Product (GDP) along with more progressive taxation (increasing the effective tax rate on capital income by 1%-point and de- creasing the tax rate on labour income by 1%-point) and an increase in the share of wages of GDP by 1%-point of GDP in each country. The result was 6.72% higher GDP in the EU.

The effects of our suggested policy mix on GDP are most marked in Finland (12.04%), Greece (15.29%) and Spain (16.15%).

Private investment increases as well, by 2.30% as a ratio to GDP (on average in Europe); i.e. overall public spending does not crowd out but rather crowds in private investment despite a rise in tax rates on profits. Although public spending increases, the budget balance in Europe improves (by 0.86% as a ratio to GDP) due to the beneficial fiscal effects of higher economic growth and higher tax rates on capital. Concerns about the possible inflationary effects of wage increases are not supported by empirical evidence. A wage stimulus leads to only a modest 1.5% increase in price levels in Europe on average and would help to steer the European economy away from deflation.

Growth, private investment and the budget balance improve both in the periphery and core countries of Europe. The effects of our suggested policy mix on GDP are most marked in Finland (12.04%), Greece (15.29%) and Spain (16.15%). GDP increases by more than 2% in all countries: e.g. by 5.85% in Denmark, 6.77% in Germany, 4.82% in France, 2.91% in Ireland, 3.81% in Italy, 8.03% in Portugal, 9.90% in Sweden and 4.47% in the UK.

The key message of our research is that an expansionary fiscal policy can make a significant contribution to economic growth and can be sustainable when it is combined with wage policies and progressive taxation in a coordinated fashion.

Coordination must aim at avoiding a deflationary adjustment with substantially higher wage growth in the surplus countries.

In practice, the suggested increase in the wage share can be achieved by re-regulating the labour market, improving the Union’s legislation, increasing the coverage of collective bargaining, increasing the minimum wages and enforcing equal pay legislation more effectively. Also, coordination of wage policies at the European level is necessary to ensure that wages increase in line with historical increases in productivity, stabilising effective demand, avoiding counter-productive ‘beggar thy neighbour’ competition policies based on low wage policies and preventing a race to the bottom. In the Euro area, this implies that wage policy has to take into account current account surpluses as much as deficits and coordination must aim at avoiding a deflationary adjustment with substantially higher wage growth in the surplus countries.

As for public investment, its positive effects on spending go beyond those examined with our model. Public investment as part of an industrial strategy is key to achieving convergence in productivity between European countries. In addition, public spending in physical and social infrastructure can lead to environmental sustainability and gender equality. For example, public investment in green projects could reduce the carbon that is generated as a result of EU production and consumption. In addition, spending on health, social care, education and child care is crucial to improve gender equality and could lead to the creation of jobs with high labour intensity (i.e. generating more jobs per output) having an additional beneficial effect on carbon intensity. This is not only because these sectors have low emissions but also because more employment is created for a modest increase in output.