The third stage of European Economic and Monetary Union (EMU) was launched on January 1, 1999, with the creation of a single currency, the euro. Monetary and exchange rate policies have been fully centralized, but EMU fiscal policy will remain largely a national responsibility. The Maastricht Treaty and the Stability and Growth Pact (adopted in July 1997) provide for a certain degree of fiscal policy coordination among EMU member countries, but unlike existing federations, such as the United States or Canada, the fiscal framework of the European Union does not incorporate a central fiscal authority. In a recent IMF Working Paper, Will Fiscal Policy Be Effective Under EMU? Marco Cangiano and Eric Mottu—both of the IMF’s Fiscal Affairs Department—suggest that as economic integration in Europe proceeds, the case for a central fiscal authority may become stronger.
Fiscal Policy in Federations and in EMU
The European Union (EU) fiscal framework, according to Cangiano and Mottu, is one of coordination of fiscal policies rather than a federation comprising a central fiscal authority. In existing federations, the three basic functions of fiscal policy—allocation, redistribution, and stabilization—are carried out largely by central governments, with varying degrees of participation from intermediate and local governments. To address vertical and horizontal imbalances, federations rely on transfers, mostly from central to regional levels of government. These arrangements tend to increase the effective degree of centralization by creating financial dependency on the part of regional governments.
In contrast, the EU philosophy is underpinned by the “subsidiarity principle,” which was introduced into European law in 1992 by the Maastricht Treaty. By expressing the presumption that the primary responsibility for public policies lies in the hands of EU member countries, the principle recognizes that countries are not yet ready to yield more fiscal authority to the EU. Thus, although allocative efficiency is pursued mainly through the establishment of a single market, the redistribution and stabilization functions are left largely to member states. Within this framework, the EU budget provides for limited redistribution, mainly through structural funds, aimed at financing regional and social policies designed to raise employment levels and close income gaps among EU regions.
Although it is much less centralized than a federation, the EU framework is nevertheless closer to a federation than the other monetary unions, such as the CFA franc zone and the currency union between Belgium and Luxembourg, the authors note. The euro area, moreover, is characterized by much closer political, judicial, and economic integration than other monetary unions; a central budget; a process of harmonization of regulations and taxes; and policy coordination mechanisms.
EMU and Fiscal Policy
The policy framework envisaged under EMU will not alter significantly the way basic fiscal policy functions are assigned in the current EU institutional setting, according to the authors. It remains to be seen, however, whether the EMU policy framework, embodied in the Maastricht Treaty and the Stability and Growth Pact, provides clear procedures to ensure that fiscal policy is carried out effectively, or whether more centralization will be needed to address redistribution and stabilization issues.
Excessive Deficit Procedures. The Maastricht Treaty makes the stabilization function the prerogative of each member state, but subject to multilateral surveillance and excessive debt procedures, which have been clarified by the Stability and Growth Pact. The pact calls for a medium-term fiscal position for EMU participating states that is close to balance or in surplus. A government deficit exceeding 3 percent of GDP is considered excessive and should be corrected or financial sanctions will be imposed. Except in the event of exceptional circumstances, an excessive deficit must be corrected by the year after it has been identified or the European Council may apply financial sanctions against the member.
Tax Harmonization. Under a common currency, tax competition is likely to increase. Tax-inclusive prices will become more transparent and, with the loss of the monetary and exchange rate instruments, the role of tax policy in attracting business and enhancing competitiveness will become prominent. It has become increasingly evident, according to the authors, that excessive competition could lead to harmful tax practices. These could, in turn, lead to lower revenue or change the structure of tax systems in directions not always desired by member states. Harmful tax competition could seriously undermine the capacity of member states to conduct independent fiscal policy.
European Structural Funds. The EU budget performs some interregional redistribution, mainly through its structural funds, whereas interpersonal redistribution and social security are left to member states.
As long as mobility, solidarity, and central intervention remain limited within the European Union, redistribution policies appear sufficient, the authors observe. But in the medium to long run, as European integration proceeds, demands for a larger central redistribution function—including social security— may emerge and put pressure on the limited size of the structural funds.
An expanded central redistribution function may face strong resistance, however, at least in the short term, especially from member states reluctant to finance large and permanent transfers to specific countries or regions.
Should Macroeconomic Stabilization Be Centralized?
In a federation, the federal budget has an automatic stabilizing effect in the event of shocks affecting local economies. In the case of a local recession, federal taxes paid by local residents decrease, and federal transfers increase, thus having a countercyclical effect. Some observers have suggested that a separate EMU budget would be necessary to achieve the same effects in case of asymmetric shocks. Others have pointed out that local fiscal policies are sufficiently well equipped to handle these shocks by running temporary deficits and surpluses.
To the extent that member states maintain balanced budgets over the medium term, there appears to be some agreement that the Stability and Growth Pact would allow automatic stabilizers to operate, the authors note. In addition, economic and monetary integration should increase the positive correlation of output fluctuations among EMU members and therefore reduce the likelihood and importance of asymmetric shocks. But to the extent that new member states will enter EMU at the upper limit of the Stability and Growth Pact fiscal criterion, there may be little room initially for the normal operation of automatic stabilizers, which could lead to weaker stabilization and greater output volatility than has been the historical norm. This outcome could be aggravated as member states see the range of discretionary policy tools—notably tax policy—reduced by EU integration, and since the magnitude of automatic stabilizers is likely to have diminished in the past few years—a somewhat neglected issue, according to the authors. Under such circumstances, there may be calls for stabilization through the EU budget, which could result in large and lasting transfers.
Role for Central Fiscal Authority?
In the current EU fiscal framework, coordination relies exclusively on exchange of information, publicity, and peer pressure. No EU institutional body is equipped with the necessary instruments to handle policy coordination, while the imposition of sanctions against noncompliant member states provided for in the Stability and Growth Pact does not substitute for the lack of appropriate policy coordination.
The European Central Bank has been vested with a high degree of independence, which is essential to the credibility of the EMU. However, credibility risks being undermined if the framework designed to coordinate fiscal policies is perceived to be weak. The ECOFIN Council (comprising economic or finance ministers of the European Union) coordinates fiscal policies for all EU member states and not strictly those of the euro area. In addition, the ECOFIN Council does not have the necessary instruments to enforce its decisions on coordination. The Stability and Growth Pact, although it provides a clear and strict framework for fiscal convergence and stability, sets no binding rules for member states that stay within these limits. In addition, there is some skepticism about the ability and willingness of EU authorities to strictly enforce the sanctions for non-compliance envisaged by the Stability and Growth Pact. Imposing sanctions and fines on a country facing genuine economic difficulties, which would have already been penalized by market mechanisms through higher interest rates, could only worsen its situation. Also, sanctions are not automatic, requiring majority approval among participating members. As a result, decisions of this sort will certainly be highly politicized, undermining the accountability and transparency of enforcement. If transitional frictions were to arise, the credibility of the EMU might be severely challenged from the beginning.
Decentralized stabilization policies may also entail free-riding behavior, and member states may not be willing to provide necessary fiscal stimulus or restraint if a large part of the benefit would accrue to other countries or if their fiscal position already satisfies their domestic needs.
The need to coordinate discretionary fiscal policies within EMU may arise in a number of situations, such as a risk of overheating, a severe EU-wide recession, or a supply shock. The envisaged policy response is that the European Central Bank would carry out an EU-wide stabilization policy through monetary policy. But if inflation is already high, monetary policy might end up following conflicting objectives, since it is supposed to focus primarily on price stability. Discretionary fiscal policy measures may then become necessary.
In the short term, enhanced coordination may be able to address most of the above-mentioned issues effectively, but over the longer term, decentralized fiscal policies may not be able to provide the degree of macroeconomic stabilization required by the euro area. Creating a central fiscal authority and providing it with a larger budget may not be feasible in the short term because of the absence of political agreement and the delays inherent in the European Union’s institutional process. But although EMU has been launched in a favorable economic upturn, the business cycle may change direction in the medium term and lead to economic difficulties. These may reveal that the Stability and Growth Pact does not achieve as much cohesion as intended and may require either more flexibility in its procedures or a more strongly coordinated policy response.
In this context, the authors conclude, a central fiscal authority, endowed with some funds, may prove an effective instrument for macroeconomic stabilization. And although the current flexible framework may be sufficient in the short and medium term, as integration proceeds and a sense of European unity grows, it may have to be strengthened progressively in the long run to address the demands and needs of fiscal policy.
Copies of IMF Working Paper 98/176, Will Fiscal Policy Be Effective Under EMU? by Marco Cangiano and Eric Mottu, are available for $7.00 from IMF Publication Services. See page 56 for ordering information.