KEY INSIGHTS

• A budget financed by wages: Gross national income-based national contributions rest largely on taxes on labour and consumption, so the EU budget ultimately leans on ordinary earners.

• The net-position trap: While Brussels depends on national transfers, the debate collapses into who pays in and who takes out, crowding out any discussion of European public goods.

• Taxing the very wealthy: A minimum tax on individuals with net wealth above €100 million carries by far the largest revenue potential of the options assessed.

• Mobility argues for Europe: Financial trades, crypto assets and flights cross borders too easily for national taxation to bite, which is precisely why EU-level levies would work better.

• New money, not recycled money: Taxes on ultra-high wealth and crypto transactions barely exist nationally, so an EU levy would add revenue rather than take it from national treasuries.

Spending needs for the EU budget for 2028–2034 have grown, and nowhere more so than in the investment required for the social and ecological transformation. At the same time, it is important to move beyond the problematic debate about higher national contributions to the EU budget, since those contributions are financed largely through taxes on labour and consumption. We have analysed how new EU revenue sources — among them taxes on ultra-high wealth and on crypto transactions — could help to do exactly that.

Political negotiations on the EU budget for the years 2028–2034 are entering a critical phase. The European Commission has presented a concrete proposal for a larger EU budget. Under it, the budget for the 2028–2034 period would amount to almost €2 trillion, or around 1.26 per cent of the EU’s gross national income (GNI), compared with approximately 1.1 per cent under the current financial framework.

The larger budget is intended to address growing public spending requirements related to climate action and digitalisation, public security and competitiveness, while also meeting the repayment obligations arising from the Covid-19 recovery fund.

The EU budget is currently financed predominantly through contributions from the member states, calculated on the basis of GNI and raised, in turn, mainly through taxes on labour and consumption. They are supplemented by revenue from value-added tax and customs duties.

Source: Schütz and Heimberger (2026).

This financing architecture has long been criticised, because it frequently narrows political debate to national net positions. Attention then fixes on how much each member state contributes and how much EU funding it receives in return. Such a perspective makes it more difficult to view the EU budget as an instrument for financing common European tasks, and it thereby limits the political scope for collective action at the European level.

Expanding genuine EU own resources — that is, revenue that does not come directly from national budget contributions but rests on common European levies or cross-border tax bases and is permanently assigned to the EU budget — could partly break with this logic. On the one hand, the Commission’s proposal for the 2028–2034 EU budget includes channelling 30 per cent of the revenue from the Emissions Trading System (ETS) and three-quarters of future revenue from the Carbon Border Adjustment Mechanism (CBAM) into the EU budget. On the other hand, it includes a levy on uncollected electronic waste, a European tobacco tax and a new corporate contribution. Together with adjustments to existing own resources — such as reducing the share of customs revenue retained by member states and increasing the plastic levy — these measures are intended to generate an additional €58.2 billion in annual revenue.

The plans presented by the European Commission have, however, already encountered reservations in several member states. It therefore makes sense to consider options that go beyond the Commission’s current proposals.

Untapped revenue potential

Our study assesses both the own resources proposed by the European Commission and a range of alternative options, evaluating them according to criteria that include their European dimension, their distributional effects, their suitability for addressing environmental and societal externalities, and their revenue potential.

The results show that various alternative instruments — among them a financial transaction tax, an EU-level digital tax, taxes on cryptocurrency transactions and online gambling, aviation-related levies, and taxes on very wealthy individuals — could generate revenue while simultaneously addressing challenges such as tax avoidance, financial-market instability, climate change and rising inequality.

The sums involved vary widely. At the modest end sit annual revenues of around €2 billion from taxing online gambling and €3 billion from levies on cryptocurrency transactions. Aviation-related taxes occupy the middle ground, at between €5 billion and €7 billion a year. At the top end, taxing ultra-wealthy individuals could raise as much as €41 billion annually.

Source: Schütz and Heimberger (2026).

Where only Europe can act

A financial transaction tax would not only generate additional revenue for the EU budget; it would also make short-term and speculative trading in financial markets more expensive. It could therefore help to curb certain forms of destabilising financial-market activity. Since financial transactions frequently take place across borders, and market participants can relocate relatively easily, there is a strong case for a coordinated European solution rather than fragmented national approaches. Previous proposals for a European financial transaction tax envisaged, for example, low tax rates on transactions involving shares, bonds and derivatives.

An aviation-related levy is another natural candidate for a new EU own resource. Aviation benefits from preferential tax treatment compared with other transport sectors, including exemptions from value-added tax and the limited inclusion of international flights in carbon pricing. A levy linked to the carbon dioxide emissions generated by flights could therefore reflect environmental externalities more accurately in ticket prices while simultaneously generating revenue for European priorities. Since emissions from international flights cannot meaningfully be attributed to a single member state, and national ticket taxes can partly be circumvented by flying from airports in neighbouring countries, an EU-wide solution would be best.

Source: Schütz and Heimberger (2026).

The taxation of crypto-assets could also be considered as a new source of revenue for the EU budget. Here the European Commission is discussing in particular a tax on crypto transactions or, alternatively, a tax on capital gains from crypto-assets. Two caveats must be taken into account: the tax base for crypto-assets fluctuates, and activities could relatively easily be relocated to jurisdictions outside the EU. This is precisely why a coordinated European solution would be preferable to a patchwork of separate national measures.

A tax on ultra-high wealth would have particularly high revenue potential. One possible approach would be a minimum tax for individuals with net wealth exceeding €100 million, ensuring that the taxes paid annually by this group amount to at least a specified proportion of their wealth. Such a tax would specifically target individuals whose effective tax burden is lower than that of other groups. At the same time, it could help to limit tax competition between member states for particularly wealthy residents.

Source: Schütz and Heimberger (2026).

Increasing the EU budget’s dependence on GNI-based national contributions, which rely heavily on taxes on labour income and consumption, risks undermining public support. A more developed system of genuine EU own resources could help to reorient the debate away from higher national contributions and towards the financing of European public goods and common political priorities. An agreement on additional own resources is essential if the proposed expansion of the EU budget is to be financially and politically sustainable.

Taxes on particularly mobile tax bases appear especially suitable for implementation at the EU level, since national approaches are often less effective in the face of tax competition and cross-border mobility. Some proposals — such as taxes on ultra-high wealth or on crypto-asset transactions — are particularly attractive because they currently do not exist at the national level and could therefore strengthen EU revenue without reducing any existing national tax revenue.

A better mix of own resources could strengthen the EU budget while distributing its financing more evenly across different parts of the economy, including between businesses and households.

Note: This article first appeared in Social Europe.

Interviewer: “How can debates on justice be distinguished from debates on envy, for example when it comes to the distribution of resources within states or between states, e.g. within the EU?”

Debates on justice revolve around normative principles: Equality, fairness, meritocracy, etc. What distribution is fair? These are debates that are open to nuanced arguments.

Envy debates, on the other hand, deliberately seek to activate base instincts in politics and society. They are highly emotionally charged; the emotion is intended to nip rational thought about nuances, pros and cons in the bud. Envy debates are particularly effective when they fuel personal or collective dissatisfaction that others are taking it easy and lying on their lazy backs, which is only possible thanks to the honest and hard work of the exploited core group.

This can then be transferred to disputes between EU states, for example during the euro crisis: politicians in northern countries repeatedly claimed that southern Europeans had been having a good time at the expense of taxpayers in northern Europe for a long time; and now these brazen people also want “us” to pay for the crisis caused by their excesses! The stoked emotions are intended to stifle any consideration of the systemic causes of the crisis in a complex system in which the northern countries also made a significant contribution to the emergence of macroeconomic imbalances, which later exacerbated the crisis.

Interviewer: “Would you say that periods of weak economic growth (and increased uncertainty) are a breeding ground for envy debates?”

There is recent research that suggests that in times of weak growth, “zero-sum thinking” increases: that is, more people hold the worldview that the gains of some are always the losses of others, based on the assumption that societal output is limited; effort and exchange cannot create value, only redistribute it.

When “zero-sum thinking” takes hold in times of weak growth, higher unemployment and rampant fears about the future, it is easier to stir up further envy. This makes it easier to score points by claiming that politicians must expel large numbers of migrants and stop further immigration, as this is the only way for the native population to win. And it is also easier to succeed with the argument that we need to seal ourselves off more from neighboring countries, as this is the only way to gain an economic advantage at home.

Interviewer: “Have there been any major European envy debates in recent years/decades?”

There were major economic policy envy debates that lasted for many years, particularly during the euro crisis in the 2010s and during the Covid crisis (2020-2021). “I can't spend all my money on liqueurs and women and then go and ask for your support”, said the then Eurogroup leader Jeroen Dijsselbloem (the Dutch Finance Minister) in the context of the euro crisis in the direction of the crisis-ridden countries in southern Europe.

German Finance Minister Wolfgang Schäuble had already called for austerity policies in southern Europe at the height of the euro crisis, claiming that “excessive deficits and debt levels” had caused the crisis: “You can't cure an alcoholic by giving him alcohol.” Major German-language newspapers enthusiastically reported such political statements and wove them into their envy-inducing coverage of the crisis in southern European countries. The Bild newspaper, for example, ran a one-sided campaign against Greece in particular for years: “Why are we paying the Greeks their luxury pensions?”, “Why don't you sell your islands, you bankrupt Greeks... and the Acropolis too” - these were among the headlines in those years. The aim was to create a mood against Greece among German readers and thereby increase the pressure on German politicians to align crisis policy with nationalist considerations.

The fact that the first “aid packages” for Greece were primarily intended to minimize the losses of German and French banks, which held a large proportion of Greek government bonds, was not worthy of headlines - after all, this was not a way to create a mood against the Greeks.

During the Covid crisis, especially in the first few months, leading northern European politicians focused on Italy and Spain, which were particularly hard hit by the waves of infection. If the governments in these countries failed to prepare their healthcare systems for such a crisis, why should “we” in Northern Europe now pay for the “failures”? Why should there be European subsidies (non-repayable loans) for these countries if the money is only being “squandered” there anyway, as has been seen time and again in the past? Several member states - including Austria - entered the negotiations surrounding the Covid recovery fund with nationalistic, envy-inducing undertones; leading politicians used base instincts to create a supposedly better negotiating position for themselves.

Interviewer: “Is envy a factor or obstacle in the integration of European fiscal policy, for example?”

During the aforementioned crises, the stirring up of envy - along the lines of: “We” are certainly not paying for your fiscal profligacy - was most pronounced. But in slightly adapted forms, this keeps cropping up in debates on European fiscal policy. This envy motif is now so well anchored in the discursive substructure that it can also be activated quite quickly.

Interviewer: “What lessons can you draw from your analysis of previous fiscal consolidation episodes in the European Union? In comparison, is the adjustment planned for 2025 and beyond a cause for concern?”

The fiscal consolidation requirements for some member countries are large in historical comparison, including France. The next years are characterised by an austerity outlook: Europe is approaching a multi-year period of simultaneous fiscal contractions in many euro area member countries that represent a large share of the overall euro area economy.

Data: Darvas et al. (2024).

Simultaneous fiscal consolidations across many countries may slow economic growth more than officially expected. Fiscal consolidation during the adjustment period may well lead to economic downturns or at least stagnation, which may trigger a larger-than-expected increase in public debt ratios in the short term, thereby risking a reduction in government approval and an erosion of financial market confidence.

Interviewer: “In your study published in October 2024, you state that the need for fiscal consolidation imposed in the eurozone in the mid-2010s was based on the “incorrect interpretation” that the crisis was fiscal in nature. You also point to a fiscal multiplier estimation error. What is the situation today?”

The key idea of the new framework is that governments just have to show sufficient fiscal discipline to bring public debt ratios down over the medium run. However, if the negative growth effects of fiscal consolidation were to turn out higher than anticipated by the European Commission, public debt ratios may also turn out higher than expected.

Interviewer: “You also demonstrate the contractionary effect of fiscal adjustments on growth, leading to higher public debt ratios. Is fiscal austerity ultimately ineffective, or even counterproductive?”

The overall effect of fiscal consolidation on the economy depends on the timing, the composition and the size of the consolidation. Going for austerity in a downturn and focusing mostly on government spending cuts will give you stronger contractionary effects due to high multipliers. If there are strong and persistent negative effects of austerity on output, the impact on the public debt ratio will indeed be counterproductive, as the debt ratio will tend to be higher in the medium term than it would have been without the fiscal adjustment.

Interviewer: “Then, how can deficits and public debt be reduced?”

If you aim for lower budget deficits in the medium term, you have to think about what needs to happen in different parts of the economy. The greatest potential lies in reducing the household savings surplus through targeted redistribution policies and measures that reduce unemployment and reduce uncertainty, as well as in stimulating credit-financed investments by companies. If you want to have sustainable public finances in the medium and long run, the economy has to be doing well, so that a large number of people have (good) jobs from which they can live and contribute to financing the welfare state by paying taxes and social security contributions. The idea that debt sustainability can be ensured by being more and more restrictive on fiscal policy, without taking the overall economic effects and links to other sectors of the economy into account, is flawed.

Interviewer: “In France, in the current context (economic context, situation in other European countries, global economy, etc.), is it advisable to pursue a policy of budgetary adjustment?”

I think that it is not a good idea to pursue austerity in the current environment. This whole idea is doomed to failure: that the top priority of fiscal policy should be to ensure primary fiscal surpluses via fiscal consolidation at a time when the private sector is not doing well, there are major public investment needs to tackle climate change, when there are major geopolitical uncertainties in the context of wars and trade conflicts. Do policymakers really want to say in ten years: well, we missed the climate targets, social inequality increased, we did not prepare well for the new geopolitical environment, but at least we tried our best to move from primary fiscal deficits to primary surpluses – although we even failed to meet our budgetary targets since the economy did worse than we expected?

One also has to take into account that the academic literature on the political costs of austerity suggests that fiscal adjustments, especially during downturns, lead to a significant increase in extreme parties' vote share, lower voter turnout, and a rise in political polarization. Fiscal consolidations typically reduce government approval, thereby increasing political instability. We should not discuss the economics of fiscal adjustment while ignoring the political economy aspects.

Interviewer: “What room for maneuver does the French government have, within the European budgetary framework, to avoid negative effects on growth, and ultimately public accounts, while carrying out the required budgetary adjustment?”

No matter who will be in government in France in the future, what the government can do is to ask the European Commission to extend the adjustment period from four to up to seven years by submitting a package of investments and reforms. If the European Commission accepts this package, then this will reduce the annual fiscal consolidation requirement substantially. This could at least reduce the negative macroeconomic effects in the short run.

However, the reformed EU fiscal framework does not provide broad-based exemptions for public spending on the green and digital transition. This implies that, if member countries wanted to increase green and digital public spending, they would have to make room for it by restraining other spending items (e.g. social protection, health or education). In sum, the new EU fiscal rules will not enable national governments to promote additional public spending on the green and digital transition on the scale required. Falling behind on the twin transition may then prove to be an economic burden in the long-run, and lower long-term growth would undermine sustainable public finances.

Interviewer: “What is the impact of achieving this through more cuts in government spending or more tax increases?”

It would be counterproductive to achieve the consolidation required to comply with EU fiscal rules mostly through spending cuts. The empirical evidence shows that spending cuts have much stronger negative growths effects than tax measures, particularly during economic downturns.

Data from the International Monetary Fund on fiscal consolidations in developed economies since the 1970s show that governments usually adopt a mix of revenue and expenditure measures when pursuing the goal of reducing the budget deficit. Purely expenditure-side consolidations are rather rare. Moreover, the empirical literature shows that spending cuts have stronger distributional effects at the expense of lower income groups.

The view held in the debate that spending cuts could even have a positive effect on the economy is at odds with the empirical evidence. Even during the euro crisis ten years ago, economists and politicians claimed that spending cuts would boost business and consumer confidence. In fact, the focus on budget cuts in many euro countries exacerbated the downturn, with negative consequences for longer-term debt sustainability.

Of course, there are spending cuts that are less of a burden on the economy than others. However, the multi-year consolidation requirements to comply with EU fiscal rules are so significant that larger groups in the population will inevitably be affected by the spending cuts. Many of the current prominent proposals for government spending cuts would hit low-income earners relatively harder than those with high incomes.

Source: IMF (2024).

The International Monetary Fund also points out in its current research that fiscal consolidation leads to significant declines in economic output and private consumption. Cuts in public investment are particularly detrimental, but a decline in government consumer spending also has a dampening effect. However, the loss of growth is lower when progressive taxes are increased, which hit people with high incomes harder, than when spending is cut.

Interviewer: “A high level of public debt is often thought to reduce growth, which argues in favor of fiscal consolidation when public debt exceeds a certain threshold. However, your quantitative analysis of studies on the subject, published in November 2021, reveals that the causal link between high levels of public debt and lower growth is not so obvious. In the case of France today, do you believe that the level of public debt is reducing economic growth?”

My study provides a quantitative analysis of the whole empirical literature on the impact of public debt levels on economic growth; that’s more than 800 estimates from about 50 studies. Once you properly summarise this literature, there are two main findings: first, the average linear effect of public debt levels on growth cannot be distinguished from zero. Second, there is no evidence for uniform thresholds in the public-debt-to-GDP ratio in all countries beyond which growth falls.

This finding is quite plausible, since there are no strong reasons why there should be a “magic“ threshold in the public debt level beyond which growth slows. The well-known researchers Reinhart and Rogoff claimed this in a famous paper in 2010, and policy-makers used this to argue in favour of spending cuts to bring down public debt. But it was always a chimera – unfortunately a very costly one, since this kind of reasoning has promoted a “one-size-fits-all” austerity approach that has wreaked havoc on the Eurozone during the 2010s.

There is no end to the internal coalition dispute in Germany over fiscal policy. Finance Minister Christian Lindner (FDP) is staging himself as an austerity champion who is putting a stop to the spending wishes of his coalition partners. For him, the debt brake is sacrosanct and must not be relaxed. The new EU fiscal rules, Lindner claims, will even create additional pressure for spending cuts in the coming years.

The finance minister is deceiving the public with this game of alleged EU constraints. Experts have known for months that the consolidation requirement for Germany to comply with the new EU fiscal rules is low. The Brussels-based research institute Bruegel has calculated that Germany could even reduce the fiscal consolidation requirements to almost zero if it were to submit an acceptable investment and reform plan to the European Commission.

Source: Darvas et al. (2024).

In this case, according to Bruegel's calculations, Germany would have to improve its structural primary balance by just 0.02% of economic output per year in the period from 2025 to 2031. The primary balance is the headline fiscal balance excluding interest payments, calculated for a hypothetical “normal” business cycle position (i.e. corrected for cyclical conditions based on potential output). For France and Italy, on the other hand, the fiscal consolidation requirements is 0.6 percent per year and for Spain 0.5 percent. France and Italy must therefore consolidate substantially in order to comply with EU fiscal rules, Germany only marginally.

Source: Heimberger et al. (2024)

The budget plan drawn up by the Ministry of Finance for 2025 envisages an improvement in the structural primary balance of 0.75% of GDP. This is much more than the 0.02% that would be required per year with the investment and reform plan. Even without an investment plan, the European Commission would only require 0.11%.

Although the deadline of October 15 has already passed, Germany, unlike most other EU countries, has not yet sent a multi-year budget plan for the coming years to the European Commission. It is reasonable to assume that Lindner is delaying the official submission to the EU Commission so that he can continue to misuse the new EU fiscal rules as leverage in the national budget debate.

The European Commission has now published the calculations for the consolidation requirements for all countries that submitted their multi-year fiscal-structural plan by the mid-October deadline. Some member states, such as Austria, published the reference paths, which were initially submitted in secret in June, immediately.

The opinion of the Stability Council's advisory board also does not provide any good reasons for delaying the submission of the plan. The higher expenditure in 2024 discussed by the Stability Council is not relevant for compliance with the rules. What counts are the consolidation requirements calculated on the basis of the spring forecast data: The “safeguard” for the public debt ratio mentioned by the Stability Council does not apply to Germany in the European Commission's reference path. Germany’s Ministry of Finance should not take any steps that require a more restrictive fiscal policy than required by the European Commission. Otherwise there is a risk of a further slowdown in economic growth.

Lindner is in favor of a more restrictive fiscal policy for political and ideological reasons. However, he should have to argue for this on substance without deceiving the public with wrong claims about austerity constraints due to EU fiscal rules that currently do not exist for Germany.

After some tough negotiating, shortly before Christmas EU finance ministers reached an agreement on the reform of EU fiscal rules (Council, 2023). The Council agreement was the basis for the political deal between member state negotiators and the European Parliament on February 10^th 2024. The provisional agreement by EU co-legislators will now be subject to votes in both the Council and the European Parliament, and enter into force soon after their publication. Member states will have to submit their first national plans based on the revised framework in September 2024.

The main principles of the new rules: medium term and ‘country specific’

The agreement on reforming EU fiscal rules shifts the focus from the annual development of public finances to a longer-term view. The previous framework’s well-known deficit limit of 3% of GDP and public debt limit of 60% of GDP remain, but the old annual budgetary targets, based on the ‘structural’ (cyclically adjusted) deficit, are no longer there, and the old mechanical debt-reduction rule (public debt ratios had to fall to 60% within 20 years) will also be abolished. Under the new framework, when public debt exceeds the 60% reference value, or when the budget deficit rises above the 3% reference value, the European Commission will put forward a ‘technical trajectory’. This is supposed to ensure that by the end of a fiscal adjustment period of at least four years, the public debt ratio is on a ‘plausibly downward trajectory’.

Multi-year budget plans of at least four years will be negotiated between the European Commission and national governments against the background of the technical trajectory and will be rooted in an analysis of the sustainability of a member country’s public debt. Hence, the country-specific nature of the fiscal adjustment requirements is an important change from the old framework. The net expenditure path (i.e. expenditure net of interest payments and cyclical items) will be the main operational target under the new framework. There will be a general EU escape clause and national escape clauses that can be triggered in the event of some serious occurrence that justifies temporary non-compliance with the rules.

Member states can commit to a range of investments and reforms, extending the fiscal-adjustment path to a maximum of seven years, provided the European Commission agrees that the investments are consistent with debt sustainability. However, any quantitative analysis of the medium-term fiscal and growth implications of investments underpinning a longer adjustment period is difficult and contains the potential for political conflict.

The Council agreement fails to incentivise public investment adequately, even though additional green public investment of at least 1% of EU GDP will be required if the ambitious climate targets are to be met over the coming decades. When assessing whether individual member states comply with their fiscal plans, the European Commission will exclude national spending on the co-financing of EU funded programs from government expenditure. In the short-term, this will not have a big impact, since most national co-financing relates to spending on EU regional funds. In the longer run, however, it will provide incentives for channelling extra money through the EU budget, and may increase the scope for steering national fiscal spending into EU policy priorities to increase co-financing expenditures. However, the reform compromise does not include broad exemptions for green public investment at the national level irrespective of co-financing with EU programs.

The resulting fiscal consolidation pressure from 2025 onwards will therefore make it virtually impossible for several national governments – especially those with high public debt ratios, including large euro area countries such as Italy, Spain and France – to sufficiently increase their investment ratios. Yet this is something that is badly needed if economic development and climate targets are to be met, since public investment can be reduced or postponed more easily than other government spending components whenever the pressure to pursue fiscal consolidation increases.

The insistence by Germany and certain other countries on stricter fiscal rules has led to a problematic compromise regarding the introduction of so-called ‘safeguards’ for minimum fiscal consolidation. A new ‘deficit resilience safeguard’ will be applied when the multi-year spending path is set: this will require governments to continue with fiscal adjustment – even after they have reached the 3% deficit target – until a common ‘resilience margin’ of 1.5% of GDP below the 3% deficit benchmark has been reached. This ‘safeguard’ will lead to overly harsh adjustment requirements for some member states compared to the EU Commission’s original proposals.

Implementation of the new rules could result in excessive austerity and may prove politically costly

The widespread view that the new EU fiscal rules will be lax is unfounded. The new framework will be less restrictive than would have been the case had the old framework been reactivated. After the rise in public deficits and debt due to the pandemic, the old framework would have been so harsh as to be virtually unenforceable. Nevertheless, after years of using the escape clause, it will be tough to return to fiscal restraints under the new framework; and the new rules will be much more restrictive than many believe – especially for countries with high public debt ratios. Simulations provided by Bruegel that are based on the Council agreement show that implementation of the new rules will mean Italy and Spain having to make an annual structural fiscal adjustment effort of 0.6 percentage points (pp) of GDP over a period of seven years from 2025. For France, the required annual adjustment is estimated at 0.5pp; for Austria – 0.3pp; and for Germany – 0.1pp.

Source: Zettelmeyer (2023).

The design of the new rules also demonstrates that policy makers have learnt too little from past mistakes, when lack of fiscal-policy coordination among member states exacerbated the euro crisis in the period 2011-2013. With expenditure paths derived from the Council agreement, large fiscal consolidations will be required in a number of (big) euro area countries from 2025 onwards, in order to comply with the reformed fiscal rules. Depending on where a country is in the business cycle at the time when fiscal consolidation is pursued, the cross-border effects of simultaneous budget cuts could exacerbate the adverse impacts of fiscal consolidation on economic growth. And with growth slowing, public-debt-to-GDP ratios may have a tendency to overshoot the projections of the European Commission, thereby undermining the main goal of the framework – which is to reduce public debt ratios in the medium and long term.

Given the Council agreement, better enforcement of the rules in countries such as Italy and France will not succeed in the long term without major economic and political damage. Just how unrealistic it is for countries with high public debt ratios to comply with the new rules over the long term can be seen from the fact that the political agreement provides for a transition regime for countries in an Excessive Deficit Procedure (EDP) until 2027. For instance, France has gained a concession that interest payments will be exempt from the minimum fiscal adjustment requirement under the EDP until 2027, but not thereafter. Italy argued that the reforms and investments undertaken as part of the EU’s post-pandemic recovery plan may already be sufficient to gain approval for the extension of fiscal adjustment from four to seven years; without that, even tougher fiscal consolidation would have to be implemented.

France and Italy agreed to the ‘safeguards’ advocated by Germany for short-term motives. However, future governments will have a very hard time because of this short-sighted compromise, particularly as governments will need to undershoot on public investment in order to meet the fiscal consolidation requirements. Therefore, it is likely that we will again have to discuss the political unenforceability of the reformed rules and their adaptation in the not-too-distant future.

This article first appeared in the wiiw Monthly Report February 2024.

This is a translation of my column published in German business newspaper Handelsblatt.

Last year, Germany's economic growth was weaker than in all other G7 countries. The IMF predicts that this will also be the case in 2024.

Source: Financial Times.

For a long time, Germany was regarded as Europe's industrial powerhouse. However, new data show a broad industrial downturn. Since December 2021, i.e. since the formation of the federal government under Chancellor Scholz, industrial production in manufacturing and mining has fallen by 6%, while production in energy-intensive industries has fallen by as much as 22%.

Source: Destatis.

This means that Germany has been one of the worst performers in the EU in terms of industrial production in recent years. The Federal Government's economic policy has not been able to prevent this.

Source: Daniel Kral.

Against this backdrop, the German government has to find an economic policy response to weak growth. Finance Minister Lindner and Economics Minister Habeck want to work on a "dynamization package".

However, the abolition of the solidarity surcharge for companies proposed by Lindner would be the wrong measure. This would mean a blanket reduction in profit tax for companies. The positive growth effects that the finance minister expects from this are exaggerated. Sebastian Gechert and I show in a study that there is little empirical evidence for positive growth effects of such corporate tax cuts.

Source: Heimberger and Gechert (2022).

Especially if government spending is cut elsewhere at the time of the corporate tax cut, weaker growth effects are to be expected. In view of the problems associated with complying with the debt brake and the resulting prospect of government spending cuts, caution is therefore required, especially as a corporate tax cut would lead to a (continued) decline in government revenue.

A loss of tax revenue in turn reduces the provision of public goods such as infrastructure and education. However, the quality of the location for companies and their business prospects are dependent on high-quality public goods.

For German companies to invest more again and for the economy to grow more strongly, the business case for investment must be right. The government would have to make it easier for decision-makers in companies to plan by combining a clear industrial policy strategy with public investment in order to attract further private investment. The turbulence within the federal government surrounding compliance with the debt brake and uncertainties as to whether even long-announced fiscal policy measures in favor of companies can be financed are counterproductive.

Germany's corporate taxation is no longer competitive internationally, it is claimed. Positive effects from across-the-board profit tax cuts are mainly achieved, if at all, by companies relocating to Germany at the expense of other countries. Despite its current weak growth, Germany is Europe's most powerful country both politically and economically. As such, its government should not promote a race-to-the-bottom in corporate taxation that does little for growth.

Italy - heavily in debt, unwilling to reform and thereby pushing all of Europe towards the abyss! In the run-up to Italy’s general election in September, countless articles were again published in international media that struck such a tone. Indeed, the standard narrative on Italy in Germany, Austria and other countries is still that reckless fiscal spending and a lack of “structural reforms” based on European best-practices are major sources of Italy’s economic problems.

Italy indeed faces major problems. Over the last decades, labour productivity issues and a lacklustre industrial performance have culminated in substantial losses in relative living standards. Up to the late 1990s, Italy’s income per capita was still higher than in France and other Eurozone countries and only slightly lower than in Germany. However, a large gap has opened up over the last two decades, so that Italy’s GDP per capita in 2021 was about €8000 lower than in Germany and roughly €3000 lower than in France.

Unfortunately, the simplistic standard narrative on how Italy ended up with its long decline typically remains unchallenged: “Italians have been living above their means; they finally need to adjust!” While this position dominates public discourse on European issues, it is high time to take a data-based look at Italy and, in doing so, also dispel some myths that unfortunately continue to be spread regularly by international media, which promotes a lop-sided economic policy debate.

Italy has not been living beyond its means

From a macroeconomic perspective, a country can live beyond its means if it imports significantly more goods and services than it exports over a longer period of time, which goes hand in hand with rising foreign debt. If, on the other hand, roughly the same amount is exported as is imported, it makes little sense to speak of "living beyond one's means", because production and consumption match. And in Italy it is even the case that since 2012 the country has recorded higher exports of goods and services than imports. The country consumes less than it produces. If anything, Italians are not living above their means, but below their means.

Public debt is high because of the legacy of the 1980s and recent crises

Private sector debt in Italy is low in comparison with other OECD countries. Overall debt is certainly not a bigger issue in Italy than in other European countries. But Italy’s public-debt-to-GDP ratio at around 150% of economic output is the second-highest in the euro area just behind Greece.

High public debt is primarily a legacy from the 1970s and 1980s and the impact of deep economic crises over the past two decades. Furthermore, the mistakes that were made 40 years ago took place in an environment of rising interest rates. Since then, the Italian state has been carrying a heavy interest-rate backpack. If we exclude the burden of interest rates, however, the Italian state consistently ran budget surpluses from 1992 up to the Covid-19 crisis.

Source: AMECO.

Even Germany, Austria and the Netherlands recorded a comparable ‘primary’ budget surplus less frequently than Italy. The Italian state has not been as ‘profligate’ as is often claimed: it has consistently collected more in taxes than it has spent. IMF data show that Italy implemented the most severe fiscal consolidation packages of all advanced economies between 1992 and 2009, especially when it comes to spending cuts.

Per capita spending of the government for social and health is much lower in Italy than in Germany or France. But the interest burden—high due to legacy debt—has repeatedly pushed the overall budget balance of the Italian state into negative territory. Fiscal consolidation has contributed to weaker domestic demand for goods and services, which has led to lower economic growth.

Italy has carried out many market-liberal reforms

Italy’s “reform efforts” have been significant; Italy is actually a top performer in liberalising reforms over the past decades compared with other advanced economies. Overall, Italy has adhered much more closely to the EU's reform policy rulebook than Germany or France.

Source: Baccaro and D’Antoni (2020).

A flexibilisation of the labour market since the 1990s brought a sharp increase in fixed-term contracts, a pushback against trade unions and a decline in real wages compared to Germany and France. These measures not only reduced inflation in the 1990s. Cheap labour has increased the labour-intensity of production, thereby reducing the incentives for labour-saving investment by companies. Private investment, however, is key to rising productivity and is particularly crucial in high-tech sectors. Productivity growth is in turn the basis for growth and rising incomes. Market-liberal labour market reforms have thus arguably done more harm than good to Italy's productivity growth.

Italy remains the second-largest industrial location in the EU

It continues to surprise people in Germany, Austria and beyond that, despite weak productivity growth and problems with price competitiveness within the euro area, Italy has important economic strengths. Italy is still the second most important industrial location in the EU (which would be true even if the United Kingdom were still part of the EU), mainly due to the economic structure in the north of the country.

Source: Eurostat.

The country has the second highest share in EU industrial production after Germany; it has exported significantly more industrial goods than it has imported, including during the Covid-19 crisis. By far the most important export sector is mechanical engineering, followed by vehicle construction and pharmaceutical products. These sectors rank under "medium-high-tech" to "high-tech" industries in the OECD’s classification. Over the last eight years, Italy’s industrial production has outperformed Germany.

Challenging myths to improve economic policy

Similar to other European countries, Italy certainly has its own significant structural problems. These problems include the North-South polarisation of the country, weak productivity growth and dysfunctional elements of the political system. As the EU’s third-largest economy with tight trade links, other EU member countries certainly also have a keen interest in seeing positive economic developments in Italy. But instead of asking how European policy mistakes during past crises – such as pushing Italy deeper into fiscal austerity during the Euro Crisis – may have contributed to the long rise of the right-wing and a major decline in voter turnout, most European observers simply reacted to the Italian election results by expressing that they are “very concerned” about Italy, which should double down on doing its “homework”.

There is little critical thinking about how EU policy-makers could support Italian politicians in coming up with a credible strategy on opening up a positive development perspective for Italy beyond sticking to the Covid-19 recovery fund. A first step would require us to get rid of the wrong standard narrative about how Italy ended up in long-term economic decline. This must involve an analytical consideration of how domestic Italian factors have interacted with the policy constraints imposed by European integration and globalisation to accelerate Italy’s decline since the 1990s.

If austerity policies and market-liberal reforms have failed to move the country forward over the past decades, then the obvious thing to do is to develop a coherent long-run investment strategy and give Italy's industry a boost by launching a modern and green industrial policy strategy. Macro policy and labour market policy need to consider that efforts to push down labour costs have had negative effects on wages and domestic demand, exacerbating the problems of labour productivity growth. European policymakers need to support a proper coordination of wage, industrial and fiscal policy by rethinking the rules of the game, e.g. with regard to reforming the EU’s fiscal rules and industrial policy strategies.

The European Central Bank's (ECB) Pandemic Emergency Purchase Program (PEPP) has played a crucial role in preventing a crash in bond and equity markets. Markets had been under tremendous stress in March 2020 due to excessive market reactions around the impact of the pandemic, which quickly receded with the introduction of PEPP.

The ECB ended its PEPP net purchases of government bonds in March 2022. But it now holds €1690 billion in government bonds purchased since 2020. The maturities of these bonds vary from a few months to three decades. When a bond matures, the respective government pays it back to the ECB. To avoid shrinking its balance sheet and draining liquidity from financial markets, which would be particularly risky in the current uncertain economic environment, the ECB reinvests the funds.

One PEPP characteristic is that the ECB has the flexibility to decide which bonds to buy. So now, when a German bond is redeemed, the ECB can reinvest the funds in buying existing bonds of other countries.

In fact, in June and July 2022, the ECB did just that: it reinvested €17 billion in Italian, Spanish and Greek government bonds, while its portfolio of German, Dutch and French debt shrank accordingly.

Source: Financial Times.

The PEPP reinvestments are the first line of defense against a new euro crisis on the horizon that could result from a divergence in interest rates between German bonds and those of southern European countries. ECB action in recent weeks curbed the interest rate differential between Germany and Italy in particular.

The ECB's reinvestments help reduce interest rate differentials (“spreads”); they contribute to balancing structural advantages and disadvantages. It often goes unmentioned in public discourse that Germany, as the economically and politically most powerful country in the eurozone, has an unearned advantantage: Especially in times of crisis, investors want to buy bunds, which are considered the safest haven; thus, Germany benefits from the lowest interest rates.

Southern Europe is exposed to structural disadvantages because of the euro construction. The euro combines supranational monetary policy with national fiscal policy. If the ECB does not credibly backstop bonds issued by individual governments that have been singled out by investors as shaky, they cannot defend themselves against speculative market exaggerations that cause their interest rates to rise much more sharply than those of structurally advantaged Germany.

To remove legal doubts and stabilise the monetary union in the long term, the monetary policy approach to sovereign debt should be discussed democratically and regulated more cleanly in the ECB mandate than has been the case to date.

The French magazine Atlantico asked me to do an interview about the main results of my study and some of the broader policy implications. Here is the interview in French.

And here is an English translation of the interview:

Atlantico [AT]: It is usually assumed that high levels of public debt are a drag on growth. However, your study published for the Vienna Institute for International Economic Studies shows that it is not so easy to make a causal link between public debt and lower growth and that the effect is rather null. How do you arrive at this conclusion?  How do you explain this?

Philipp Heimberger [PH]: My study provides a quantitative analysis of whole empirical literature on the impact of public debt levels on economic growth; that’s more than 800 estimates from about 50 studies. Once you properly summarise this literature and correct for publication bias in favour of negative growth effects, there are two main findings: first, the average linear effect of public debt levels on growth is zero. Second, there is no evidence for uniform thresholds in the public-debt-to-GDP ratio in all countries beyond which growth falls.

This finding is quite plausible, since there are no strong reasons why there should be “magic“ threshold in the public debt level beyond which growth slows. The well-known researchers Reinhart and Rogoff claimed this in a famous paper in 2010, and policy-makers used this to argue in favour of spending cuts to bring down public debt. But it was always a chimera – unfortunately a very costly one, since this kind of reasoning has promoted a “one-size-fits-all” austerity approach that has wreaked havoc on the Eurozone.

AT: If public debt is not responsible for a drop in growth, what is the concrete impact of this debt on the economy of a country?

PH: My study is about the impact of public debt levels on growth. Think about it this way: does it matter for growth going forward if country A in the initial period had a public-debt-to-GDP ratio of 110%, while country B had a ratio of just 60%. My findings suggest that the effects on growth are, on average, close to zero. Governments may still be confronted with country-specific unsustainable debt levels, in particular if interest payments increase strongly. With higher public debt levels, the risk of being pushed into a bad situation with panic-induced bond sell-offs by financial market investors is higher – especially in the Eurozone, when there are doubts about whether the ECB will backstop government bond markets. However, this would suggest that a government’s ability and willingness to use fiscal policy properly depends more on the monetary arrangements and on public debt structures than on the actual level of the public-debt-to-GDP ratio.

The results in my study suggest that – given the further increase in public-debt-to-GDP ratios against the background of the Covid-19 crisis in most countries – there is no evidence for a general urgency to bring down public debt levels to avoid a drag on growth. A cautious reading of the existing evidence calls for caution when it comes to “one-size-fits-all” fiscal policy prescriptions in response to high public-debt-to-GDP ratios such as the simultaneous drive towards fiscal consolidation in Europe from 2010 onwards.

AT: In view of these results, does it make sense to try to reduce public debt at all costs to boost the economy, for example in a health crisis? 

PH: No, going for a reduction of public debt levels “at all costs” would actually backfire, as we have learned during the Euro Crisis. Back then, there was the dominant argument that public debt levels are too high and would act as a drag on growth; and that this should mainly be addressed by cutting government spending. However, this strategy choked the economic recovery in several Eurozone countries, and thereby made it more difficult for countries to grow out of their higher, crisis-induced public debt levels. An excessive focus on bringing down public debt levels can be counterproductive. European policy-makers should strive to learn from this after the Covid-19 crisis, and avoid the mistakes from the recent past.

AT: Does this mean that all forms of debt control or austerity measures should be stopped?

PH: Public debt sustainability should still remain one of several important goals of fiscal policy. But my results suggest that past concerns about higher public debt levels as a drag on growth have been exaggerated.

Policy-makers should recognise that the economic policy strategy needs to be more balanced than the strategy pursued during the Euro Crisis: we need to make sure that the recovery from the Covid-19 crisis can continue over the next quarters and years, and that unemployment rates can decline towards full employment; fiscal policy needs to support this, for example by promoting public investment with positive long-run growth effects. A vibrant economy with a well-functioning labour market is essential for long-run public debt sustainability. This idea that we just need to control the public debt level to succeed in bringing about stronger growth and debt sustainability is flawed. My study is one piece of the larger empirical puzzle suggesting that we should critically assess our public-debt-to-GDP fixations of the past.

Of course, the German election campaign is not the first campaign in which we hear promises that corporate tax cuts will provide a strong boost to the economy. The claim that lower corporate taxes will benefit the broader population through more growth has been a core element of supply-side economics at least since Ronald Reagan, touted in the past by conservatives and liberals as much as by flexible power politicians a la Trump.

From an economic theory perspective, the growth effects to be expected from tax cuts are ambiguous. In recent growth models, corporate tax cuts may have a positive effect on the growth rate by boosting technological progress and innovation. However, other theoretical work suggests that capital taxation is not harmful to growth if it shifts the tax burden away from taxing labour or funds productive government spending. The growth effects of tax changes are thus essentially an empirical question.

In a new study, Sebastian Gechert and I synthesise the relevant literature on the effects of corporate taxes on economic growth by using econometric methods from the meta-analysis toolbox. We show that a proper summary of existing studies indicates that there is no evidence for positive growth effects of corporate tax cuts. The empirical evidence thus suggests that those who claim strong growth effects from falling corporate taxes are pushing exaggerated hopes.

Source: Gechert and Heimberger (2021): Do corporate tax cuts boost economic growth?

Companies hit hard by the pandemic with high loss carryforward will foreseeably gain little from a tax cut anyway, because they do not pay profit tax. And then there is the big problem that cutting corporate taxes will lead to billions of euros in lost tax revenue when the promised positive growth effects do not materialise. This will further increase the fiscal austerity pressure for the government in the wake of the COVID-19 crisis, putting downward pressure on public investment.

It would be more effective if the next German government did not reduce corporate taxes and instead used the tax revenues to invest in climate- and digitization-friendly infrastructure. Companies would then also benefit from future-proof infrastructure.

This comment is a slightly adapted version of a text that first appeared in Handelsblatt in German.

Lukas Haffert, Nils Redeker and Tobias Rommel provide a representative survey of Germans' memories of economic history concerning the interwar period. Almost half of the respondents conflate the mass unemployment and poverty of the early 1930s with the hyperinflation that ended in 1923. The survey shows that this conflation is more common among well-educated and politically interested people.

Only one in 25 Germans today knows that the crisis of the 1930s was characterized by deflation (falling prices). When Germans are asked to characterize the Great Depression in their own words, they describe it simultaneously as a crisis of inflation and unemployment. The Weimar Republic, they say, was consistently plagued by high inflation.

Because the hyperinflation up to 1923 and the Great Depression of the 1930s in German collective memory merge into one event, a misconception can dominate public discourse: hyperinflation directly led to the rise of the Nazis! Recent research by Gregore Galofre-Vila, however, suggests that there is no evidence for such a direct impact: linking inflation data for more than 500 German cities with election results between 1924 and 1933 shows that people in areas more affected by (hyper)inflation did not vote to a greater extent for the National Socialist party.

The Nazis had only 2 percent of the vote in 1928, but 38 percent in 1932. The mass effect of Nazi electoral success in the early 1930s occurred in an environment of deflation. Reich Chancellor Brüning's austerity policies fuelled the electoral successes of the Nazi party and thus the rise of Hitler in the early 1930s.

The hyperinflation experience made Reich Chancellor Brüning and his cabinet wary of using expansionary policies to combat mass unemployment. The government took further austerity measures by emergency decree, and the Nazis proved extremely effective in exploiting the suffering of large segments of the German population caused by austerity policies for their political benefit.

Because of the severe impact of the collapse of democracy, the memory of the Weimar Republic remains a key reference point for postwar politics in Germany. Unfortunately, however, conclusions for current economic policy are regularly drawn on the basis of distorted memories.

This comment is a slightly adapted English translation of a column first published in the German newspaper “Handelsblatt”.

Understanding current and upcoming discussions about whether and how to reform the EU’s fiscal rules requires us to come to terms with the power of economic models. The reason is that the current set of rules is based on model-based estimates, which restrict the fiscal space of EU countries due to their importance in the EU’s fiscal rules.

In this post, I will talk about a paper I co-authored with Jakob Kapeller und Jakob Huber: “The power of economic models: The case of the EU's fiscal regulation framework” – recently published in the journal Socio-Economic Review. The paper provides an in-depth analysis of the underlying estimation approach of “structural” deficits. I will try to relate our study to some important elements of Keynesian thinking. I will also provide cross-references to current fiscal policy debates in Germany and Europe.

We will see that political processes in Europe have been characterised by feedback loops where political decisions are coined by technicalities and, as a consequence, seemingly innocent technical assumptions become objects of political demands.

The issue of how to estimate output gaps and “structural balances” is currently important in the debates over when and how the EU’s fiscal rules and national “debt brakes” should be reintroduced and reformed.

Keynes and the role of economic ideas

At the end of his book "The General Theory of Employment, Interest and Money," Keynes wrote:

These reflections by Keynes on the role of economic ideas are a central starting point for our study.

In recent decades, research on economic ideas and their influence on policy and political programs has focused on the level of abstract theories – such as explaining the economic policy paradigm shift from Keynesianism to monetarism in the 1980s. We take a new approach because we are interested in the role of concrete economic models that play an important role in policy processes.

We argue that economic models can serve as a transmission device between economic paradigms and policy programs, which allow actors drawing on the model to exercise power in political processes. From this perspective, models translate paradigmatic assumptions into political action, but this is usually hidden from public discourse.

In this context, we claim that models can mediate between economic paradigms and political programs by providing simplified representations of complex economic processes that specify causes and quantify effects, as they emphasise the influence of certain variables while downplaying the importance of other factors. In doing so, a relevant economic model draws on a paradigm in such a way that makes it possible to operationalise the paradigm for specific policy programs.

Under what conditions can economic models act as such a transmission device between paradigmatic assumptions and policy programs? We tackle this question by looking at the important case study of the EU’s fiscal rules.

The output gap in the EU’s fiscal framework

What is special about the EU fiscal rules is that there is a legal basis for employing a specific model as its technical backbone. The EU Commission uses the so-called potential output model to estimate the output gap – the difference between actual output (as measured by gross domestic product) and a model-based estimate of potential output –, where the output gap is interpreted as an indicator of an economy's position in the business cycle. Output gap estimates are an important basis for the EU Commission's assessment of how much of the actual fiscal deficit (or surplus) in a given EU country is "structural" in the sense that it is not due to the impact of the fluctuations of the business cycle on tax revenues and government spending.

Model calculations of the output gap are, however, just as relevant for calculating "structural" deficits in the context of "debt brakes" at the national level. For example, the European Commission's model is used in the context of the German "debt brake" to estimate whether the state adheres to the restrictions on government borrowing in the form of the "structural" fiscal deficit limit of 0.35% of Gross Domestic Product per year for the federal government and of the zero “structural” deficit limit for the federal states.

Our study shows that the theoretical and technical foundations of estimating output gaps are of high political importance. If, e.g., the output gap is estimated to be small in an economic downturn, this means that an economy’s production factors are almost fully utilised; the fiscal room for manoeuvring of the government decreases as the achievement of model-based budgetary objectives is estimated to be at risk. As a consequence, EU fiscal rules give countries in an unfavourable economic situation only limited scope for higher fiscal deficits to combat the downturn. This results from the use of statistical filtering techniques to calculate subcomponents of potential output, which are subject to a procyclical bias because they are disproportionately driven by the last data points to enter the estimation procedure.

The mechanism is at follows: procyclical model estimates – implying a downsizing of the output gap – increase fiscal consolidation requirements for the affected government during economic downturns. Fiscal consolidation in an adverse economic situation then reduces economic growth and employment, and leads to further fiscal consolidation requirements based on the fiscal rules. Such a vicious circle was at play in several member states in the context of the Euro crisis.

In-depth analysis of output gap estimates after the onset of the Corona crisis shows: there is still a procyclical bias due to the underlying estimation problems, which will directly affect EU member states as soon as the fiscal rules – currently suspended due to the crisis – are reactivated. From a Keynesian perspective, revisions of the model estimates threaten to put counterproductive fiscal consolidation pressure on national governments, which could undermine fiscal stabilisation policies after the COVID19 crisis and make it more difficult to increase public investment.

Output gap estimates in European fiscal policy-making

The EU Commission's model estimates have gained importance in European fiscal policy-making due to the reforms of the EU’s fiscal rules after the financial and economic crisis of 2008/2009. Our study examines the basic assumptions and technical developments of the potential output model mentioned above, which underlies the calculation of the output gap. Generally speaking, the model is based on a neoclassical production function approach, and further assumptions are incorporated at the level of modelling and estimating the factors of production. In recent years, the technical details of the model have been adapted in several steps.

Several governments of individual EU member states have expressed dissatisfaction with the model estimates and their implications for fiscal policy-making; as a consequence, they pushed for model adaptions. Over the course of the euro crisis, for example, Spain criticized the European Commission's estimates of the "structural" unemployment rate (proxied by the so-called NAWRU; Non-Accelerating Wage inflation Rate of Unemployment), which essentially determine the contribution of labour as a production factor in the Commission's model, for being implausibly high. According to the Commission's real-time model estimates, Spain's "structural" unemployment rate stood at around 20% in 2012 and 2013 – almost as high as the actual unemployment rate. As a consequence, the output gap was estimated to be small, which put additional fiscal consolidation pressure on the Spanish government in the context of the EU’s fiscal rules, because a large part of the fiscal deficit was considered "structural." The Spanish government, with the support of other countries, pushed for changes in the estimations of "structural" unemployment. After major political conflicts in the background, a compromise on adaptation of the underlying model was finally reached in 2014, which somewhat reduced the fiscal consolidation pressure for Spain and some other countries.

Source: European Commission.

This anecdote points to the fact that fiscal policy decisions in the EU in the pre-Corona era were often shaped by technical details, and as a result seemingly innocent technical assumptions in the context of calculating the "output gap" became the subject of political conflicts and demands.

What would Keynes say about these output gap estimates?

Our study results suggest that the prevailing European Commission model for estimating output gaps helps translate paradigmatic priors into policy action. Paradigmatic priors of supply-side economics are translated into economic policy programs through the application of these model estimates in political processes; demand-side Keynesian arguments are side-lined or suppressed. The procyclical bias that the potential output model promotes in conducting fiscal policy of EU member states contrasts with a Keynesian view in which discretionary fiscal policy should be countercyclical, i.e. expansionary in recessions and restrictive in cyclical upswings.

We cannot, of course, know exactly what Keynes – were he alive today – would say about the role of output gap estimates in fiscal rules. But with recourse to Keynesian thinking, the theoretical and technical orientation in modelling potential output can at any rate be criticised on the basis of our study. The procyclicality of the underlying model estimates is particularly problematic because it undermines effective countercyclical stabilisation policy. Economists and policy-makers should discuss this publicly and seek improvements as part of the upcoming reform efforts concerning the fiscal rules after the Corona crisis.

Should democratic economic policy-making depend heavily on such model estimates? How can the underlying model estimates be improved? These questions are of great importance for the future of fiscal policy in Germany and Europe, and I will talk more about it in future posts.

But the US pushing for a global minimum tax is a very significant political development, which would also put the model of EU tax havens like Ireland or the Netherlands at risk. In the words of Treasury Secretary Janet Yellen: 

France, Germany and the IMF have voiced support when it comes to plans for a global minimum tax rate. The recent political push will now need to be translated into detailed agreement, which will determine how much bite a minimum tax rate actually has.

The empirical evidence on corporate tax competition

Before we discuss the political momentum and current proposals further, we strive to answer the following question: what does US Treasury Secretary Yellen mean when she talks about a “race to the bottom” in corporate taxation over recent decades. And is there actually empirical evidence for this?

With the deepening of economic integration in the context of the globalisation process of recent decades, the transaction costs for the cross-border movement of goods and services, capital and jobs have decreased markedly. This has changed the conditions for corporate taxation. Corporate capital can often be moved across borders more easily and quickly than labour and real estate. And if there is the prospect of lower taxes, it sometimes makes a lot of sense for companies from an individual perspective to relocate their headquarters or parts of their business to other countries. A first look at the data suggests that statutory corporate tax rates have indeed declined strongly over the last decades. But is this really due to tax competition?

Source: Tax Foundation.

From a macroeconomic perspective, strategic interactions between governments in corporate tax policy are of particular interest in the context of globalisation. This is particularly true in economic blocs such as the EU, whose basic idea is actually that its members should benefit economically through cooperation.

The following figure shows that the tax rates for corporate income have indeed fallen markedly within the EU in recent decades. On average, the top corporate tax rate in the EU-27 countries fell from 35% in 1995 to 21.5% in 2020. In more populous countries, corporate taxes are somewhat higher on average. But even in Germany, the top tax rate of 29.9% in 2020 was markedly lower than in 1995, when it was 56.8%. In Ireland, one of the EU’s major tax havens, the statutory corporate tax rate is only 12.5%. Outside Europe, too, a trend of falling corporate tax rates can be observed in many countries.

Source: European Commission (top statutory corporate income tax rate including surcharges); own calculations. EU27 excluding the United Kingdom.

Does tax competition really explain the fall in tax rates?

But can the observed decline in corporate income tax rates really be explained by tax competition? Finding a clean empirical answer to this question is anything but easy. After all, a drop in corporate taxes could be due to a variety of economic, political and institutional factors - for example changing policy preferences of governments.

We can define tax competition broadly as any form of noncooperative tax setting by independent governments interacting with each other. The specific role played by tax competition is a significant question for empirical research. Corporate taxes are an important source of government revenue, and the effects of tax competition are the subject of political controversy.

The US administration has voiced concern about the potential consequences of a "race to the bottom" – based on the argument that declining corporate tax rates result in relative losses in tax revenues and could thus undermine the financing of essential government activities. In fact, the US government wants to use additional revenues from higher corporate taxes to pay for investment in public infrastructure. Others, however, argue that uncooperative cuts in corporate tax rates by individual governments can help countries remain attractive to foreign direct investment, which in turn creates economic growth. Political leaders of tax havens, in particular, will try to defend the model of their countries in terms of tax policy.

But what conclusions does the empirical evidence even allow us to draw about the extent of corporate tax competition? In a study recently published in the European Journal of Political Economy, I provide answers to this question based on a quantitative analysis of the relevant literature.

Source: Heimberger (2021)

Meta-analysis of corporate tax competition

The empirical literature sometimes reports contradictory results. Some studies present results that clearly suggest that tax competition plays a central role in explaining lower corporate tax rates. Other studies, however, point to mixed evidence, seeking to refute that tax competition is important when it comes to explaining tax decisions.

At least in part, differences in reported results could be due to the fact that different studies use different data sets in terms of country groups and time periods, as well as divergent estimation methods. Against this background, it makes sense to conduct a systematic review of all relevant estimates, taking into account, among other things, differences in research designs and databases.

Meta-analysis can be useful in this regard. The basic idea is to compile all relevant estimates from the literature on the basis of criteria clearly defined in advance and to make these estimates directly comparable with each other. Each estimate then enters into a larger statistical picture. By applying econometric methods, conclusions can then be drawn about how strong the average effects of corporate tax competition are, while also incorporating different data and modelling choices.

My meta-analysis of the empirical literature on corporate tax competition includes 33 primary studies that report a total of 604 comparable estimates. All estimates are based on so-called tax reaction functions. These model strategic interactions of governments in tax policy, which are at the core of the concept of tax competition. Here, the corporate tax decisions of the domestic government are modelled as mutually dependent on the chosen tax rates of governments abroad with which the domestic government competes. In this context, one can also control for other possible explanatory factors in the economic and political dimension. A (significant) positive association between corporate tax rates in a given country and tax decisions abroad then serves as an indicator of tax competition.

The following figure shows a selected subsample of the dataset using only corporate tax competition estimates that use statutory corporate tax rates (as in the first figure above). The standardised effect sizes are shown on the horizontal axis and the precision of these estimates on the vertical axis.

Source: Heimberger (2021).

The standardised effect size indicates the average percentage change in domestic corporate tax rates when corporate taxes in countries with which the government competes fall by one percentage point. There are some (imprecise) estimates to the left of the zero vertical effect line. However, it is clear that most of the results reported in the literature lie on the right-hand side of the graph, although these also vary in precision. The estimates with a positive sign point to tax competition: they indicate that domestic tax policy interacts with foreign tax policy by adjusting taxes in the same direction – that is, tax cuts abroad are responded to by tax cuts at home.

But how strong is corporate tax competition based on the estimates available in the literature? The (precision-weighted) average of the effect sizes seen in the subsample in Figure 1 is 0.8, meaning that a reduction in corporate taxes by "competitor" governments abroad by one percentage point is associated with a 0.8% reduction in domestic statutory corporate taxes.

In my study, I show that the average magnitude of the effect is similar when corporate taxes are measured differently. Another important way of measuring corporate tax rates (besides using statutory corporate taxes) are the so-called effective average tax rates. In this context, this means that tax rates are calculated by computing the actual average tax burden of investment projects. However, the statistical analysis reveals that the results on the existence of corporate tax competition do not change significantly when different ways of measuring corporate taxation are considered.

Thus, on average, the empirical evidence provides robust evidence that corporate tax competition plays a role in tax decisions. Of course, this result does not imply that competitive pressures were and are equally strong in all countries. Although the results also suggest that the reported competitive effects based on data samples with European countries are not significantly different on average from those based on samples with non-European countries, competitive pressures may nevertheless vary across countries depending on domestic and institutional factors.

The latter point is also supported by broader results from the analysis, which suggest that country size (measured by economic output or population size) and the ideological orientation of governments moderate the strength of the effect of corporate tax competition, respectively.

This result confirms considerations from the theoretical literature on tax competition: first, competing countries of the same size have similar incentives to reduce corporate taxes. However, when countries differ in size, the incentives for competitive tax cuts are stronger in smaller countries. Second, accounting for domestic factors has extended the basic theoretical model on tax competition. Political determinants and institutional restrictions may contribute to delaying or even preventing the adjustment of tax policy to the pressures of international tax competition - for example, in the case of national governments that reject reductions in corporate tax rates for ideological reasons. Partisan politics and country size thus influence how strongly corporate tax competition is reflected in domestic tax decisions.

Current negotiations on combating tax competition

The issue of tax competition, which puts pressure on the financing of the welfare state, has been addressed at the European and international level for some time. But the recent moves by the US government create political momentum for reaching an agreement within the existing international negotiating framework. The OECD, in cooperation with the G20, has recently developed concrete proposals to improve tax coordination between countries.

The OECD-G20 proposals consist of two pillars: first, they would give individual governments some rights to tax the profits of multinational corporations - taxing rights would be partially shifted to where the consumers are located. This would apply, for example, to the foreign operations of U.S. tech giants, which could partly be taxed in Europe. But implementing the OECD plans would also give the U.S., for its part, the right to tax many European corporations.

The second pillar is an effective global minimum tax rate for corporations – which is the core of the recent public messaging and political push by US Treasury Secretary Janet Yellen. This minimum tax rate aims to ensure that corporate profits - regardless of the jurisdiction in which they were generated - can no longer be taxed below a certain minimum rate. In this context, countries would be allowed to tax the income of domestic companies generated abroad if the foreign effective tax rate was below the agreed minimum tax rate. This would make tax avoidance through profit shifting more difficult. And it would also reduce incentives for governments to reduce corporate tax rates below the minimum rate to lure corporate headquarters to their country. This would be a step toward getting to the root of tax competition. The level of the minimum tax rate remains undecided, but the US administration has proposed 21%. 

A global minimum tax rate is intended to reduce corporate tax differentials between low and normal tax countries. The OECD assumes that this would also lead to a reduction in tax dodging by multinational corporations because the minimum tax rate would run against profit-shifting strategies. This would generate additional tax revenue.

Incidentally, the OECD does not see any significant negative economic effects in terms of investment and employment if the plans are implemented. This is because the increased investment costs and administrative burden for companies resulting from implementation would be offset by better capital allocation (due to limited tax competition) and greater legal certainty.

A minimum tax alone will not be enough

But side effects cannot be wiped off the table: Administrative and tax compliance costs would rise. Of course, this would not only affect multinational corporations, which partly engage in profit shifting, but also companies that have not previously engaged in profit shifting at all, thus also influencing their decisions. This could result in negative investment and liquidity effects for numerous companies, which must be taken into account, especially in view of the effects of the COVID-19 crisis. 

The US administration has also tried to revive negotiations on the first pillar - the reallocation of taxing rights. In particular, the US administration calls for the world’s biggest businesses to pay levies to national governments based on their sales in each country as part of a deal on a global minimum tax. This would apply to the global profits of the largest companies, including big US tech firms, regardless of their physical presence in a given country. The Trump’s administration had insisted on a provision that would have made compliance by US tech firms voluntary, but Biden dropped that demand. However, views by other governments regarding the details of pillar 1 remain very different, so that negotiating a package of pillar 1 together with the global minimum tax rate could prove impossible.

A political agreement with regard to the introduction of a minimum tax rate for companies would certainly be a major step toward limiting tax competition. However, even if a political agreement were to be reached soon, it would certainly not be the end of the debates on tax competition. After all, implementing the US administration’s or the OECD’s current plans would restrict corporate tax competition, but not abolish it. The extent to which the business models of tax havens are actually curtailed will depend to a large extent on the details of the minimum tax rate – but also on negotiations on harmonising tax bases in the future, i.e. to standardise not only the minimum tax rate but also what is actually being taxed (There are also proposals on this in the OECD-G20 document.). More comprehensive steps will be needed in the future to put a stop to the profit shifting strategies of increasingly powerful multinational corporations. 

Even though the new US administration is now pushing the agenda for fighting a “race to the bottom” in corporate taxation – with support of Germany and France –, negotiations on the details of a global minimum tax rate and other pillars will remain politically controversial. Nevertheless, this is now the window of opportunity. The Financial Times reports: “Talks on how to make it difficult for international companies to shift profits round the world to minimise tax have been stuck at the OECD for years, but are now progressing rapidly.” Some of the signs are good, but the fight still needs to be won.

**

Tonia Mastrobuoni (TM): Why did you start this campaign to address distorted views about Italy?

"I recently saw many wrong claims in German-speaking media concerning Italy. I thought: if I want a change, I have to make a concrete commitment. I already did that last summer, when there was talk of the EU recovery fund - now again, as the formation of a new government in Italy was discussed; in short: with the arrival of Mario Draghi. So I thought I would tweet some data. Numbers that contradict the popular narrative of a profligate Italy living beyond its means. A problematically large part of the population in Germany, Austria, the Netherlands and other EU countries don't know basic stuff about Italy.”

TM: Few people know that Italy has always been a net contributor to the EU budget. Or that it has had a primary surplus for decades. Why do these distorted views persist?

“On the one hand, I think that simplistic stories like the one about the profligate country reach many more people than facts that paint a less black-and-white picture. For example, when Der Spiegel writes yet another story about Italy destroying itself and other EU countries because it is unable to reform as some in Germany would like. It can be shown that Italy has done many of the things that continue to be pushed. But there is not yet a strong counter-narrative that can reach as many people, not least because it is a less appealing narrative. But some clichés about Italy can be refuted with data; that's what I'm trying to do with the twitter campaign. In Germany it is indispensable.”

TM: Why?

"I think that in Germany the macroeconomic clocks work a bit differently than in the rest of the world: ordoliberalism has played an important role in economic policy and also in public opinion. This fixation with balanced budgets is very common, as is a certain scepticism about state involvement. And the widespread opinion is that Italy's biggest problem has been a lack of fiscal discipline, even though the data suggest otherwise. But beware: this German view is slowly changing.”

TM: Yes, it is changing, especially during the pandemic. Economists like Lars Feld and Clemens Fuest were the first to say 'we need something to hold Europe together'. From Germany came the impetus of the Recovery fund and a lot of public money was injected into the economy.

"Yes, I think the dominance of ordoliberalism is crumbling. But a lot will also depend on how the public discourse changes, and what the outcome of this year's federal elections will be. But you can definitely say that other German economists are gaining influence, like Isabel Schnabel, the German representative on the ECB board. She has a much more international outlook than some of her colleagues.”

TM: Unfortunately, however, the "frugal" countries are reviving some false narratives about Italy.

"True. And in Austria or in the Netherlands you can't use ordoliberalism to explain it. But the narrative of a profligate and untrustworthy Italy simply works, you can gain a political advantage in the short term. The unfortunate thing is that these divisive narratives also drive the growing political polarisation in Europe. And Italy is a favourite victim because its public debt was already higher before the pandemic than in other countries. The Germans, the Austrians and the Dutch are not wrong in saying that we need to think hard about how to deal with public debt. But the truth is also that spending cuts have been made in the wrong places, for example in the health system.”

TM: Some say that we should simply write off part of the debt. Do you agree with that?

"No. And I am not at all in favour of playing down Italy's problems. I have often repeated it: of course Italy has structural problems. The skyrocketing public debt was mainly due to mistakes made in the 1970s and 1980s. Then, because of fiscal austerity, which had negative macroeconomic effects, it was not possible to bring down the public-debt-to-GDP ratio. Then came the financial crisis and the debt-ratio started to increase again. There are other problems, of course: stagnation, the North-South divide, dysfunctional politics, income levels lagging behind countries like Germany. I have the impression that the stagnation of the last 20 years and now this sequence of economic crises have been a breeding ground in Italy for a certain fatalism. And I think that the worst reaction from the German and northern European side is to hit Italy hard. It's clear that large parts of the Italian population are asking themselves 'What kind of tone is this from our partners?’ Maybe we should start to see Italy mainly as an important partner again.”

TM: Do we need something like 'change through rapprochement', like Willy Brandt's famous campaign for the East, but this time for the South?

Yes. Merkel has already started with her push for the Recovery Fund. It is a significant change to commit to a large, albeit temporary, fund to ensure Italy and others can recover faster from the crisis.

TM: Perhaps dictated, however, by the awareness that a fast German recovery and a collapse of countries like Italy, after the pandemic, would again put the survival of the Eurozone at risk.

“Yes, but it's still a big political shift. My hope is that we don't stop there now. That the Next Generation EU will concretely contribute to Italy recovering. And that we will then proceed along this path of making European integration work. We must also hope that Italy can get rid of this fatalistic spirit, which has often been, and risks being in the future, a self-fulfilling prophecy.”

The government of the new prime minister Mario Draghi as well as future Italian governments will have to find a sensible way in dealing with Italy's public finances. Given the impact of the crisis, Italy's fiscal deficit was more than 10% of GDP last year. Public debt rose to around 160% of GDP.

Why was Italian public debt so high even before Corona? It is mainly a legacy from the 1980s, when public debt soared in an environment of interest rate hikes.

Source: Macrohistory database; Eurostat.

Since then, however, Italy has been more “frugal“ than any other country: since the early 1990s, the Italian government has consistently run budget surpluses if interest payments are excluded. Nevertheless, the interest burden, high due to legacy debt from the 1980s, has repeatedly pushed the overall budget balance into the red. In the period leading up to the financial crisis, Italy implemented by far the most drastic budget cuts compared with all other industrialised countries.

Source: Devries et al. 2011

Italy's public debt to GDP ratio remained so remarkably high before Corona mainly because economic growth had been so weak in the preceding twenty years. Instead of reducing the government debt-to-GDP ratio, repeated government spending cuts for the purpose of deficit reduction contributed to the stagnation of the Italian economy. Thus, Italy has not been able to grow out of its public debt.

Source: AMECO.

Italy's experience is a cautionary tale: a one-sided focus on fiscal consolidation can produce negative macroeconomic effects and increased unemployment - and thus undermine debt sustainability. This lesson is supported by the experience of other Eurozone countries with negative effects of excessive fiscal consolidation policies during the Euro crisis.

France and Spain will have similarly high government debt ratios after the Corona crisis as Italy had before Corona. European policymakers must do their utmost to avoid driving these countries into a vicious cycle in which fiscal consolidation undermines economic recovery and thus the achievement of fiscal targets, leading to further consolidation requirements. If this is not avoided, the continued existence of the Euro will once again be at stake - with potentially negative domino effects for Germany and other member countries.

A sensible approach to public debt requires a departure from the mindset that only a strict general fiscal consolidation stance can ensure debt sustainability. More public investment is needed, which has fallen sharply as a result of austerity policies. The Italian economy must grow for the public debt to remain sustainable in the long term. Future governments - starting with Mario Draghi's - must think about this, as must the EU Commission.

Source: AMECO.

·      Since the 1980s, income inequality has been rising within many advanced and developing countries.

·      Globalisation is often considered to play an important role in explaining rising inequality. 

·      My recent meta-analysis of the relevant econometric literature shows that economic globalisation, on average, has a small-to-medium-sized effect of increasing income inequality - which, however, can be explained less by trade globalisation than by financial globalisation.

Direction and magnitude of the effect of globalisation on inequality are controversial

Several explanations exist to explain the increasing income inequality within nation states since the 1980s. An inequality indicator that clearly points towards rising within country inequality across Europe and in the US is the share of the incomes of the top-10% in pre-tax national income.

One explanation for rising inequality relates to economic globalisation: in recent decades, questions of how increasing market integration in the areas of international trade and finance has affected income inequality around the world have been at the centre of social science controversy. Academic scholarship has contributed to a rapidly growing body of literature.

Source: World Inequality Database.

Despite considerable research efforts, different and partly contradictory results are being reported in the literature regarding the direction and magnitude of the effect of globalisation on inequality. At the theoretical level, the most prominent theory is the so-called Stolper-Samuelson theorem, which states that increasing international trade integration reduces income inequality within developing countries but increases inequality within advanced countries. Other theories concern the effect of financial openness on distributional aspects. Here, it is often suggested that the opening of financial markets should be accompanied by an improvement in financing opportunities - with ambivalent distributional effects - and a tendency to increasing inequality and vulnerability to crises.

The empirical literature concerning the effect of trade globalisation on income inequality is quite voluminous. There is both support for the Stolper-Samuelson theorem and refutation. Increasingly, however, aspects of globalisation that do not revolve around the trade in goods and services are also coming into focus. The increasing international integration of financial markets and the growing number of financial crises have led to numerous studies on the financial dimension of globalisation in recent decades - but with equally contradictory conclusions.

Another line of research deals with the question of whether the influence of globalisation is not so important because domestic political, institutional or other factors (such as technology, education or macroeconomic variables) are much more important for the development of inequality, even if these factors are not entirely independent.

Meta-analysis of the globalisation-inequality nexus

In view of the large number of results reported in the empirical literature, it is advisable to evaluate them systematically and, if possible, to derive stylised facts from them instead of selectively picking out individual results. A so-called meta-analysis can provide useful services here. This involves collecting the results and characteristics of a large number of studies on the topic and systematically evaluating them using statistical methods.

What do existing studies tell us about the effect of globalisation on income inequality? And what factors contribute to explaining the differences in reported findings on the relationship between globalisation and inequality? To answer these questions, I have conducted a quantitative survey of 123 relevant English-language econometric studies published in peer-reviewed academic journal articles by analysing the effects of economic globalisation on income inequality reported in these studies. The paper has recently been published in the journal “World Economy”.

First of all, it must be clarified how "economic globalisation" can be defined and measured. Brady et al. propose that economic globalisation should be understood as "the intensification of international economic exchange and the label for the contemporary era of international economic integration. Thus, [economic] globalisation involves the current economic environment shaping welfare states and the heightening of concrete economic exchanges between countries ". Hence, three dimensions of international market integration are captured: Trade globalisation, financial globalisation and overall economic globalisation, whereby measures of the latter combine the dimensions of trade and financial globalisation.

By far the most important indicator of trade globalisation is trade openness, which is typically measured as the sum of imports and exports as a percentage of GDP, although there are many other indicators of trade openness. In the dimension of financial globalisation, researchers have used measures such as foreign direct investment and indices of capital account liberalisation. In addition, the Globalisation Index of the KOF Swiss Economic Institute has become probably the most widely used overall globalisation index.

Adverse distributional effects of globalisation

If one evaluates the more than 1,000 individual results from the 123 published studies that I collected, the first thing that becomes apparent is that they are relatively widely scattered. There are results that indicate an equalizing distributional effect due to globalisation as well as those that find an effect in the direction of stronger income concentration at the top.

Source: Heimberger (2020).

Second, it can be seen that inequality-increasing effect sizes predominate - especially for the subgroup of financial globalisation. Surprisingly, however, there are no significant differences between advanced countries and developing countries.

Third, my meta-analysis shows that variables that proxy for education and technology influence the distributional effects of globalisation reported in the econometric literature; education and technology themselves are part of the explanation for changes in income inequality, and they seem to moderate the effect of globalisation.

Conclusions

The meta-analysis and meta-regression results presented in my paper suggest that globalisation has, on average, a small-to-medium-sized effect of increasing income inequality. Financial globalisation has influenced income inequality to a larger extent than trade globalisation. Obviously, globalization is not the only factor to impact on income inequality, as welfare state policies and domestic institutional developments have likely also played an important role. But my meta-study shows that the negative income distribution effects of (financial) globalisation should not be neglected.

However, this quantitative analysis cannot clarify further questions. One important area for future research concerns whether globalisation has a transformative impact on other policy-relevant phenomena - in particular on redistribution by the state and on growing right-wing populism. For example, there is evidence that rising import competition with China in the context of globalization has caused negative local employment effects in the US, and congressional districts exposed to larger increases in globalization-induced import competition disproportionately removed moderate representatives from office in the 2000s: where jobs are squeezed by globalization-induced pressures, voters may tend to favour more extreme political candidates. More research is to be done on the link between the (dis)contents of globalization and electoral outcomes in Europe.

A second essential area for an extended analysis concerns the time- and location-specific forms of globalisation: past efforts to enhance trade globalisation by reducing tariffs are different from trade globalisation today, where bilateral and multilateral attempts are being used to harmonise standards across countries or to enforce special rights for big multinational companies. Further and broader studies are therefore indispensable - especially with regard to the question of how economic policy-makers should try to shape globalisation in the post-COVID-19 future in order to achieve the desired policy effects.

Note: This article was slightly adapted based on an article that was previously published on the website of the Vienna Institute for International Economic Studies (wiiw).

From 1930 onwards, Reich Chancellor Brüning used emergency decrees to increase taxes and drastically cut government spending, which riddled the social safety net. Fiscal austerity worsened the situation for low-income households, and the Nazi Party became very effective at channelling the austerity-induced suffering of large parts of the German population and mass discontent. The authors of “Fiscal austerity and the rise of the Nazi party” provide evidence for this channel by showing that harsher fiscal consolidation in terms of health spending was associated with higher mortality.

This paper is not only important for understanding economic history, but should also inform current policy debates, especially in Germany. The reason is that distortions of the history of Germany’s Weimar Republic are currently used by some prominent voices in the debate that claim a direct link between the hyperinflation in 1923 and the rise of the Nazis. This alleged direct link is then used to warn of hyperinflation in the aftermath of the COVID-19 crisis, linked to the policy recommendation that monetary and fiscal policy should be tightened.

Hans-Werner Sinn’s warnings about hyperinflation

The well-known economist Hans-Werner Sinn, in particular, has repeatedly attributed Hitler's rise to power to the hyperinflation ten years earlier. In an interview with the Neue Zürcher Zeitung (NZZ) in early December 2020, he directly linked the hyperinflation after World War I in the Weimar Republic, which contributed to impoverishment of the German middle class, to the rise of Hitler: "Ten years later they elected Adolf Hitler as Reich Chancellor." Obviously, Sinn is not alone; one finds similar lines of argument in other conservative and inflation hawkish circles. Here’s Amity Shlaes in the context of the US debate: “if you're concerned about Nazis, the next important move is drastic anti-inflation policy”.

Source: NZZ-Interview with Hans-Werner Sinn

But Hans-Werner Sinn is the most prominent German economist pushing the hyperinflation-Nazi-line of warnings. In his “Christmas lecture”, Sinn did it once more: he warned of hyperinflation, drew a direct line to the Nazis and failed to mention that the rise of the Nazi party was preceded by deflation and fiscal austerity. In his talk Sinn emphasises that money, like paper, was no longer worth anything in 1923, and shows a girl who had made a dress out of worthless banknotes. Given the way Sinn spins things rhetorically, listeners are tempted to fear hyperinflation. Of course, hyperinflation won't come right away - but "what if the coachman can't find the reins" once it gets going? Sinn uses his distorted interpretation of the Weimar history to draw strong policy conclusions for today: that policymakers should introduce “tighter budget constraints” and stop “living off the printing press”. 

Source: Hans-Werner Sinn “Christmas lecture 2020”

Germans are misremembering Weimar

Sinn is feeding a common misinterpretation of economic history. Mass poverty at the time when the Nazis surged to power in the early 1930s did not result from hyperinflation, which had indeed ended ten years earlier. The Nazis thrived in an environment of deflation (i.e. falling consumer prices). The rise in poverty was primarily a consequence of mass unemployment caused by the deep recession in the early 1930s, but fiscal austerity also played a critical role.

Source: Redeker, Haffert and Rommel (2019).

A representative survey by Haffert, Redeker and Rommel shows that only one in 25 Germans today still knows that the crisis at that time was characterised by deflation. Almost half of the respondents conflate the mass unemployment and poverty of the early 1930s with the hyperinflation ten years earlier. Incidentally, this misconception is much more common among well-educated and politically interested Germans. In other words: those who are following the ECB’s monetary policy closely are, therefore, much more likely to draw the wrong lessons from German history, and from being misled by comments such as those made by Hans-Werner Sinn.

The effects that rampant inflation had on the Weimar Republic are deeply engrained in the German collective memory. Hans-Werner Sinn’s statements are a prominent exhibit for this kind of thinking. Given this reading of history, Sinn is more concerned about any form of expansionary monetary policy, even in a potentially deflationary environment.

Hyperinflation was indeed a traumatic event for large parts of the German population, and there is a point in arguing that it contributed to destabilising the Weimar Republic and making many voters feel disillusioned about the young German democracy. But whatever one may make of the indirect impacts of hyperinflation on Germany’s political economy, there is certainly not a straight line running from the hyperinflation to the rise of the Nazis, as Hans-Werner Sinn and others continue to suggest. A lot happened between the currency reform in 1923, when hyperinflation ended, and the rise of the Nazis.

Everyone interested in this period should certainly read Tobias Straumann’s seminal “1931”, a fast-paced book on how the debt crisis, mass poverty and fiscal austerity supported the rise of the Nazis in the early 1930s. The books gets one thinking about how well-meaning people across the political spectrum in Germany ended up doing things that undermined democracy and international cooperation. Obviously, the analysis in the book also suggests that mistakes were not only made on the side of German policymakers, and that one must be very careful in designing international arrangements (especially concerning the conditions of harsh reparation payments).

But what the Straumann book certainly does is to kill the idea that there is anything like a direct line running from the hyperinflation in 1923 to the rise of the Nazis. Indeed, the mass effect pushing towards the Nazis happened in a deflationary environment with unpopular fiscal austerity measures. As the paper “Fiscal austerity and the rise of the Nazi party” shows, electoral success of the Nazis is empirically linked to the harshness of fiscal consolidation in various areas.

The more interesting question is arguably to what extent the trauma of hyperinflation continued to affect policymakers in the early 1930s (a question which is not directly discussed in Straumann’s “1931”). In order words: to that extent did the hyperinflation experience make policy-makers such as Brüning more reluctant to use expansionary policies to fight mass unemployment, so that they instead introduced further deflationary cuts. Obviously, this potential link between the hyperinflation trauma, austerity and the rise of the Nazis is not what’s on the minds of Hans-Werner Sinn and others when they claim a direct link between hyperinflation and the rise of the Nazis. Otherwise, someone like Sinn would need to be much more careful about calling for “tighter budget constraints” today.

And even if one were to agree that hyperinflation "prepared the breeding ground for the Nazis", as many think, comparisons such as those of Hans-Werner Sinn would remain deeply problematic: why should the ECB’s monetary policy today lead to hyperinflation similar to the early 1920s? Direct government financing by the German central bank back then was different from ECB monetary policy today. The economic and political circumstances are very different. The ECB is not under the direct political control of governments. The ECB buying bonds from investors primarily increases the central bank reserves held by commercial banks, but does not trigger (hyper)inflation as economies are running well below their productive capacities. Given recent deflationary pressures in Europe, it is even more amazing how the history of the Weimar Republic is misused to call for tightening policy now.

Why interpretations of history are so important

Calls for a rapid shift to fiscal consolidation to prevent a political turn to the right after Corona are a dangerous distortion, given that the empirical evidence shows that effects of austerity policies were an essential factor in the early 1930s in the Nazi’s electoral success.

Misinterpretations of history can be momentous if they lead economic policy down the wrong track. That's why careful research such as this new paper linking votes for the Nazis to fiscal consolidation while controlling for other factors is so important.

The most recent OECD forecast suggests that China’s economy will power ahead; real GDP in 2022 is forecast to stand more than 15% above the pre-COVID-19 level. The US economy will also recover relatively fast from the COVID-19 shock, with GDP in 2022 about 7% above the 2019 level. The recovery is, however, forecast to be much weaker in the Eurozone, where GDP in 2022 will barely surpass the pre-crisis level. Even more worrying is that we’ll see divergence between Eurozone countries, as Germany is set to do significantly better than Italy and Spain.

Source: OECD March Interim Report.

Differences in the discretionary fiscal response to the crisis play an essential role in explaining this divergence in recovery patterns between the US and European countries. IMF data from the IMF fiscal monitor (last update in January 2021) suggest that additional government spending and foregone revenues in response to COVID-19 amounted to about 16.7% of GDP in the US. And these numbers do not yet include the massive $1.9 trillion Biden fiscal support package, which has been approved last week. The IMF data show a discretionary fiscal impulse of 11% of GDP for Germany. Especially if we take into account that the recession in Southern Europe has been more severe than in Germany, the fiscal impulse of 6.8% in Italy and 4.1% in Spain can only be considered to be very small in international comparison.

Source: IMF Fiscal Monitor January 2021 update.

I fully share the Sandbu/Tooze argument that fiscal policy support in Europe - especially in hard-hit Eurozone countries such as Italy and Spain - has been too timid. Yes, the EU will borrow up to €750 billion for “Next Generation EU” to finance spending in EU countries (where €390 billion are in grants, which could start flowing in the second half of the year). This will provide a positive macroeconomic impulse. But it’s still to small to really turn things around and avoid a European economic decline vis-a-vis other major economic blocs.

Italy will receive grants of about 3.7% of GDP from the Recovery and Resilience Facility (RRF, the key component of “Next Generation EU”) over the period 2021-2026; Spain will get 4.8% of GDP. These numbers indicate that annual spending based on the grants will be less than 1% of GDP for large and hard-hit Eurozone countries such as Italy and Spain. We also need to take into account that partly the EU funds from “Next Generation EU” will substitute for spending that might otherwise have been financed by national government borrowing. Furthermore, it is still not clear whether every country will be able to draw on all the available funds, because the payments are attached to conditionality - countries need to submit national recovery plans until April 31st 2021 to justify how they want to use the money, where 37% need to be spent on climate and 20% on the digitalisation agenda.

Source: European Commission.

“Next Generation EU” was certainly a major political step; it would have been unthinkable before the crisis. But it remains a temporary instrument, and while its macroeconomic impact is certainly not negligible, it is way too small to support a strong recovery in all countries and to halt Europe’s relative economic decline vis-a-vis China and the US. Europe would need a second big fiscal push in terms of a large investment project that also raises potential growth and tackles climate change concerns.

In the absence of another major European effort in addition to “Next Generation EU”, national fiscal policy will need to do most of the work in supporting economic recovery. In this regard, the Damocles sword of reapplying the EU’s fiscal rules is hanging over all governments; but the problem of going back to the fiscal rules would be most acute for those countries with higher public-debt-to-GDP ratios (such as Italy and Spain), which would need to implement harsh fiscal consolidation measures that would undermine economic recovery, which is likely to also pose problems for debt sustainability.

A communication published by the European Commission implies that the suspension of the EU's fiscal rules will be extended for 2022, but the rules may be reintroduced in 2023 if GDP recovers to pre-2019 levels. Europe must urgently avoid repeating the mistakes after the financial crisis, when fiscal austerity from 2010 onwards led to a double-dip recession that made the Eurozone economy fall well behind the US. This underperformance was mostly a fiscal story, i.e. it was a policy choice. Currently, Europe is on track to repeating choices that will lead to underperformance. If policy-makers still want to avoid it, they should think about a second big fiscal push, and they must urgently come up with a meaningful reform of the EU’s fiscal rules to avoid counterproductive fiscal austerity in the years after the COVID-19 crisis at the national level. But that’s a matter for another post.

Source: AMECO (Autumn 2020); own calculations).

·      Italy has been running trade surpluses, and the country remains the EU’s second-largest industrial location behind Germany.

·      Private debt in Italy is relatively low compared to other OECD countries. Public debt is high due to the legacy of the 1970s and 1980s.

·      The Italian state has implemented by far the largest fiscal consolidation packages of all industrialised countries since the early 1990s.

·      Italy has significant structural problems (e.g. oversized banking sector, North-South divide), but tackling these problems partly requires a rethinking of economic policy. 

·      Italy's recovery must be considered a central task of European economic policy. Mario Draghi's start as prime minister should be seen as an opportunity for a "New Southern Policy".

Italy - heavily in debt and still unwilling to reform! Over recent weeks, countless articles have again been written about our EU partner country that struck such a tone. In fact, we were rarely able to read anything positive about Italy in the media over the last year. First, the negative health effects of coronavirus hit the country particularly hard during the first phase of the pandemic. Then came the severe economic crisis with discussions about European response packages, during which journalists as well as leading politicians of the self-proclaimed "frugal four" repeatedly questioned whether Italy should really receive grants to a considerable extent to mitigate the consequences of the COVID19 crisis. And then Giuseppe Conte's government had to step down after former Prime Minister Renzi removed his party's two ministers from the government, leading to intense discussions about a political crisis in Italy.

Now there is a new Italian government under prime minister Mario Draghi, the former ECB president. This government will not only have to deal with the pandemic, but also with planning the use of around €200 billion from the EU recovery fund for the coming years. In view of these important political projects, it is high time to take a fact-based look at Italy and, in doing so, also dispel some myths that unfortunately continue to be spread regularly by journalists and media.

So here are seven stereotype-defying pieces of data about Italy.

1. Italy has been living below its means

‘Italy is living beyond its means!’ This statement is often justified by pointing out that Italy's public debt has risen to around 160% of economic output, not least due to the effects of the Covid pandemic. Yet this means only that the public sector is highly indebted—it says nothing about the Italian economy as a whole. For a country can only really live beyond its means if it imports significantly more goods and services than it exports over a longer period of time, which goes hand in hand with rising foreign debt. If, on the other hand, roughly the same amount is exported as is imported, it makes little sense to speak of "living beyond one's means", because production and consumption match. And in Italy it is even the case that since 2012 the country has recorded higher exports of goods and services than imports. The country consumes less than it produces and is a net exporter of capital. So if anything, Italians are not living above their means, but below their means.

Source: AMECO (Autumn 2020), own calculations.

2. Private debt is relatively low in Italy

If the Italian economy as a whole is not living beyond its means, then the high level of debt must be confined to the public sector. And so it is, private debt in Italy is low by OECD standards. In other words, overall debt is certainly not a bigger issue in Italy than in other European countries.

Source: OECD

3. Public debt is high because of errors made 40 years ago

The Italian state has implemented by far the largest fiscal consolidation packages of all industrialised countries since the early 1990s. If the economy is not excessively indebted, why is the state so ailing? As disastrous as the performance of Italian domestic politicians from Silvio Berlusconi to Matteo Salvini has been, high public debt is primarily a legacy from the 1980s. Furthermore, the mistakes that were made 40 years ago took place in an international environment of increasing interest rates. Since then, the Italian state has been carrying a heavy interest-rate backpack. If we exclude the burden of interest rates, however, the Italian state has been consistently running budget surpluses since 1992 (with the exceptions of the financial crisis year 2009 and the COVID crisis year 2020).

Even Germany, Austria and the Netherlands have recorded a comparable positive ‘primary’ budget surplus less frequently than Italy. The Italian state has not been as ‘profligate’ as is often claimed: it has consistently collected more in taxes than it has spent. But the interest burden—high due to legacy debt—has repeatedly pushed the overall budget balance of the Italian state into negative territory. Yes, Italy is running significant fiscal deficits in 2020 and 2021, but this is due to the effects of the COVID19 crisis, which is also having a strong impact in other EU countries.

Source: IMF (Devries et al. 2011)* fiscal consolidation measures motivated by a desire to reduce the budget deficit

Source: AMECO (Autumn 2020); own calculations.

4. Italy's economy has suffered since joining the euro

Italy's public debt is also marked because its economic growth has been so weak over the last 20 years—being presented as a ratio to GDP, if the economy stagnates a state cannot grow itself out of a pool of debt, which already stood at 120 per cent of GDP in 1995. In this context, policy deficiencies, including vis-à-vis corruption and organised crime, should not be neglected. But Italy has never been a haven of political stability. The new Draghi government is the 67th since the war—and mafia and corruption have long been embedded. Yet this did not hinder the Italian economy from developing quite dynamically at times.

Italy overtook the United Kingdom in 1969 and France in 1979 in per capita purchasing power. In 2000, Italy's average standard of living was virtually equal to that of Germany (98.6 per cent of its GDP per head). But after the introduction of the euro in 1999, the country fell behind the UK (in 2002) and France (in 2005) once more. By 2020, Italian per capita income was about 25 per cent below that of Germany.

In the case of Italy, it is very striking that the commitment to the Maastricht criteria and the process of introducing the euro in the 1990s went hand in hand with the decline in economic growth and increasing productivity problems. One explanation is that being bound by European budget rules has reduced domestic demand in Italy and thus also contributed to the stagnation of the economy. Moreover, the value of the euro reflects the average strength of all Eurozone economies. The common currency is too cheap for Germany (which boosts German exports) and too expensive for Italy.

Whether Italy can ever regain economic momentum within the euro area will depend not least on the willingness of Germany and other European countries to reform the institutional euro architecture in the aftermath of the COVID-19 crisis – especially where budget rules are concerned. In any case, it is clear that countries like Germany, the Netherlands or Austria, which have benefited greatly from the "cheap" common currency, should do everything they can to keep Italy in the euro area. That would be in their own interest, because a return to an "expensive" currency like the D-Mark would be a major price burden for the industry of countries that depend on an export-led growth model.

Source: AMECO (Autumn 2020); own calculations.

5. Italy has carried out many market-liberal reforms

In 2015, the OECD assessed Italy's ‘reform efforts’ as significantly stronger than those of Germany and France. The Dutch economist Servaas Storm takes a similar line. In an in-depth study he finds that Italy has adhered much more closely to the EU's policy rulebook than Germany or France. We have already established that the Italian state has recorded greater fiscal consolidation efforts than all other European partners before the COVID19 crisis—at a high price.

This is because fiscal consolidation has weakened domestic demand for goods and services, and consequently growth, to such an extent that debt has remained high despite large fiscal consolidation efforts. Italy's austerity policy also had very concrete consequences. On the one hand, it led to severe cuts in the health care system, which proved fatal in the Covid19 crisis. Moreover, a drastic decline in public investment has hampered productivity growth in Italy.

But it was not only in the area of public finances that Italy was particularly eager to comply with EU requirements. An equally EU-compliant flexibilisation of the labour market brought a sharp increase in fixed-term contracts, a pushback against trade unions and a decline in real wages compared to Germany and France. Most recently, in 2014, under Matteo Renzi, employment protection was strongly reduced. These measures not only reduced inflation in the 1990s, but arguably also unemployment, which was finally lower than in Germany and France when the financial crisis broke out in 2008. But cheap labour has also reduced the incentive for labour-saving investment by companies. This private investment, however, is key to rising productivity and is particularly crucial in high-tech sectors. Productivity development is in turn the basis for growth and rising incomes. Both large fiscal consolidation efforts and market-liberal structural reforms have thus arguably done more harm than good to Italy's productivity growth.

Source: AMECO (Autumn 2020); own calculations.

6. Italy remains the second most important industrial country in the EU

It may sound surprising to northern-European ears but, despite weak productivity growth and problems with price competitiveness within the euro area, Italy has important economic strengths. The 60 million Italians do not live primarily from tourism. Italy is still the second most important industrial location in the EU (which would be true even if the United Kingdom were still part of the EU), mainly due to the economic structure in the north of the country.

The country has the second highest industrial production after Germany and exports significantly more industrial goods than it imports. By far the most important export sector is mechanical engineering, which alone accounts for almost one fifth of goods exports – followed by vehicle construction and pharmaceutical products. The order is almost identical to Germany's export structure and these sectors rank under "medium-high-tech" to "high-tech" industries in the OECD’s classification. The historically grown industrial structure of (Northern) Italy is just one example of the great economic potential of our southern EU partner country. If austerity policies and market-liberal reforms have failed to move the country forward over the past decades, then the obvious thing to do is to try an investment strategy – for which the use of money from the EU recovery fund could provide a first impetus – and give Italy's industry a boost by launching a modern European industrial strategy.

Source: Eurostat.

7. Italians are not richer than Germans or Austrians 

Over the last year, we have also often heard the argument that Italians are wealthier than Germans or Austrians. Therefore, they should pay for their investments themselves! The median Italian household, that located exactly between the richer upper half and the poorer lower half of the population, is indeed wealthier than the corresponding German or Austrian household. But the average Italian household—obtained by dividing the total net wealth by the total number of households—is clearly less wealthy than in Germany or Austria.

Although private wealth is lower in Italy, wealth distribution is more equal; in Germany and Austria, wealth is more heavily concentrated in richer households. One of the main reasons for this is that private-property ownership plays a greater role in Italy. This has a lot to do with the relative underdevelopment of the public safety net: social and co-operative housing, which provides many people in Germany and especially in Austria with affordable housing of a reasonable size, is rare. Social housing and co-operatives do not however count as private assets, even if people there live occasionally more comfortably than in Italian condominiums of poor standard. But it remains simply wrong to say that Italians are wealthier than Germans or Austrians.

Source: ECB

A strong Italy in a strong EU

Italy certainly has significant structural problems, such as the oversized banking sector, the North-South divide, organized crime or dysfunctional political elements. The question is: Under what conditions is the country better able to tackle these problems? In this country of 60 million people, the stagnation of the last 20 years has been a breeding ground for fatalism rather than optimism. All the more reason for media and politicians in Germany, Austria and beyond to refrain from treating Italy like a hopeless case - a southern European patient who is having problems because he refuses the reform medicine of the northern European doctor.

The European media, as well as Europe's key leaders, invoke international competition between the EU and China and the United States. A logical geopolitical conclusion from this would have to be to actively support the Italian economy, which used to be the second largest in the EU, in its recovery efforts – for example by launching a modern industrial policy strategy. This measure alone would significantly strengthen the EU's economic weight in the global economy. If Italy had grown as fast as Germany or France since 2000, the EU's GDP (in World Bank purchasing power parities) would be higher than that of the US, not lower. A strong Italy in a strong EU would also be in the interest of all those who consider such international economic rivalries to be contrived, but who want Europe to preserve its social model of a liberal democracy of social balance in the 21st century.

The pandemic is not over; the economic consequences will be felt for a long time. The economic recovery of Europe is an opportunity to trigger a sustainable economic development of Italy. Until the Covid19 crisis, Northern Europe was holding up quite passably economically by international standards, and the economic integration of Eastern European member states was mostly positive. Today, the breaking point of the euro area and the EU is Italy and Southern Europe. From a European perspective, Italy's recovery must be considered a central task of economic policy. Mario Draghi's start as prime minister should be seen as an opportunity for a "New Southern Policy" in the coming years - both on the part of the EU Commission and the German government.