The EU needs a Federal Budget

Published on October 27, 2009

European Federalists

At the end of last year’s financial turmoil, Jean-Claude Trichet i, President of the ECB, said in an interview that “the Stability and Growth Pact is the legal framework that we have as a quid pro quo for the fact that we do not have a federal budget and a federal government”. Recently, the European Commission initiated an excessive deficit procedure for 9 countries (11 had already been warned). The present situation in the EU is that only 7 countries (in the euro area, Luxembourg, Finland and Cyprus) out of 27 do not comply with the 3 per cent reference value of the deficit to GDP, as required by the Growth and Stability Pact (GSP). Moreover, not only the present situation of the EU public finances is alarming, but the future too. According to the OECD, public indebtedness of the euro area could be more than 100 per cent of the GDP in 2015 (it was 66 per cent in 2007). Therefore, the suspicion that the GSP is not the appropriate instrument to guarantee sound and stable finances for the European economy is legitimate. It is true that even the USA, severely affected by the financial crisis, are going in the same direction: their public debt should increase to more than 100 per cent of the GDP in 2017 (it was 63 per cent in 2007). But the USA were able to react to the crisis with a common plan (the American Recovery and Reinvestment Act). On the contrary, the EU approved a European Economic Recovery Plan assembling national recovery plans. Indeed, the size of the EU budget – one per cent of the GDP yearly, as established by the Multi-annual Financial Framework (MFF) 2007-13 – does not allow any significant margin for manoeuvres. This unsatisfactory response depends on the fact that the EU decided to provide an effective instrument for a European monetary policy (the ECB) for itself, but the main instruments for fiscal policy remain stubbornly at a national level. The EU has a federal currency, but not a federal budget (and neither does it have a federal government)

There are two good reasons for considering a federal reform of the EU budget. The first is that Europe has to face serious challenges: the economic recovery after the financial crisis, the reform of the world financial and monetary system, in the agenda of the G20, and, last but not least, the fight against climate change. The second reason is that the new Commission should soon open the process for reforming the EU budget. A Conference , which will close the debate and open the reform phase has been planned for November 12th at Brussels. In the following part of this short paper, we want to discuss some crucial topics dealt with by the two exhaustive and well-organized Studies backed by the Directorate General for Budget of the European Commission. The first Study is devoted to EU spending and the second one to Budget financingii. In 2007, the European Commission asked to discuss the EU budget reform “without taboos”, but unfortunately some taboos are still steadfastly on their pedestal. Our comments concern: a) the stabilisation policy, on the spending side of the balance sheet; b) the problem of own resources, for the revenue side; and, finally, c) the link between the budget reform and the democratic deficit of the EU.

The first Study on EU spending convincingly proposes that the budgetary reform should increase expenditures in the following three policy areas: climate change and energy resources; knowledge and innovation; common security and foreign affairs. At the same time, it proposes a sensible reduction of funds for agriculture and rural development policies. But it is unclear if the size of the EU budget (as a percentage of GDP) should be increased. The question of the budget size is linked to the question of the macroeconomic stabilisation policies – i.e. policies designed to stabilise aggregate income and the employment level –, which in the present situation are not considered a European policy area. The conclusion of the chapter devoted to this problem is that “all in all, there seems to be no need for the EU budget to be involved in stabilisation policies. In the end, this may also be a non-issue, as the EU budget is currently far too small to be able to have a significant impact” (p. 72). This drastic judgement seems more influenced by academic doctrines than by the needs of the EU and its citizens. It is true that the theory of fiscal federalism, originally proposed by Musgrave and Oates, assigned stabilisation policies (or anti-cyclical policies) to the federal government, for the good reason that at the local or regional level anti-cycle budgetary policies are not effective. But that result was reached within the general theoretical framework of Keynesianism, which succumbed under the attack of monetarism, the supply side economics and the rational expectations doctrine. Macroeconomic fiscal activism was increasingly taken into consideration with scepticism. While the increasing integration of the world market was shaping a global economy, national governments were fascinated by an economic policy based mainly on monetary stability. Indeed, during the last decades, the idea that a global market could go through a steady growth without global governance was widely spread among politicians and economists. The 2008 world financial crisis swept away that illusion. All governments rediscovered fiscal policies and accepted huge budget deficits in order to avoid a more dramatic fall of income and employment.

In Europe, the Commission proposed a European Economic Recovery Plan, to sustain internal demand. Contrary to the dominant doctrine of fiscal scepticism, the Commission proposed “to inject purchasing power into the economy, support demand and stimulate confidence”. The amount of the “macro-economic, anti-cyclical” European plan should have been, according to the Commission, 1.5 per cent of GDP. The main problem was that the European contribution to the Plan was only 0.3 per cent of GDP, the main share (1.2 per cent) consisted of a summation of national plans. The outcome of that unfortunate decision was that: a) only Germany, France and UK launched a national plan of the amount required, but the other countries, especially the more indebted ones, were not able or willing to follow; b) the European governments decided to finance national public goods and national employment, endangering the European internal market; c) the rules of the GSP were grossly violated.

A more general comment should be added to these shortcomings: the European recovery plan turned out to be not only of an amount lower than required but it was less efficient, because in order to face a EU external shock a certain amount of euros is spent more efficiently by a “federal government” than by a national government. Let us consider the old Keynesian idea of the multiplier. There is a wide and open debate on the scale of a fiscal multiplieriii. The effect of a fiscal stimulus depends on the way governments act (tax cuts have a different impact from building bridges and railways) and on expectations about prices and taxes. But there is a general agreement on the fact that the value of the multiplier depends on the size of the economy. Indeed, the more open an economy is the bigger the demand for foreign goods and therefore the leakages of the fiscal stimulus. According to the OECDiv there is “an inverse correlation between multiplier values and openness” (Box 3.1). The size of the short-term fiscal multiplier can take on a value of 0.4-0.6 for very open countries, like Belgium, the Netherlands and Hungary, and 1.3-1.6 for Germany, USA and Japan. The OECD does not provide an estimate for the EU economy but – we can guess – the EU multiplier should be of the same order as that of the USA and Japan. To sum up, the money of the taxpayers spent at the federal (European) level of government for European public goods has a greater impact on EU income and employment than the same amount of money spent by national governments for national public goods. A European recovery plan, entirely financed by European own resources, would have been more effective and would have avoided the free-rider behaviour of some national governments.

Now, let’s consider the objection that the EU budget “would have had to grow enormously to be able to implement successful fiscal policies” (p. 71). This statement is not true and brings about a vicious circle: the EU budget is small; since it is small no stabilisation policy is possible, therefore there is no need to propose an increase of the budget and a European stabilisation policy. The Delors plan of 1993 – for growth, competitiveness and employment – required a financial effort equivalent to 0.33% of the GDP for five years. The financial resources should have come from the EU budget, the EIB and the issue of Union Bonds. The Delors plan was considered too expensive and was not implemented. It was a mistake, probably due to the refusal to issue Union Bonds. Nevertheless, here we are interested in the size of the financial effort. A recovery plan is quicker to carry out, if the Commission can bring forward some investment projects already planned for the following years. Therefore, the size of the European budget matters, but the EU does not need an “enormous” budget. The McDougall Report, of 1977, came to the conclusion that a federal budget (excluding defence) should be 2-2.5 per cent of GDP. Even for the present day European problems, that evaluation is likely to be appropriate. With a European budget of that size, the European Commission could have proposed a recovery plan of 1.5 per cent of GDP, entirely financed by own resources: i.e., by the EU budget, by the EIB and by the issueing of Union Bonds, which certainly could have got a better rate on the international financial market than national bonds.

The second Study – Financing the EU budget – wisely states that “there is neither a best Community resource funding for the EU, yet no shortage of broadly satisfactory ones” (p. 12). Among the new revenue sources the study suggests a corporate income tax (CIT), some ecotaxes – like a carbon tax and the proceeds of selling emission trading permits – and the monetary income of the European Central Bank. Likewise, the European Parliament is willing to support these proposals. Here, we propose to focus on the crucial concept of own resources. In his classical study on Federal Government, K. Wheare says that a Federal state is based on the principle that “the general and the regional governments are coordinate and independent in their respective spheres”. If we apply this principle to the EU, it follows that the EU budget should be financed fully by European own resources, and not by national resources. The present situation is nearly the opposite. As the Study clarifies, own resources finance only 10 per cent of the EU budget; 90 per cent comes from national contributions. The consequences are ominous for EU policies, for transparency reasons and for European democracy. Since every national government provides a slice of the budget, every national government wants to receive a just retour. The EU budget becomes an appendix of national budgets. The European Parliament and the Commission are not responsible for finding the taxpayers’ money, but they spend it and, at the end of the story, the voters cannot understand who is responsible for European finances.

The degeneration of the European own resources system was caused – in greatly or completely – by the principle of the budget in balance, stated in the Treaties. There is neither an economic nor a political justification for observing this constraint strictly. The EU budget should observe, in principle, the same rules applied to national budgets by the GSP: the ratio of the deficit to GDP should not overcome a reference value during an economic cycle (and not every year). A sound management of a firm is impossible without financial outsources, coming from the financial market or the banking system. Even local governments need some financing when in deficit. The constraint of the yearly budget in balance requires a “residual resource”, when European own resources are not enough or are diminishing, as has happened in the last decades. And, since the EU has no “independent” power to raise its revenue, the residual resources can come only from national governments.

In order to be financially independent from national governments, the European Commission should have the power, of course in agreement with the European Parliament, not only to collect eurotaxes, but also to issue Union Bonds. The objections put forward by Otmar Issingv on the probable negative impact of a common European bond on certain member states, which should become less responsible for lowering their excessive rate of indebtedness, are aimed at another target. “It would be hard to find a clearer case of free riding – says Issing – a common bond would undermine the credibility of the eurozone as an area of stability and fiscal soundness.” This observation is sound, but only if the Union Bond issue is planned for “solidarity” reasons among strong and weak member states. Completely different is the case of a Union bond issue to finance the EU budget for providing European public goods. In such a case, the aims of the bond issue are European growth, employment and the welfare of European citizens: the responsibility of the indebted states is not at stake. At present, the GSP establishes rules of good behaviour among the EU member states. Now, the time has come to include the EU budget and the GSP into a single Community financial framework.

The third comment concerns the democratic accountability of the EU, the budget policy included. The two Studies take into consideration the federal perspective, but as one among other “Possibilities for our Grandchildren”. Our view is that there is an opportunity now for a federal reform and that the European parties should not miss it. The last European election showed a further lowering of the turnout and a widening gap of confidence between the citizens and the European institutions. The democratic deficit of the EU has two roots: the first one is the lack of a European democratic government (in the Lisbon Treaty the word “European government” does not exist); the second root is the veto right: were the veto survives (like in foreign policy, budgetary rules and ratification rules) a tiny minority can block the democratic process. The European Parliament approved a resolution (on June 7th 2007) in which it declares the European Union a “supranational democracy”, but it should explain to European citizens how a supranational democracy can work with the veto right and without a democratic government.

The reform of the EU budget offers the possibility to overcome at least some aspects of the European democratic deficit, even though for a more comprehensive reform a new Convention is necessary. The European Parliament should face the budgetary reform in view of the European election of 2014. The next election will be a success if the citizens can understand that, with their vote, they can choose not only a party but also a government with a political program. It will be a failure if the European election boils down anew to a summation of national elections. The European parties have the power to change the citizens’s perception of the European Union. They can include the main lines of the budgetary reform in their political programme and, at the same time, present their candidate as President of the European Commission before the election. If the main parties have the courage to do that, the voters will have the chance to take part in a real European political debate on the future of the European Union. The core of sound politics is a clear relationship between ends and means. The European parties should explain to voters that the EU has a cost, and therefore they should accept that a share of their taxes should be devoted to the EU. But the EU also provides numberless advantages. Today the citizens of Europe live in peace, a way of life unknown to their grandfathers. They can benefit from a rich internal market and can move freely in a Continent without national borders. Now, the EU has to face dramatic challenges, like the world economic crisis, international terrorism, mass poverty, migrations and the menace of climate change. The duty of European political parties is to ask for the means to face the challenges of the 21st Century.

This article was first published on Europe's World

i Trichet J.C., Interview with the Financial Times, Financial Times, 15th December 2008.

ii See the website of the European Commission “Reforming the Budget”.

iii For a survey, see The Economist, September 26th, 2009.

iv OECD, Economic Outlook, Interim Report, Chapter 3, 2009.

v Issing O., “Why a common eurozone bond isn’t such a good idea”, in Europe’s World, Newsletter 34, EW Issue 12, Summer 2009.