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IP/00/1537 Brussels, 21 December 2000 Commission calls on Member States to improve quality and sustainability of their public finances In preparation for the Stockholm European Council the Commission approved today a Communication on the contribution of public finances to growth and employment. Accounting for between 40% and 50% of GDP in the Union, public finances play a key role in the realisation of the Lisbon strategic objectives. According to Pedro Solbes, EU Commissioner for Economic and Monetary Affairs, “improving the quality and sustainability of our public finances while at the same time maintaining tight fiscal discipline is the natural way forward now that fiscal consolidation in the Union is on the right track”. The Communication identifies four main challenges: (i) the need to maintain strong fiscal discipline; (ii) the need to accelerate progress towards more employment friendly tax and benefit systems; (iii) the need to re-orient public expenditure to areas promoting a knowledge-driven economy and (iv) the need to ensure healthy public finances over the long term and take account of the implications of ageing. The Lisbon European Council last March established as a strategic goal for the EU “to become the most competitive and dynamic knowledge-based economy in the world”. Accounting for between 40% and 50% of GDP, public finances have a critical role to play in the realisation of this goal. The Lisbon European Council called up the Commission and Council to present a report to the Spring 2001 European Council assessing the contribution of public finances to growth and employment. In particular the report should assess whether, on the basis of comparable data and indicators, adequate concrete measures are being taken in order to: - alleviate the tax pressure on labour, especially on the relatively unskilled and low-paidand improve the employment and training incentive effects of tax and benefit systems; - redirect public expenditure towards actions increasing the relative importance of capital accumulation – both physical and human – and support research and development, innovation and information technologies; - ensure the long-term sustainability of public financesby examining the different dimensions involved, including the impact of ageing populations. The Commission Communication will serve as the basis for the joint CommissionCouncil (Ecofin) report on the same subject to be established early next year. While recognising that the impact of public finances on the real economy is multiple and complex, public finances enhance potential growth and employment via the accumulation of productive factors (e.g. investment in physical and human capital), by providing the right incentives through tax and benefit systems, and by ensuring a stable macroeconomic environment. The Communication identifies four main challenges to ensure that public finances maximise their contribution to growth and employment. A first key challenge is to maintain strong fiscal discipline in EMU. Recent budgetary developments indicate that the EU is on the right track. The Stability and Growth Pact (SGP) goal of “close to balance or in surplus” is within reach and public debt is on a steady downward path. At the same time, reforms are being introduced to lower the tax burden from historically high levels. However, the picture is not altogether favourable, as there is emerging evidence of a pro-cyclical loosening of the budgetary stance at a time when the output gap is turning positive in most Member States. The Communication outlines four criteria for assessing whether tax cuts can achieve a sustainable reduction in the tax burden and at the same time contribute to growth and employment. They are: (1) Member States must meet or make progress to the medium-term budget target of ‘close-to-balance or in surplus’; (2) reforms should take into account the cyclical position and must not be procyclical; (3) account must be taken of the level of government debt and long-term budget sustainability; and (4) tax reductions should form part of a comprehensive reform package. On the basis of these four criteria, it appears that recent tax cuts in many countries should be matched with further reductions in government expenditure so as to achieve a sustainable reduction in the tax burden. The Commission invites Member States to examine the merits of the criteria for assessing tax cuts and asks for their implementation as part of the budgetary surveillance process at EU level. A second challenge is to accelerate progress towards more employment-friendly tax and benefit systems. Tax reforms in recent years have focussed on the need to reduce the burden on labour, which increased by one-third in the past 30 years. Overall, progress has been made towards making tax systems more employmentfriendly, by lowering the fiscal burden on labour. However, unequal progress has been made across Member States, and overall labour taxation in many Member States remains very high by international standards. Insufficient progress has also been made towards reforming benefit systems. Changes in net replacement rates have been relatively small, while only few Member States have developed in-work benefits to boost earnings of low-paid workers. Progress has been made in the shift from passive to active measures but, according to the Commission, significant further efforts are needed. Assessing the contribution of public finances to a knowledge-driven economy is timely given the ongoing debate on the “new economy”. However, only limited information was available about concrete measures taken by Member States, and consequently, the Communication only partly responds to the mandate of the Lisbon Council. Despite the lack of information, some tentative policy conclusions can be drawn. Some progress has been made towards increasing investment necessary to facilitate the development of the information society, but greater efforts are required. Governments must also put more emphasis on education and training in order to equip European citizens with the necessary skills for an information society, while promoting the involvement of the private sector on innovation and R&D activities. Such efforts have to be made in a framework of sound fiscal policies with the increase in capital accumulation being financed through expenditure restructuring and not via an increase in overall public spending. Furthermore, restructuring of public spending should be complemented by institutional and structural reforms that enhance the role of market mechanisms and introduce adequate incentive systems to promote private accumulation of physical and human capital. What counts in the end for economic growth is not public accumulation of productive factors per se but total (public and private) factor accumulation. 2 An increase in public investment will have limited or even negative effects on growth if it crowds out private investment. Further analysis as well as better information will be required in this area and Member States should increase the information available. A final challenge is to ensure the long-term sustainability of public finances. The old age dependency ratio for the EU (population over 65 as a percentage of working age population aged between 20 and 64) will rapidly increase from 27% in 2000 to over 50% in 2050. Projections provided by a recent study conducted by the Economic Policy Committee where the European Commission is a member show that ageing populations could lead to increased pension expenditure of between 3 and 5 percentage points of GDP in most Member States. Given that spending on health care is also expected to rise substantially due to ageing populations, the EU is facing a major challenge as regards the sustainability of public finances, which will be most acute in countries having a large stock of public debt and that finance their pension systems on pay-as-you-go (PAYG) basis. A comprehensive approach is needed to address the budgetary implications of ageing. Firstly, Member States should pursue fiscal consolidation and reduce public debt levels at a faster pace: this will lower the future interest burden, and thus partly offset increased public spending on pension and health care. Secondly, labour market reforms are needed to increase employment rates, especially amongst women and older workers. In addition to limiting access to early retirement schemes, the tax and benefit provide positive incentives for older workers to stay in the labour market. Thirdly, in many Member States further reforms to public pensions systems are needed to ensure greater actuarial fairness between contribution and entitlements, and funded pension provision will be expected to play a greater role. The EU can play a constructive role in helping Member States address the budgetary consequences of ageing populations. The Commission will support efforts to extend long-term expenditure projections to cover health care and long-term care for the elderly. Member States should fully incorporate long-term budgetary sustainability aspects into their stability and convergence programmes. Finally, the Commission will examine the possibility of establishing, in cooperation with Member States, a European Longitudinal Ageing Survey, with a view to assisting countries in the design of public policies that cater for the changing needs of an ageing population. 3