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The paradox of the most competitive economy in the world until 2010


 By Rok SPRUK



On November 10th 2005, Mr. Jean-Claude Trichet, the president of the European Central Bank, delivered a speech in which he claimed:

"We need structural reforms to make sure that the soil is fertile enough for

the seeds of technological progress to produce the fruits leading to higher
productivity growth and per capita output growth. We know what we have to
do, the way has been identified in the Lisbon strategy and the first steps
have been taken. That way needs now to be followed in a more decisive
manner. Only in this way can per capita output growth be sustained, thereby
supporting economic prosperity today, and in the future."


Western Europe had indeed achieved vicious sustainable levels of prosperity
mainly because of sensible policies and institutions. United Kingdom and
Netherlands, for example, have enjoyed globe's highest living standard
levels at various times. In Sweden, high economic growth rates and very low
levels of government intervention between 1870s and 1950s, explain the
majority of its wealth today. The U.S. took the leading edge thanks to
strong growth rates but also because of the WW1 and the WW2. In 1950s, the
U.S. GDP per capita, compared to Western Europe, doubled. One of the
foremost reasons why European policymakers are very much in the need of
writing a Lisbon Agenda is that at the beginning of 1970s, the European
public policy shifted to statism. Government spending, tax burden and the
regulation of business and industrial sector posed a serious threat to
faster structural convergence in catching up the per capita GDP of the U.S.
When Ronald Reagan in the U.S. and Margaret Thatcher in the U.K took the
office, they also launched the program of rapid privatization, deregulation
and tax reforms. In the 1980s, the president Reagan reduced the top tax
rates from 70 percent in 1980 to 28 percent in 1988. As a result, the
economic growth averaged almost 4 percent per year. Total tax revenues
expanded impressively by 99.4 percent. In the United Kingdom, Margaret
Thatcher advocated free market policies and entrepreneurialism. She believed
in her main objective of reversing socialism that had done a huge harm to
the British economy. She entitled the program, calling for deregulation,
privatization, tax cuts and a rigorous control of government spending in
order to keep the inflation low. Back in 1979, when Margaret Thatcher
entered the office, the first major tax cuts was enforced. Sir Geoffrey Howe
reduced the top income tax rates from 83 percent in 1979 to 60 percent in
1980. Seven years later, Sir Nigel Lawson, a chancellor in the second
Thatcher government, further reduced the top income tax rate from 60 percent
in 1985 to 40 percent in 1986. In only seven years, the British tax system
was completely reset as the progressivity scale of taxation went from 83
percent top income tax rate to the top rate of 40 percent that we still have
today.






Western Europe failed to step on the road to free economy as serious
structural distortions were left ignored. Institutional transformation in
the majority of the European countries started to stream toward the
protection of specialized interest groups under significant political
pressure. Among them, trade unions harmed the economic performance in
Europe. Unemployment policy was transmitted to restrictive government
regulation. It hampered the productivity growth directly through the
devastating establishment of collective bargaining. As a result, the gap
between the U.S. and Europe in terms of working hours per employee, widened
significantly.

Today, the EU set out an ambitious agenda having a strong desire to become
the most competitive economy in the world until 2010. Many enthusiasms have
plagued the European minds since the agenda was successfully ratified.
Today, 3 years before the final eve, it turned out that European
policymakers have not reached targets and objectives therein. The aim of
this paper is to show where exactly the Europe is lagging behind the U.S.
and how structural deficiencies undermine the ability of European countries
to sustain high rates of economic growth and increased levels of
competitiveness and prosperity.


Rapid fiscal expansion, severe ageing population pressures, rigid labor
markets and awful regulation are among the most obvious factors in European
drift away from objectives written in Lisbon Agenda. Public expenditures in
Europe are very high. The wealthiest economies such as Ireland and
Switzerland, where government spending and consumption expenditures are low
compared to stagnant European economies, enjoy a high degree of economic
freedom coupled with solid, fair and transparent institutional framework. It
is projected that increasingly ageing population will prolong fiscal
pressures and therefore post more macroeconomic risk such as a lingering
worry of public debt. Current public debt of Italy is equal to 107.8 percent
of the GDP. High and risky macroeconomic pressures are mostly the result of
state welfare-dependent ageing population through fiscal mechanisms that
cannot sustain in the long-run. Going for growth in order to emerge as the
most competitive economy in the world in such a short period of time will
certainly not meet the expectation when the persistence of structural
problems is widespread while there are no signs of recovery features
undertaken by the macroeconomic and structural policymakers.



Labor freedom in Europe is low as labor markets are marred by a persistent
rigidness and inflexibility. This is partly attributed to the inexplicit
support of the position of trade unions in collective bargaining. Labor
costs per unit are high as well as the unemployment among youth is
significant, except for Denmark, Ireland and Netherlands where statistical
rates of youth unemployment are low compared to other economies in Western
Europe. High costs of labor coupled with hard hiring and firing practices
inevitably impair the productivity growth and dynamics of firm's change as
well. The spiral of rigidness and signs of economic downturn are usually
resulted in sluggish and anemic economic growth rates. The pursuit of labor
freedom is a necessary requirement for a competitive economy.
Maintaining a 'status quo' is not a solution to achieve higher levels of
competitiveness.






Third obstacle of Lisbon goals is a heavy burden of regulation which has
turned out to be inefficient and a barrier to further capital formation, job
creation, productive behavior and doing business in general. High proportion
of administrative costs set a big limit to the reform of the business
environment in which enterprises in Western Europe operate. Rigidities and
further inflexibilities occurred after French government officially declared
its economic patriotism through which the dominance of some domestic
enterprises over foreign companies was exercised. The ease with which
businesses can secure rights to property is difficult. According to World
Bank, it takes 183 days to register and secure a private property in France.
In Ireland, it takes only 38 days. Taking the situation seriously, the
ability of business sector in most of the EU countries to compete globally
in an international perspective is further limited due to dealing with
licenses. Robust institutional framework and the difficulty of its
responsiveness to business change largely contributed to the decline of new
joint ventures that could be attained. Instead, venture companies, in most
cases, chose other more attractive locations to invest. According to IBM
Global Investment Locations Survey, less than 20 global R&D investment
projects were done in every European state while the United Kingdom was the
hottest destination for global investors in 2005. When Ronald Reagan slashed
the monopoly power of trade unions and deregulated the economy through tax
cuts and vast administrative reforms, the economy skyrocketed as well as the
business sector statistically improved the majority of its parameters. The
policymakers in the European Union should reconsider whether it makes sense
to transfer budget subsidies to certain companies that suffer from difficult
business environment conditions while the regulatory framework is floating
away and remains unreformed.



At the end, I would like to pay attention to some structural parameters in
the EU showing the reason why competitiveness and rapid global shift in the
EU seem virtually impossible in such a short time. Tax systems in the EU
have undergone dramatic changes in recent periods. The flat tax revolution
has been taking place in Eastern Europe while continually prolonged tax
codes with high progressive tax rates remained in action in the majority of
EU member states. Slovakia, Estonia, Latvia and Lithuania are young and
hopeful boomers of tomorrow. Despite being so young, the policymakers in
those countries implemented radical tax reforms and thus became the leading
reformers in Europe as well as in a global sphere. Productivity growth, the
role of free-market institutions, free enterprise, personal liberty and
economic freedom are the main requirements for economic growth. Perhaps the
most influential variable is a level of taxation that varies from time to
time, from place to place. Empirical studies have shown that highly
progressive tax rate reduce the ability of economy to sustain high growth
rates. When tax code with progressive taxation rates is in action, it poses
a twin-tracked risk. First, it degrades the productive behavior of
individuals and companies to compete and rally for growth in an enhanced
global position. The inability of knowledgeable, successful and productive
individuals is therefore very much the result of high tax rates on corporate
and individual income. Lisbon Agenda declared the need for technological
progress and investment in human capital infrastructure and innovations
while, at the same time, burdensome taxation levels through which the
explosive welfare spending is financed, sets a panel of difficulties to
technological investment and service restructuring based upon innovations.
This often parallels with uncompetitive education sector in a global
perspective. With the exception of reputed British Universities such as
Oxford and Cambridge, the highest rated university in the EU is ranked
40thin the world according to
Shanghai Academic Ranking Survey.

Second, progressively-rated income taxes device a series of ways, through
which tax evasion, tax sheltering and tax avoidance are easily exercised.
The result that follows is a decline in total amount of tax revenues.
Progressive taxation causes compliance costs to grow beyond the edge of
assumptions. Influential individuals may achieve privileged tax treatment
and status which gives them an opportunity to avoid paying taxes at the
expense of taxpayers. When Russia instituted a flat, total tax revenues grew
significantly, economic growth as well. In the United States, there were
three main tax reforms in the 20th century. When President Coolidge reduced
the top rate from 73 percent in 1921 to 25 percent in 1925, the economy grew
59 percent in real terms between 1921 and 1929 while annual economic growth
averaged more than 6 percent. During the same period, personal income tax
revenues grew by more than 61 percent. When President Kennedy reduced the
top income tax rate from 91 percent in 1963 to 70 percent in 1965, the
following years brought the largest economic expansion in America's history.
Between 1961 and 1968, the inflation adjusted economy expanded by more than
42 percent, a yearly average of more than 5 percent. During the same period,
total tax revenue grew by a solid 62 percent. As mentioned above, Reagan tax
cuts brought the largest tax revenue increase the U.S. has ever recorded. On
the other side, maintaining high progressive tax rates negatively affect the
behavior of economic growth. Flat tax is simple, transparent, fair and
efficient and it stimulates economic growth through radically lower taxation
of productive behavior. It encourages capital formation and human capital
investment as business and entrepreneurial sector becomes equipped with the
ability to compete, enterprise, innovate and invest. Flat tax also
encourages economic growth while fears of falling revenues are overheated.
They also postpone very much needed fiscal reforms, so that under
progressive taxes policymakers do not take care of instability of public
finance so what they are concerned with is an amount of revenues when the
policymakers hardly show any desire to cut welfare spending.



Under such circumstances, high-flying hopes for becoming the most
competitive economy in the world until 2010 are a pretension and a road to
relative stagnation on the long-run since unreformed structural problems are<;span>
leaving an enormous pressure on public finance that cannot sustain high
welfare spending in the long run as well. Without the set of serious radical
pro-growth economic and structural reforms, the hopes for technologically
most developed know-how economy in the world will quickly disappear as the
agony of welfare statism and strong government intervention will prevail
over the need for free market institutions and higher prosperity.

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Rok SPRUK is a supply-side economist and a classical liberal. He currently lives in Slovenia where he studies economics. His fields of research are economic growth, macroeconomics, monetary economics, international economics, tax policy and international competitiveness. His articles, observations, views and ideas are posted on his blog Capitalism & Freedom


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