France's fiscal follies

André Sapir

28 June 2007

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According to the latest forecasts published by the European Commission, France is set to break another record in 2007. For the first time, it will become  the EU country with the highest level of public expenditure. Commission economists estimate that total government expenditure as a share of GDP will reach 53.2 % in France this year. This will be more than in any other EU27 country, including the three Nordic countries: Finland 47.7%, Denmark 50.1% and Sweden 53.0%.

What is striking is that although total government revenue as a share of GDP in France is also expected to be very high (50.7%), it will actually be lower than in the three Nordic countries who top the EU class: Finland 51.3%, Denmark 53.8% and Sweden 55.2%. Hence, whereas these countries will register budgetary surpluses ranging between roughly 2% and 4% of GDP, France will have a deficit of 2.5%, the second largest in the euro area behind Portugal.

No wonder that Joaquin Almunia, the EU Commissioner for Economic Affairs, has expressed strong concern about the budget plans of the new French government that would (at least initially) cut government revenue more than expenditure, and therefore risk increasing the deficit, perhaps even above the 3% threshold of the Stability and Growth Pact (SGP).

Even more worrying is the fact that France might increase its cyclically adjusted deficit well above the limit set by the SGP. Remember indeed that, contrary to what is often assumed, the innovation of the SGP was not the 3% limit, an obligation already specified by the Maastricht treaty, but the requirement that EU countries respect ‘the medium-term objective of budgetary positions of close-to-balance or in surplus’.

The original SGP, adopted in 1997, did not specify a numerical value for the medium term objective (MTO), nor when it should be reached. As a result, fiscal consolidation stalled as soon as the single currency was adopted. In 1997, five of the eleven initial euro area members had actual deficits close to 3%: France (3%), Germany (2.6%), Italy (2.7%), Portugal (3.4%) and Spain (3.3%). This condition was not so much the result of cyclical but of structural factors, as indicated by the cyclically adjusted deficits: France (2.1%), Germany (2.2%), Italy (2.5%), Portugal (3.2%) and Spain (2.3%).

Firm commitment to the SGP would have demanded serious fiscal consolidation in these five countries in 1998 and beyond. In reality, little or no progress was accomplished in four of these countries (Spain is the exception), and in Greece, which joined the euro area in 2001. This is shown in the chart, which indicates that the cyclically adjusted deficit for the euro area as a whole (where the five delinquent countries account for 70% of the GDP) remained around 2 % throughout the period from 1998 to 2005.

Source: DG ECFIN, Key indicators for the euro area

This situation eventually led to the crisis of the SGP in 2003 and 2004, and to its revision in 2005. One of the innovations of the new SGP was the formulation of country-specific MTOs, which are defined in structural (i.e. cyclically adjusted) terms, with values ranging from a surplus of 2% for Finland and Sweden to a deficit of 1% for several new member states. The MTO was set at zero for ten EU countries, including France, Germany and Italy.

The new framework seems to be working. The chart shows, indeed, that the cyclically adjusted deficit for the entire euro area dropped sharply in 2006. This progress is expected to continue in 2007. Yet, a closer look at individual situations indicates a sharp distinction between Germany and France on the one hand, and Greece, Portugal (and, to a lesser extent, Italy) on the other.

Much of the current budgetary discussion in France focuses on the idea of following Germany’s example with a ‘social VAT’, a reduction of social charges financed by a rise in VAT, aimed at increasing competitiveness. The French authorities should, however, remember that their public finances differ from Germany’s in three important respects. First, at 19.6%, France’s VAT before the envisaged five percentage point increase is already higher than Germany’s after its three point raise. Second, public spending as a share of GDP will be almost nine percentage points higher this year in France than in Germany. Third, the German government is fully committed to bringing the structural deficit down to zero by 2010. By the end of this year, its structural deficit will already be under 1% of GDP. By contrast, in France, the cyclically adjusted deficit will still be at 2%, and may even increase next year, thereby jeopardising the objective of reaching the MTO in 2010 to which the French government is also committed in principle.

Commissioner Almunia is right to urge France to stick to its commitment under the SGP. This is the only way to bring the public debt down and to force a reduction or at least a restructuring of public spending, both of which are required to boost growth and ensure the sustainability of public finances.

Editor’s note: This originally appeared on http://www.Eurointelligence.com and has appeared in French on our Consortium partner’s site http://www.Telos-eu.com

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Topics:  Taxation

Tags:  VAT, government expenditure, deficit

Professor at Universite Libre de Bruxelles, Senior Fellow of BRUEGEL and Research Fellow of CEPR

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