October 21, 2003

Quantifying four scenarios for Europe

The future of Europe

Press release
A better application of the subsidiarity principle in the EU is required and current welfare states unsustainable
  • The European Union (EU) would gain public support and effectiveness if it applies the subsidiarity principle more consistently. If international policy spillovers are important, European responsibility is required. Current practice in Europe, however, is that a number of prerogatives are assigned to the EU in the field of social policy. Since labour mobility is limited, the arguments for European involvement are weak. In contrast, the EU is hardly involved in the harmonisation of corporate taxation, while capital is highly mobile across countries. As profits can easily be shifted across borders, European coordination may be helpful to avoid the loss of tax revenues in countries with high tax rates and a process of tax competition among member states.
  • Structural trends, like ageing, a deterioration of the position of low-skilled workers, more heterogeneity in society and higher mobility of production factors all put pressure on European welfare states. Public expenditures increase, while raising public revenue is accompanied by rising social costs. Consequently, European welfare states are not sustainable in their current form. This forces countries to undertake drastic measures in the coming decades. In particular, governments should either retreat or reform.

These conclusions appear from the CPB study "Four futures of Europe", written by Ruud de Mooij and Paul Tang. They analyse the most relevant challenges for the European Union and its member states in the coming decades, to adequately cope with developments like the next enlargement of the EU, ageing and increasing wage inequality. The study develops four scenarios for the future of Europe to explore long-term uncertainties in a consistent framework. This may help structuring the debate on strategic policy issues, both in the EU and its member countries. How will Europe proceed in the coming decades? And how will member countries change their welfare states?

Challenges for the EU: Maintain effective and legitimate decision making in the enlarged Union
The EU is about to enlarge with ten new member countries, has to take a decision about the starting date of negations with Turkey about its accession, and currently discusses how to improve the institutional framework. To improve public support and legitimacy of an enlarging Union, it is essential that the EU appropriately applies the principle of subsidiarity: leave national responsibilities intact when feasible, and consider European responsibilities only when necessary. A consistent application of the subsidiarity principle - indeed one of the aims of the Convention - may help the European Union to build the trust with the public as well as with policy makers, that the European Union is more than just another layer of bureaucracy. This will add to the credibility of European institutions.

The subsidiarity principle is, however, not applied consistently. For instance, this study argues that the case for harmonisation of corporate taxes, in some form, is stronger than the case for Social Europe. Capital mobility is much higher than labour mobility. Hence, international spillovers in corporate taxation are more important than in social policy. Yet, corporate taxation is still almost the exclusive domain of the member states, while the European Union is involved in a number of areas of social policy. This inconsistent application of subsidiarity principle becomes more notable with the accession of new member states from Central and Eastern Europe. The need for diversity in social policies increases. At the same time, the need for tax harmonisation will grow, since new member states will increase the intensity of tax competition among nations.

Pressure on European welfare states
Structural trends put pressure on European welfare states. Public expenditures tend to rise, while increasing social heterogeneity and rising cost of taxation make financing these expenditures more difficult.

Ageing raises public expenditures
Ageing populations raise public expenditures on old-age pensions and health care. Besides, relatively slow productivity growth and high income elasticities will lead to extra demand for publicly provided services. Without changes, for example in pensions system, the tax burden on the young, working generations will rise significantly, for some countries by more than 5% of their gross domestic product.

A deeper divide between low- and high skilled reduces equality
The position of high-skilled workers on labour markets is steadily improving relative to low-skilled workers. That the income differences between the two groups have not grown (fast) in the recent past, is a result of the fast increase in supply of high-skilled workers. When the increase levels off, as is expected during the coming decades, the income differences may start to grow.

Increasing social heterogeneity increases the need for diversity
Society has become more heterogenous. Individualisation as well as immigration has contributed to that. More heterogeneity makes economic policy less effective. Some specific transfers, for example, not only benefit those who need support, but are also provided to those with high incomes. Heterogeneity also raises the demand for diversity, which the public sector often fails to deliver.

Increasing tax avoidance
The choice set of individuals has expanded, which has increased the response to income taxes and income transfers and has amplified the distortionary consequences of taxation. Adding to this is the increasing mobility of capital and firms. With further integration of capital and good markets, this mobility will only increase. This further increases the costs of taxation.

Challenges for member countries: achieve the Lisbon objectives on growth, solidarity and the environment, despite the pressure on welfare states
The four developments put welfare states in EU countries, especially the larger ones, under growing pressure: expenditures increase but become less effective and more costly to finance. This complicates achieving the Lisbon objectives of the EU-leaders on economic growth, social cohesion and environmental sustainability. Governments can follow two courses to still achieve the Lisbon goals: retreat or reform.

Governments can scale back the public sector and give private initiative more leeway. A lower tax burden and stronger incentives may increase efficiency. It comes, however, inevitably at the expense of equity. This can be in line with social preferences for individual freedom and diversity.
When retreating, governments need to find a new demarcation between public and private responsibilities. In this connection, it is important to note that the welfare state not only redistributes income, but also provides an insurance against several risks. This enhances economic efficiency, since it allows individuals to undertake risky but profitable investments. The market not always delivers all forms of insurance so that public intervention improves efficiency.

An alternative to retreat is reform. Thereby governments need to target their policies better so that policies become more effective and more efficient. To illustrate, redistributive instruments may be better targeted to those that need income support, such as low-skilled individuals with little skills and talent. This could substantially reduce redistribution via the public sector. At the same time, active labour market policies may reduce the poverty trap. For those with more skills and talent, stronger incentives are necessary to avoid moral hazard and improve efficiency. Using more information about individual characteristics will make policy instruments more complex, which put a strain on the implementation by governments. Furthermore, it raises the concern regarding individual privacy. Hence, reform is not a free lunch.

Four futures for Europe
Europe's future is uncertain. Even more uncertain than long-run developments in demography, ICT, and individualisation are the responses to them by societies. To get a grip on this uncertainty, the underlying study develops four alternative scenarios on the future of Europe. The scenarios - Strong Europe, Global Economy, Transatlantic Market and Regional Communities - combine alternative assumptions regarding the two key uncertainties: international cooperation and the response by governments to the pressure on the welfare states.

Strong Europe
Reforming the process of EU decision-making lays the foundation for a successful, strong European Union. The enlargement is a success and integration proceeds further, both geographically, economically and politically. Strong Europe is important for achieving broad international cooperation, not only in the area of trade but also in other areas such as climate change.
European countries maintain social cohesion through public institutions, accepting that this limits the possibilities to improve economic efficiency. Yet, governments respond to the growing pressure on the public sector by undertaking selective reforms in the labour market, social security and public production. Combined with early measures to accommodate the effects of ageing, this helps to maintain a stable and growing economy.

Global Economy
Economic integration becomes broader as countries find it in their mutual interest. Closer cooperation in non-trade areas is not feasible as governments assign a high value to their national sovereignty in these areas. The problem of climate change is not tackled while European taxes on capital gradually decline under the pressure of tax competition.
National institutions are increasingly based on private initiatives and market solutions. European governments concentrate on their core tasks, such as the provision of pure public goods and the protection of property rights. They engage less in income redistribution and public insurance so that income inequality grows.

Transatlantic Market
Countries primarily focus on national interests. Reforms of EU decision making fail. Instead, the European Union redirects its attention to the United States; they agree upon transatlantic economic integration. This yields welfare gains on both sides of the Atlantic, sharpening the split between the club of rich countries and the group of developing countries.
European countries limit the role of the state and rely more on market exchange. This boosts technology-driven growth. At the same time, it increases inequality. The heritage of a large public sector in European countries is not easily dissolved. New markets, e.g. for education and social insurance, lack transparency and competition. The elderly dominate political markets. This makes it difficult to dismantle the pay-as-you-go systems in continental Europe.

Regional Communities
The European Union cannot adequately cope with the Eastern enlargement and fails to reform her institutions. As an alternative, a core group of rich European countries emerges. More generally, the world is fragmented in a number of trade blocks and multilateral cooperation is modest.
European countries rely on collective arrangements to maintain an equitable distribution of welfare. At the same time, in this scenario governments are unsuccessful in modernizing welfare-state arrangements. A strong lobby of vested interests blocks reforms in various areas. Together with an expanding public sector, this puts a severe strain on European economies.

The four scenarios have been translated into quantitative sketches, using a macroeconomic model for the world economy. The table below shows these quantitative sketches. GDP grows between 0.6% per year in Regional Communities to 2.5% per year in Global Economy. Scenarios with the highest growth show the poorest performance in terms of income equality and environmental quality.

Economic development in the EU-15 in four scenarios (figures in %annual growth)

Yearly growth1980-2000Strong EuropeGlobal EconomyTransatlantic MarketRegional Communities
World trade5.
Income Equality +--+
Environmental equality +--+

Together with "Four futures of Europe", CPB launches the publication "Quantifying four scenarios for Europe", written by Arjan Lejour. This CPB Document provides the background for the quantitative assessment of the scenarios and elaborates in particular on three dimensions: developments in economic growth, opportunities for further integration, and developments in the real interest rate.

 In the scenarios Strong Europe (SE) and Global Economy (GE), international cooperation is prominent, while the other scenarios, Regional Communities (RC) and Transatlantic Market (TM), feature limited international cooperation. Public institutions are important in Strong Europe and Regional Communities. In Global Economy and Transatlantic Market the role of the public sector is limited. There is more room for private initiatives in these scenarios.

To illustrate the scenarios, this document presents quantitative developments described with an applied general equilibrium model developed at CPB: WorldScan. By using this model we are able to derive consistency between developments in the scenarios and to apply common economic mechanisms. The variation in the outcomes for the scenarios is derived by introducing differences in exogenous trends. This document explains and motivates these differences.

More regulation and income redistribution in Regional Communities and Strong Europe is accompanied by higher unemployment rates and lower participation, as compared to the scenarios in which private initiatives are given more leeway (i.e. Global Economy and Transatlantic Market). Combined with the ageing of the population, this result implies that employment contracts in Regional Communities, while it grows only moderately in Strong Europe, due to immigration. More incentives for labour supply imply a higher participation rate in Transatlantic Market than in Strong Europe. However, lower population growth in the former scenario has the effect that overall employment growth is equivalent in Strong Europe and Transatlantic Market.

The emphasis on an efficient functioning of markets in Global Economy and Transatlantic Market is accompanied by a higher labour productivity growth than in Strong Europe and Regional Communities. Labour productivity growth is weakest in Regional Communities. This weak growth, together with a fall in employment, causes GDP per capita in Regional Communities to grow by only 0.6% per year.

Trade liberalisation and economic integration boost trade and growth in Global Economy and Strong Europe. High growth in Asia redirects European trade flows towards that continent, so that the share of intra-EU trade decreases. In Transatlantic Market, the EU cooperates more closely with the United States and Latin America, which boosts EU-US trade. In Regional Communities, growth in world exports is negligible, and the share of intra-EU trade remains relatively high.

In Strong Europe and Global Economy, governments stimulate national savings by curbing budgets deficits and stimulating private savings. Although this does not prevent a decline in saving rates because of ageing, it is less dramatic than in Transatlantic Market and Regional Communities, where saving rates decrease by 6%-points between 2000 and 2040. As the demand for capital also falls substantially, real interest rates still decrease in Regional Communities and, to a lesser extent, in Strong Europe. In Global Economy and Transatlantic Market, increasing investment demand causes a higher real interest rate.



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