Fiscal regimes and equality among states

Amid talk of a ‘Hamiltonian moment’, the Next Generation EU recovery fund recalls a later US Treasury secretary as a fiscal union emerges.

Whoever controls taxes and force, according to the German sociologist Max Weber (1864-1920), also controls political power. The building of the modern nation-state was made possible by their combination. State builders used taxes for creating force; force was indispensable for extracting taxes.

Since the second world war, European nation-states have come to share power in the construction of a single market but they have refused to share fiscal power (and the control of force). The European Commission’s proposal to finance a €750 billion ‘Next Generation EU’ programme through borrowing on the market on behalf of the European Union—with €500 billion to be allocated as grants and the rest as loans to the countries hit hardest by the pandemic—is thus unprecedented.

As the European Commission president, Ursula von der Leyen, told the European Parliament, these new resources would be guaranteed by an EU budget uplift to 2 per cent of EU gross domestic product—an increase made possible by new taxes rather than additional national contributions (which constitute two-thirds of the current budget). In the commission’s report justifying Next Generation EU, it is indicated that the new taxes should come from the Carbon Border Adjustment Mechanism, the operation of large companies, digital companies, non-recycled plastic and a simplified Value Added Tax.

This proposal, if accepted by the European Council at its meeting on Friday (June 19th), will not only change the relationships between member states and the supranational institutions. It will also help reduce the inequality among states which emerged during the pandemic and previous multiple crises. The Treaty on European Union (article 4) declares ‘The Union shall respect the equality of Member States before the Treaties’ but the crises of the past decade and the pandemic have made certain (northern) states more equal than (southern) others.

As taxes affect relationships among social groups within states, the fiscal regime affects the relationships among states in a union. Conversely, the less equal members of a union of states tend also to display more domestic inequality. That’s why it’s important to discuss the EU’s fiscal regime. Three models are on the table.

Fiscal regulation

The EU is currently characterised by a regime of fiscal regulation. Particularly in the eurozone, member states have retained fiscal sovereignty in form only; in substance, it has been highly regulated by rules established jointly by the heads of government. Since the eurozone design was based on centralisation of monetary policy yet decentralisation of fiscal policies, the latter inevitably ended up being hyper-regulated to be compatible with a common currency—from the Stability and Growth Pact (1997-98) onwards, but particularly during the financial crisis.

This has however been relative: regulation has hollowed out the actual fiscal sovereignty of some countries (the debtors) but boosted that of others (the creditors). The outcome has been growing economic divergence between one group and the other.

In dealing with the pandemic, the governments of the ‘frugal four’ (Austria, Denmark, Netherlands and Sweden), with the sympathy of other northern leaders, have insisted on preserving this regime. For them, the commission’s proposal is an attempt at debt mutualisation.

The ‘frugal four’ proposed to help the hardest hit countries with an ad hoc special fund distributed through loans, without altering the logic of the current fiscal regime. Using the latter to respond to Covid-19 would however deepen the divergence: loans would increase the stress on the public finances of the southern states, giving the northern states (less affected by the pandemic) a formidable advantage in rebuilding their economies.

How could the single market function on the basis of such disparities among its constitutive states? This regime celebrates the de facto sovereignty of a group of member states relative to supranational institutions.

Centralised model

Commenting on the commission’s proposal, some Italian politicians and a few figures in government among the southern member states have detected, finally, movement towards ‘a European centralisation of fiscal policies’. In pro-EU political circles, the alternative to the current regime is thought to be a centralised fiscal model.

Fiscal centralisation is epitomised by the postwar German federal state, even if decisions emerge through a system of committees involving Länder representatives and tax collection is implemented by the Länder themselves. The German regime is based on the principle, in article 107 of the Basic Law (Grundgesetz), of ‘a reasonable equalization of the disparate financial capacities of the Länder’. This principle is guaranteed vertically (with transfers of resources from the Bund to the poorest Länder) and horizontally (from rich to poor Länder, via the Länderfinanzausgleich).

After unification in 1990, this fiscal regime was sorely tested by the burden of supporting the five new Länder in the east and the reunited city-state of Berlin. An uninterrupted reform process is still not complete, spurred also by appeals to the Federal Constitutional Court (Bundesverfassungsgericht) by the richest Länder: Bavaria, Baden-Württemberg and Hessen. In their view, solidarity among the Länder has encouraged the poorest to shirk their responsibilities.

Transposed to the EU, such a fiscal regime would certainly help reduce, through its centralisation, the disparities among states. But could this ‘transfer union’ be implemented? No. The centralisation of fiscal policies, already difficult in the context of the German state, would be impossible in the condition of a union of states. The EU, constituted by demographically asymmetric states with distinct national identities, cannot adopt any form of fiscal or political centralisation, if it wants to prevent centrifugal pressures by small member states or a logic of domination by larger ones.

Fiscal union

Is there then an alternative? Yes: it is the regime of fiscal union. Between a confederation (fiscal regulation) and a federal state (fiscal centralisation), there is space for experiment with the model of a federal (fiscal) union. This is a coming-together federation, rather than a holding-together federal state.

In a federal union, the member states maintain fiscal sovereignty for the policies for which they are responsible, while the union must have fiscal sovereignty for the limited policies assigned to it. Fiscal power is thus unevenly divided—not transferred from the states to the union.

By using taxation to finance Next Generation EU, the EU will have to take on the burden of the debt entered into by individual countries to respond to the consequences of Covid-19—no more. This would increase the role of supranational institutions, without depleting that of member states. As the German finance minister, Olaf Scholz, acknowledged in a recent interview in Die Zeit, a common problem requires common resources.

If we take the early years of the United States as a case of a federal union’s formation, rather than looking at Alexander Hamilton (secretary of the Treasury 1789-95) we should consider Albert Gallatin (secretary of the Treasury 1801-14). While the former pushed the federal government to ‘redeem’ the debt contracted by the individual states in the War of Independence against the British empire, the latter invented the formula of grants-in-aid to apply to the states which received aid to pursue federal objectives.

In the case of Next Generation EU, the aid to the states should support the environmental and digital reconversion of their economies (the Green Deal), complying with the standards of social inclusion, administrative transparency and the rule of law. In short, the response to the consequences of Covid-19 might be the occasion for constructing a European fiscal union, which keeps separate the fiscal responsibilities of the states from that of the EU. Each must play their part, but with the means available to perform their allocated duties.

A fiscal union is less effective than fiscal centralisation in neutralising inequalities among states, although more effective than fiscal regulation in so doing. But, going back to Weber, the fiscal regime for reducing inequality among states should be congruent with the necessity of building a viable political model for their union.