Europe’s Voodoo Economics

Europe’s Voodoo Economics

The debt crisis can be traced to regressive tax cuts, which have also led to growing inequality.


Europe’s debt troubles have roiled global markets and led to much braying about people who live beyond their means. In the United States, many fear we face a similar reckoning, and deficit hawks in both parties appear to be in the ascendant as Republicans decry President Obama’s "European" tendencies. But something is missing from this discussion, and that is the fact that what helped get Europe into trouble was actually something very American: big, regressive tax cuts that were supposed to pay for themselves but didn’t. Thus, the problem is not that we will become Europe but that Europe was trying to become us. And voodoo economics didn’t work any better there than it did here.

I am aware that "tax cuts" and "Europe" are not concepts that go together in the minds of most Americans. But bear with me while we look at a few examples. If we take the period from the mid-1990s until today, Germany reduced its corporate tax rate by twenty-seven percentage points, while the top income tax rate was cut by 9.5 points. Over the same period, Spain and France slashed their highest income tax rates by about thirteen percentage points, and Italy reduced its corporate tax rate by 20.8 points and its top income tax rate by 6.1 points.

Along with rate cuts that have disproportionately benefited top earners, the long-term trend in Europe, as in America, has been to shift the source of revenue away from taxes on personal and corporate income, as well as away from employers’ share of payroll taxes, and on to workers’ share of payroll taxes, according to a 2009 report by the EU statistical agency Eurostat. Some countries have also increased the regressive value-added tax to try to pay for cuts in more progressive sources of revenue, like the income tax.

The upshot, according to Thomas Piketty, professor at the Paris School of Economics, is that taxation in Europe has become more regressive over the past decade and a half, as European countries fight among themselves to attract capital in an era of intensified integration. "We have tax competition in Europe, and the result is very simple: the mobile factor of production, i.e., capital, is taxed less and less; consequently, a less-mobile factor like low-skilled labor is overtaxed," says Piketty.

In Germany, regressive tax cuts have fundamentally changed the country’s economic model, according to Peter Bofinger, professor at the University of Würzburg and a heterodox member of the German Council of Economic Experts. "Germany was almost in the same league as Scandinavia [before tax cuts]," says Bofinger. "But now it’s no longer in that category."

The results for public finance are clear, according to Bofinger, who recently published an op-ed in the Süddeutsche Zeitung under the contrarian headline "Germany Is Living Below Its Means." "If we had the tax rates that were in place in 1998, we would have 75 billion euros more revenue per year. Meanwhile, countries that refrained from major tax cuts—as in Scandinavia—are in a better fiscal position," said Bofinger. (Germany now plans 81.6 billion euros in spending cuts over four years.)

Henri Emmanuelli, a Socialist member of the French National Assembly and a former budget minister, makes a similar point regarding France’s deficit. "If you take the tax cuts, that is our deficit," he said on a recent French radio talk-show.

As in America since the early 1980s, so in Europe—tax systems have become less progressive and have helped increase shortfalls in public budgets. Unfortunately, European tax cuts have done something else Americans can relate to: they’ve reinforced the trend toward greater income inequality.

Camille Landais, a French economist working at the University of California, Berkeley, has studied the evolution of top incomes in France from 1998 to 2006. Before this period France had actually resisted the trend toward greater inequality seen elsewhere. But Landais found what he calls an "explosion of top income shares" beginning in the late ’90s. He emphasizes that this wasn’t all due to the decline in top marginal income tax rates, which started around the same time, but tax cuts were a big part of the picture. "Tax cuts reinforce the trend," he said. "And it’s a big reinforcing effect."

In Germany, even before the economic crash, studies showed that the middle class was shrinking, the percentage of the population that was poor was growing, and the gap between rich and poor was widening. In a 2008 article Markus Grabka, of the German Institute for Economic Research, described this as "a catching-up process"—i.e., Germany was catching up with the levels of inequality observed in the English-speaking world.

Continental Europe is still far less unequal than the United States. "But the trend is in line with the trends in the United States since the 1980s," says Landais. "If the tax systems—which are much flatter than most people think—continue to be as flat as they are, it’s clear that in twenty years there’s no reason France and Germany wouldn’t be as unequal as the United States."

Ironically, center-left parties enacted some of the most regressive tax policies. In France, Prime Minister Lionel Jospin’s Socialist government (1997–2002) began steep rate cuts, which were continued by subsequent conservative governments in preparation for the tax-slashing apotheosis that would occur when President Nicolas Sarkozy took office in 2007.

In Germany, the Social Democrat/Green coalition led by Chancellor Gerhard Schröder (1998–2005) showed a zeal for tax cuts that surprised everyone. As the important weekly Die Zeit commented in a 2000 editorial: "The coalition is pursuing a policy that no one would have believed two years ago: the retreat of the state, symbolized by…the forswearing of tax revenue and the biggest cuts in the top tax rates in the history of postwar Germany."

Why the European center-left went down this path is a vastly complicated subject. But one reason is that center-left parties wanted to be seen as competent economic managers, and this meant not challenging the reigning dogma that growth occurs when capital is liberated. It is not widely enough known in the United States just how deeply this thinking penetrated European public discourse, but it is emblematic that the editorial quoted above from the very Social Democratic Die Zeit did not criticize the Schröder government’s tax cuts. It warmly approved of them, and even justified them with the following categorical statement, which could have been taken from a US Chamber of Commerce policy paper: "There’s no doubt about it: The powers of growth in the economy will be strengthened thanks to a lower tax burden, German companies will become even more competitive, and foreign investors will no longer recoil before high German taxes. All that improves the prospect for new jobs."

With the intellectual battlefield almost entirely ceded in this way, what did the center-right do? It demanded even further tax cuts. Thus Friedrich Merz, the most vigorous proponent of smaller government among Germany’s conservative Christian Democrats, mounted attack after attack on the Schröder tax cuts for being too timid. The center-left was for massive, regressive, history-making tax cuts; the center-right was for bigger ones. In her 2005 campaign, Angela Merkel even employed a prominent flat-tax advocate as a key adviser (although she had to distance herself from him as Schröder, trying to rally the socialist base, made hay of this). After the 2009 elections, Merkel’s coalition with the probusiness Free Democrats proposed yet more tax cuts—but these have been put on hold for now, as the focus turns to aggressive deficit reduction.

It is in this context that one begins to understand how galling the current drive for austerity might appear to the average European voter. Revenue was decreased in ways that disproportionately benefited the very wealthy. The promised boom that was then supposed to create growing incomes for all failed to appear. Then the banks were bailed out as the economy fell into recession. And now the bill is being presented to people who weren’t even invited to the party.

Besides the technical economic reality that this is probably the wrong time for contractionary measures, the politics of austerity will be made all the more difficult because of the recent history of regressive tax cuts. This is important to remember because most media will surely portray those who protest spending cuts as unreasonable and spoiled, as coddled crybabies who refuse to recognize that the money simply isn’t there to be spent. It will be important to remember why the money’s not there. As in the United States, a big reason the money is not there is that taxes were cut too much on the richest individuals and corporations.

While policy-makers should focus on growth and employment, not deficit reduction, we will need in the longer term to establish a new political economy in both Europe and America. This postcrisis political economy will have to be based on a reinvigorated philosophy of economic justice and equality, and the policy manifestation of this can be nothing other than a return to the much higher tax rates on very high incomes that existed before the Reagan presidency in the United States and the recent spate of tax cutting in Europe. While tax increases—including for the rich—are on the agenda on both sides of the Atlantic, no one is talking about a fundamental rethinking of tax policy and a return to the tax rates that existed in the United States from the 1940s to the ’70s—incidentally the period of the most broadly shared prosperity in American history. Here, as in so many other areas, our response to the crisis has been meek and unimaginative.

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