Fiscal Union in Europe? Redistributive and Stabilising Effects of a European Tax-Benefit System and Fiscal Equalisation Mechanism

The current debt crisis has given rise to a debate about deeper fiscal integration in Europe. The view is widespread that moving towards a ‘fiscal union’ would increase the ability of the currency union to maintain economic stability in situations where some member states are affected by economic shocks. At the same time the idea of deepening fiscal integration raises a number of concerns. In particular, residents of high income countries fear that more fiscal integration may lead to massive redistribution in favour of low income countries. As a result, taxes in high income countries could increase and undermine incentives to work and invest. Higher transfers in low income countries could also distort incentives to work. While deeper fiscal integration in Europe is thus a widely debated issue, little is known about the economic implications of sucha move. This paper contributes to filling this gap by analysing the economic effects of two key elements of fiscal integration, i) the introduction of an EU-wide integrated tax and transfer system which partly or fully replaces the existing national systems and ii) the introduction of a system of fiscal equalisation. These reforms would be far reaching, but they do reflect the widespread view that radical steps towards more fiscal integration are necessary. Even if these reforms seem unlikely to find political support in the short term, it is important to understand why this might be the case and whether much is lost if fiscal integration fails to proceed into this direction. In this paper we study the economic effects of introducing two elements of a fiscal union: Firstly, an EU-wide tax and transfer system and secondly, an EU-wide system of fiscal equalisation. Using the European tax-benefit calculator EUROMOD, we exploit representative household micro data from 11 Eurozone countries to simulate these policy reforms and to study their effects on the distribution of income as well as their impact on automatic fiscal stabilisers. We find that replacing one third of the national tax and transfer systems by a European system would lead to significant redistributive effects both within and across countries. Our analysis confirms that labour supply incentives may be undermined in both low and high incume countries. The EU system would improve fiscal stabilisation especially in countries which cannot rely on national automatic fiscal stabilisers because they face borrowing constraints while such constraints are unlikely to occur at the EU level. The EU system would absorb between 10 and 15 per cent of a macroeconomic income shock. Introducing a horizontal fiscal equalisation system based on taxing capacity would redistribute revenues from high to low income countries. The stabilisation properties of this system, however, are ambiguous. This suggests that not all forms of fiscal integration will improve macroeconomic stability in the Eurozone.