Concept note The fiscal compact for social cohesion. European view

Theme 1: Fiscal compact. EUROPE Concept note The fiscal compact for social cohesion. European view First Latin American Social Cohesion Conference. A strategic priority in the European Union-Latin American partnership Nuria Badenes Plá PROGRAMME FOR SOCIAL COHESION IN LATIN AMERICA

Concept note The fiscal compact for social cohesion. European view First Latin American Social Cohesion Conference. A strategic priority in the European Union-Latin American partnership Santiago, Chile, 22 nd and 23 rd January 2015 Nuria Badenes Plá Instituto de Estudios Fiscales

This publication was prepared with the assistance of the European Union. The content thereof is the exclusive responsibility of the author and should not be deemed to reflect the opinion of the European Union.

Index 1. Introduction... 5 2. Theoretical or reference framework... 7 3. Internal comparative perspective of the EU... 9 4. Remaining challenges and future perspectives... 11 5. Topics for discussion... 13 Bibliography... 15 Annexes.... 17

1. Introduction The welfare state attained thanks to a public sector with a large presence in the economy has retreated in Europe as a result of the crisis. At a moment in which unemployment is emerging as an important problem, various difficulties are arising related to the sustainability of a system that requires social protection now more than ever. This makes it necessary to consider the role of fiscal policy, both in terms of expenditure and revenue, to search for alternatives other than taxing income from work, and to reflect on short-term solutions to the most pressing problems and long-term solutions to support lasting welfare. 5

2. Theoretical or reference framework This section defines the concepts needed to understand the results described in the third point of this note. Income quintile share ratio: Ratio of the income concentrated in the hands of richest 20% (quintile) of the population (numerator) to that of the poorest (denominator). EUROSTAT calculates it in terms of equivalized disposable income, i.e. taking into account family size and composition and deducting tax payments. The minimum value of this ratio is the unit at which there is no inequality between the richest and poorest quintiles. The value obtained indicates how many times higher the richest quintile s income is than the poorest quintile s. Gini coefficient: Measures the area between the Lorenz curve 1 and the diagonal line representing perfect equality. It ranges from zero (no inequality because all agents have the same income) to one (a single agent concentrates all income). EUROSTAT calculates the Gini coefficient of equivalized disposable income. Current taxes on income, wealth % of GDP. Coefficient between all periodic taxes levied on income and wealth, whether in cash or in-kind (included in code D.5 of the ESA2010 classification) in relation to the country s GDP. This is the tax burden related exclusively to income and wealth. Implicit tax rate on labour income: Sum of all direct and indirect taxes and employees and employers social contributions levied on employed labour income divided by the total compensation of employees working in the economic territory, plus total wage bill and payroll taxes. It is calculated solely on employed labour, i.e. it excludes taxes levied on social benefits and pensions. It should be interpreted as the average effective tax burden on labour income in the economy. At-risk-of poverty or social exclusion rate: Represents the ratio of the total number of people at risk of poverty or severe material deprivation or with low work intensity compared to the total population. People at risk of poverty are those with an equivalized disposable income of less than 60% of the equivalized median income. Material deprivation is established based on indicators related to economic pressure and access to durable goods. Severe material deprivation refers to people with living conditions seriously constrained by lack of resources and inability to afford at least four of the following nine items: i) to pay their rent or utility bills; ii) to keep their home adequately warm; iii) to face unexpected expenses; iv) to eat meat, fish or an equivalent protein every second day; v) a one-week annual holiday away from home; vi) a car; vii) a washing machine; viii) a colour television; ix) a telephone. People living in households with very low work intensity are those between the ages of 0 and 59 who live in households where the adults (aged 18 to 59) worked less than 20% of their total potential working time during the previous year. In-work at-risk-of-poverty rate: The proportion of people who are working and have an equivalized disposable income below the poverty threshold, which is set at 60% of the median equivalized disposable income (including social transfers). 1. Lorenz income curve: graphical representation of the ratio between cumulative income and cumulative population, ranging from the population with the lowest level of income to that with the highest. It makes it possible to compare the cumulative percentage of wealth corresponding to each x% of the cumulative population. If the cumulative population and income coincide, the Lorenz curve is a diagonal line. The greater the deviation from the diagonal, the greater the inequality in the income distribution. 7

Nuria Badenes Plá Expenditure on social protection per inhabitant: This expenditure includes social benefits consisting of cash or in-kind transfers to households or individuals to relieve the burden of a defined set of risks or needs; it includes administration costs, or the costs of managing or administering the social protection scheme, other miscellaneous expenditure by social protection schemes (payment of property income and other). Correlation: This is a way of measuring the dependence between two variables in a bi-dimensional distribution (x,y). It is defined mathematically as the coefficient between the covariance between x and y, and the product of the typical deviations of x and the typical deviation of y. A positive sign (indicates) that the two variables are moving in the same direction (opposite). It takes values of between -1 and 1, and the greater the absolute value, the greater the direct ratio (positive) or inverse ratio (negative) between the variables. It is also typically expressed in terms of percentages. 8

3. Internal comparative perspective of the EU The fiscal policy of European countries has been conditioned in recent years by the eruption of a serious financial crisis which have generated an economic inertia whose consequences can be seen in growth and unemployment levels, and in parameters that show the society s levels of inequality and poverty. At the same time as needs are becoming more pressing, budgetary problems and growth of debt prevents the presentation of budgets that cover all the economic needs considered. Unemployment levels in the EU vary based on worker qualification (see Table 1 in the Annex). On average, greater educational training by workers has not been in the 2008-2013 period a guarantee of immunity from unemployment, as unemployment rates for workers with high levels of training exceed those of workers with lower educational levels. The maximum unemployment values for each year are stable at around 40% for the lowest educational levels and 30% for median and high levels. The countries hardest hit by the crisis are also those with the highest unemployment levels (Greece, Spain and Portugal). The evolution of unemployment is a result of GDP contraction, especially in 2009, although it is also true that all European countries have not reacted equally to the shocks of the crisis. Thus we find that in the post- 2009 years there is a group of countries that maintained negative growth rates (Greece, Spain, Portugal, Cyprus, Slovenia and Italy) while others presented GDP growth rates that exceeded 2%, such as Germany, Sweden, Slovakia, Lithuania, Latvia and Estonia. The crisis has caused European governments to react, and in recent years there have been multiple reforms of fiscal systems by means of both income tax rates and transfers. The higher the debt level and lower the growth rate, the more intense the reforms have been. The measures related to the tax rate for individuals consisted in modifying the brackets and rates, creation of solidarity levies, increasing the tax rate on capital. In terms of expenditure, the reforms have consisted of cutting benefits in either the amount or the duration of retirement and unemployment benefits. 2 Next we will present the situation in Europe between 2007 and 2013 (or the most recent year for which data is available) using data published by EUROSTAT. All the values shown in the tables in the Annex and in the main text are commented. In terms of inequality, the income quintile share ratio (Graph 1 of the Annex) indicates that the richest quintile on average has five times the income of the poorest quintile. The worst values (where the ratio exceeds 7) are found in Romania, Latvia and Lithuania in certain years before 2010, and in Spain between 2010 and 2012. The countries with the best results, with values consistently below 4, are Slovenia, Sweden, Slovakia, the Czech Republic, Finland and Norway. If we measure inequality by the Gini coefficient of equivalized disposable income (Graph 2 in the Annex), which takes into account the entire income distribution and not just the extremes, we find great differences between countries; the minimum inequality values are around 0.23 and the maximums are between 0.35 2. For a detailed analysis of the reforms undertaken in Europe between 2008 and 2012 and the intensity of same, see The effects of fiscal policy on income distribution in Latin America and the European Union (2014). 9

Nuria Badenes Plá and 0.37. Among the countries that in some years reach a Gini of 0.35, we find Spain, Lithuania, Portugal, Romania and Bulgaria; among those that maintain values consistently below 0.25 are Slovenia, Sweden and Norway. No pattern of growth or contraction is observed between the countries considered, as the evolution of each presents different trends. Taxation of income and wealth is the main tool for redistribution by means of revenue. If we compare the percentage of GDP represented by this taxation, the differences between countries are considerable: from minimum values of around 6 points to a maximum of 30 points. Apart from the changes between the years considered, Croatia Romania, Bulgaria and Lithuania show the lowest tax rates compared to GDP, while at the other extreme, Finland, Sweden, Belgium and Denmark 3 are the countries with the highest tax rate by these means. The most recent data for the implicit tax rate on labour income are from 2009 (Graph 4 in the Annex) and show significant differences: a tax rate of 21% in Malta and 42% in Italy, with a median of between 35% and 37% in the EU depending on the countries considered. In terms of poverty (Graph 5), the differences between countries are also significant. The median percentage of the population at risk of poverty in the EU is around 24%. Sweden, the Czech Republic, Iceland, the Netherlands and Norway systemically appear as the countries with the fewest poor people. Bulgaria was the poorest country in 2007 and 2013, but it is also the country that has most reduced its poverty rate, going from 60.7% to 48%. Poland has median values, but it has also experienced a reduction of this rate from 34.4% to 25.8% in six years. Above the median for poverty, we find countries like Portugal, Italy, Ireland, Spain and Greece, which were very hard hit by the crisis. If we analyze poverty among working people (Graph 6), the median values for the EU indicate that 9% of workers are poor. Romania (with a great difference compared to the next country), Greece, Spain, Italy and Poland are, in this order, the countries with the greatest percentage of poor working people; Norway, the Netherlands, the Czech Republic and Finland are the countries with the lowest percentage of poor working people. Lastly, in Graph 7 we analyze the value in euros of social expenditure per inhabitant, with large differences (for example, in 2012 Luxembourg presents seven times the social expenditure per inhabitant of Turkey). Among the countries with the highest expenditure, we find for all periods Luxembourg, Norway, Denmark, Sweden, Switzerland, the Netherlands and Austria. Among the countries that spend the least are Estonia, Latvia, Lithuania, Romania and Turkey. The increase in expenditure per capita of Ireland from 6,098 in 2007 to 9,687 in 2012 is noteworthy. In general, a trend of continuous growth is observed in the expenditure per capita. It may be interesting to compare the correlation between social expenditure per capita and income and wealth taxation. The value obtained in this correlation is positive and very high, as to be expected, at 73% for 2012. This value demonstrates that the countries with the greatest tax burden on income and wealth are also those with the highest per capita social expenditure. 3. Denmark is the country where tax rates on income and wealth represent the greatest percentage of GDP, practically doubling those of the next country, Sweden. 10

4. Remaining challenges and future perspectives The concern over social cohesion in Latin America has made it look on many occasions to Europe as an example to be followed for having achieved acceptable levels of income distribution and poverty. These achievements were the result of striving for a Welfare State in which fiscal policy has played a leading role. The economic crisis in which Europe is immersed, as well as the incorporation of new EU members, has meant that the past scenario is not being maintained at the moment. Europe is not necessarily an example to be followed any longer in terms of results, which can be greatly improved, but it can be an example of the path to attaining it, as once an acceptable situation is attained, it can be attained again. The data for Europe shows countries hit by unemployment and considerable income inequality and poverty levels that are also affecting the employed population which have grown more in the countries hardest hit by the crisis. At the same time, considerable tax rates on income and wealth, in particular on wage income, are observed. The tax reforms undertaken in recent years have tried to address the situation, but it seems there is still a long road ahead. 11

5. Topics for discussion If the current fiscal system in European countries is not capable of providing a solution to the challenges represented by lack of social cohesion, reforms will be necessary. In addition to inequality and poverty, the degree of income polarization (concentration at the extremes) must be addressed because of its implications in terms of conflict. Income taxation, particularly on labour, is a fundamental resource of tax agencies. In a context in which unemployment can thwart tax collection and distributive targets, which depend on this tax base, it is necessary to reflect on alternative bases. Although indirect taxation presents the disadvantage of lack of progressivity, the philosophy of fiscal devaluation (reduction of tax rates on labour and increase of VAT rates) must be considered as an alternative. Environmental taxes must also be considered an alternative means because of the advantages involved in the double dividend (increase in environmental taxation and reduction by other means). The attainment of acceptable levels of inequality and poverty must not retreat in Europe. The policies used to confront this challenge must distinguish between short-term goals and pressing needs, which disappear when the problem is solved, and policies designed to be permanent. 13

Bibliography CEPAL e IEF (2014). Los efectos de la política fiscal sobre la redistribución en América Latina y la Unión Europea. Colección Estudios nº 8. Esteban J, Ray D (1994) On the measurement of Polarization. Econometrica 62: 819-852. EUROSTAT DATA BASE: http://epp.eurostat.ec.europa.eu/portal/page/portal/statistics/search_database 15

Annexes Table 1. Unemployment levels in the population between 25 and 64 years of age by educational level. High: University education. Medium: Secondary education. Low: Primary education or less 2008 2009 2010 2011 2012 2013 Min (high) 9.1 10.1 10.4 10.6 9.3 10 EU28 (high) 16.2 17.1 17.7 17.9 18.1 18.3 Max (high) 29.9 29.4 29.3 31.4 31.9 32.5 Min (medium) 1.4 1.9 2.4 2.2 2.2 2.3 EU28 (medium) 5.6 7.2 7.8 7.7 8.2 8.6 Max (medium) 29.1 28.6 28.9 28.7 28.7 28.1 Min (low) 2.5 4.1 4.1 5.2 4.1 5.4 EU28(low) 9.8 12.8 14.2 14.7 16.7 17.9 Max(low) 40 38.3 40.8 39.4 41.5 40 Source: own based on EUROSTAT data. Note: in addition to the median of the 28 EU countries, it includes the lowest and highest unemployment rates by country in each year. 17

Nuria Badenes Plá Graph 1. Ratio between the equivalized disposable incomes of the last and first quintiles. EU. 2007 2013 Source: Eurostat http://epp.eurostat.ec.europa.eu/tgm/table.do?tab=table&init=1&plugin=1&language=en&pcode=tessi180 18

Concept note The fiscal compact for social cohesion. European view Graph 2: Inequality measured by the Gini coefficient of equivalized disposable income. (2007-2013) Source: Eurostat http://epp.eurostat.ec.europa.eu/tgm/table.do?tab=table&init=1&plugin=1&language=en&pcode=tessi190 19

Nuria Badenes Plá Graph 3. Current taxes on income, wealth % of GDP Source: Eurostat http://epp.eurostat.ec.europa.eu/tgm/table.do?tab=table&init=1&plugin=1&language=en&pcode=tec00018 20

Concept note The fiscal compact for social cohesion. European view Graph 4. Implicit tax rate on labour income. 2009 Source: Eurostat http://epp.eurostat.ec.europa.eu/tgm/table.do?tab=table&init=1&plugin=1&language=en&pcode=tec00119 21

Nuria Badenes Plá Graph 5. Percentage of the population at risk for poverty or social exclusion Source: Eurostat http://epp.eurostat.ec.europa.eu/tgm/table.do?tab=table&init=1&plugin=1&language=en&pcode=t2020_50 22

Concept note The fiscal compact for social cohesion. European view Graph 6. Poverty among working people Source: Eurostat http://epp.eurostat.ec.europa.eu/tgm/table.do?tab=table&init=1&plugin=1&language=en&pcode=tesov110 23

Nuria Badenes Plá Graph 7. Social protection expenditure per inhabitant (in ) Source: Eurostat http://epp.eurostat.ec.europa.eu/tgm/table.do?tab=table&init=1&plugin=1&language=en&pcode=tps00100 24

Consortium led by Coordinating partners Over 80 Operational Partners and Collaborating Entities from Europe and Latin America PROGRAMME FUNDED BY THE EUROPEAN UNION

EUROsociAL is a regional cooperation programme between the European Union and Latin America for the promotion of social cohesion through support for national public policies and the strengthening of the institutions that put them into practice. EUROsociAL aims to promote a European-Latin American dialogue about public policies surrounding social cohesion. Its aim is to contribute to reform and implementation processes in ten key areas of public policy in certain thematic areas selected for their potential impact on social cohesion. The instrument provided is that of institutional cooperation or peer-to-peer learning: the exchange of experiences and technical advising between European and Latin American public institutions. www.eurosocial-ii.eu