With the continuing weakness of the euro, it is tempting for global investors to reject raising expos...
Germany's recent move to reform and reduce its tax system has been hailed as a benchmark for other Continental European governments to follow, but it is in fact just a continuation of a trend that has been established for some time. EMU governments, mostly under pressure to bolster political support, have used the dividends from improved growth to cut taxes, reversing the process, driven by the need to converge ahead of the single currency launch, of fiscal tightening.
The German example will be an incentive for other states to maintain their drive to attract foreign investment and retain skilled labour in an increasingly competitive global environment. There is every indication that most euro-area governments are set to continue to lower taxes, although not engaging in a wholesale re-casting of their tax systems in the way the UK did in the 1980s.
Elections are scheduled in Germany, France, Italy and the Netherlands in the next two years, so it should come as no surprise that fiscal concessions are being granted now, in time for the full benefit of incumbent governments' policies to be felt. Fortunately, they are in a position to be generous - most euro-area governments are running ahead of their medium-term Stability Plan targets.
The focus of fiscal reform indicates the target. Current or envisaged tax plans suggest the emphasis is on reducing direct taxation, particularly household taxes. France is looking at a 1% cut in the two lowest income tax rates (under household income tax) this year; in Belgium, the 3% surcharge on household tax is set to be scrapped. Similar measures are in the pipeline in Spain, Italy, and the Netherlands.
Focusing on the household taxation encourages people to seek work, thus easing labour constraints. In the Netherlands, France and Italy, the aim is to cut taxes for the lowest brackets, but there is also some relief for top income tax rates, despite some political resistance. And there is some way to go. Eurozone nationals might be grateful for new relief, but Euro tax rates are still likely to top those in the UK and US for some years.
For investors, the planned Euro area fiscal stimulus could add on average some 0.25% to 0.33% to GDP growth over the next two years, according to some analysts. It will encourage a shift from work to welfare, boost domestic demand and stimulate the business environment, with positive implications for equity markets. The looser flow of labour and capital around the Eurozone has highlighted the negative implications of high taxes from an investment standpoint.
But there are competing claims for the fiscal windfall. High levels of debt still need to be addressed (Belgium and Italy) and downsizing civil services is a priority across the region. There is increasing tension between the ageing population in Europe, with rising long-term health and social welfare costs, and the fact that few governments enjoy clear majority status in power: old people still vote.
So the economic boost afforded by fiscal concessions will be moderated by rising interest rates. The next hike of 25 basis points from the European Central Bank is expected after the summer break.
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