Eurozone Watch

Third part of our series on Sarkozy and Europe

After his election as a president, Nicolas Sarkozy did not lose any time pushing forward with his economic and fiscal policy agenda. Even before the first round of the parliamentary elections this week-end (in which Sarkozy's party did extremely well), a number of legislative initiatives have been prepared to be pushed through the Assemblée Nationale over the summer. According to Sarkozy, France needs now a "fiscal shock".

Among the measures brought forward by Sarkozy are the following (initiatives with little or no macroeconomic effect or costs have been omitted):

• Overtime payment: overtime payment will be excluded from taxes and social security contribution. For full time employees, this applies to all voluntary hours in excess of the original 35 hours work-week. For part-time employees, tax free overtime may only reach 10 percent of the regular work time. In addition, the companies' social contributions for overtime will also cut. However, this money does not necessarily end up with the business sector: At the same time, the legal overtime surcharge small companies have to pay will be increased from 10 to 25 percent.
• Working students: Students will be exempted from the income tax
• Mortgage subsidies: New home buyers will be allowed to deduct mortgage payments up to a certain amount from their taxes for the first five years after having acquired a new house or apartment.
• Inheritance taxes will be cut.
• Limit on direct taxes: No one will have to pay more than 50 percent of direct taxes (social security contributions excluded), starting on January 1, 2008.

All in all, the costs of these proposals add up to probably as much as € 15 bn, or 0.75 percent of French GDP. Measures introduced into the legislative process last Wednesday already amount to € 11 bn. So far, Sarkozy has not presented any ideas of how to finance this spending spree, but his call for a "fiscal shock" and his attacks on the Stability and Growth pact hint that he is going to increase the government deficit.

To judge these measures, the important question is: What does France really need at the moment? Our regular guest contributor David Milleker, chief economist of Union Investment, has long argued that France needs some supply side reforms bolstering the profitability of the French corporate sector (see his contribution for the Financial Times Deutschland's website here or his comment to our post on the "TVA sociale" here). David used to argue that the profitability of the French corporate sector is low in international comparison and that thus investment is low. Since supply side reforms tend to suppress demand in the short run, David has been in favour of a combined approach of supply and demand policies for France.

A look at the investment ratio in France supports David's analysis of problems of the French business sector (see figure). Investment in equipment as a share of GDP has long been trailing behind the rest of EMU. In addition, while investment has picked up sharply in Germany, it has only risen slightly in France. This might be an indication that the French corporate sector indeed is not in a very good position, most likely because the French economy has lost price competitiveness vis-à-vis Germany in the past years of aggressive German wage restraint.

Thus, if Sarkozy would use a strategy of combined supply and demand policies, improving competitiveness while bolstering domestic demand, there would not be much to object. If he would for example introduce his "social VAT", increasing the VAT tax while cutting social security contributions (as the Germans have done) and at the same time use his fiscal policy to bolster demand so that the VAT shock does not hit the domestic economy, this might amount to a wise strategy. One could also make the point for relaxing rules about employment protection and at the same time hand workers a tax cut, as this would also improve supply conditions while limiting the short-term negative outfall on demand.

However, Sarkozy's program does not meet this aim. There is basically nothing in the proposal which improves France's competitiveness. While Sarkozy has said that he would replace the large number of different labour contracts in France by one which provieds less protection, nothing to this end has been introduced in the legislative process and there are no specifics about his plan known yet. It remains to be seen if Sarkozy will ever come back to this project. However, even if employment protection is slightly loosened, this will provide little help to France's ailing productivity.

The proposed cut in taxation on overtime is set to be redistributed to a large share towards the households as Sarkozy is at the same time increasing the mandatory overtime pay. The taxation limit to 50 percent will most likely only apply to very wealthy individuals and will not help the corporate sector much. Relieving working students from income tax will most likely lead to new strategies to have someone counted as a student, not to lower labour costs. Most students do not earn enough to profit from this exemption anyway. The cut in marginal taxes on overtime will increase the French's willingness to work beyond their 35 hour week, but labour shortages have not been a problem for the French economy over the past years, so the positive macroeconomic effect of this measure should be small. In fact, the cut in taxation for overtime payment might even jeopardize the Lisbon target of increasing the employment ratio: Under the new rules, relative to the status quo, it becomes more attractive having the old employees working longer hours than hiring new workers. In the context of women's participation in the labour market, some extra hours for the husband might now seem more attractive than women remaining in the labour force.

In addition, the demand stimulus from Sarkozy's program is hard to evaluate. The tax deductability of mortgage payments might well have quite a high multiplier: As the new tax rules might lead to an even stronger house price increase as hitherto, this might also give another boost to the French consumption which is driven by the wealth effect. However, one should note that this increases the risks for a bursting of the bubble in the real estate market and serious consequences for the economy further down the road. The cuts in the inheritance tax and the limit on overall direct taxation in contrast will only have very limited effect.

Thus, overall, it is safe to say that Sarkozy's measures so fay rely only on demand stimulus, something which the French economy does not really need given the already strong demand in the rest of Europe and the still robust growth in France (the OECD sees French GDP growth at 2.2 percent both for this and next year). France's problems, on the other hand, are not really tackled. For the rest of the Eurozone, Sarkozy's policies are quite dismal: France is now fuelling the boom exactly at a moment in which the ECB is debating on how high it has to raise the interest rate in order to prevent the European economy from overheating. This is exactly the kind of fiscal policy a monetary union does not need.

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