Digging into France’s fiscal mess

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France finally has a government — for now. Michel Barnier, one of France’s most experienced politicians, former European commissioner and onetime chief Brexit negotiator, has put together a team with threadbare support amid the parliamentary wreckage of snap elections in the summer.

They face the immediate hurdle of passing a budget, with no clear path to a fiscal programme that a legislative majority will accept. Paris has already had to ask Brussels for an extension of the deadline to submit its deficit and debt reduction plan under the EU’s new fiscal rules.

And, as my colleagues reported this week, investors are getting worried: the yield demanded on French sovereign borrowing converged with Spain, at about 0.8 percentage points per annum above German government borrowing costs. This morning, it has even edged above it.

This public finance challenge has been in the making for some time. France is a curious outlier among its peer countries in two interesting ways. First, while the rest of the Eurozone largely contained or reduced public debt-to-GDP ratios in the previous decade, the French government’s debt burden kept drifting upwards, as the chart below shows.

Second, this divergence, which started around 2013, was not because of slower growth: France has done about as well as the Eurozone average over the past few decades. Instead, it was because the gap between the French deficit and that of other Eurozone governments widened from typically about 1 per cent of GDP before 2013 to 2 per cent or more for the past decade or so. This divergence reappeared after the pandemic, when the French deficit seemed stuck above 5 per cent while many other Eurozone governments have kept shrinking theirs.

How did it come to this? To identify what is behind this long-term budget slippage, note a different way in which France is an outlier: it has long had some of the largest public spending and the largest public tax take (compared with the size of its economy) of almost every European country.

In 2022, the government spent more than 58 per cent of French GDP, which was 8 percentage points more than the Eurozone average and 9 percentage points more than the EU as a whole. The biggest part of this gap was accounted for by high spending on social protection, a category that varies widely across Europe. In the terse language of the EU’s statistics agency:

While social protection represented the most important area of general government expenditure in 2022 for all the EU countries, a wide variation was observed among the EU countries. Government social protection expenditure as a percentage of GDP varied from 7.5% of GDP in Ireland, 10.1% in Malta, 11.8% in Cyprus and 12.7% in Estonia (as well as 11.1% in Iceland among EFTA countries), to 23.8% of GDP in France, 23.6% in Finland and 21.9% in Italy.

Most of Europe spends a lot on social protection, it has to be said, but on average 4 per cent of GDP less than France. The question, however, is how much this difference has changed — and so how much such spending can be blamed for the worsening of France’s public finance gap with its peers. The chart below shows how the French spending gap (compared with its peers) has evolved over time, separated into the big categories of public expenditure.

Note that the overall spending gap has increased by about 2 percentage points since just before the global financial crisis. Of this, only a little can be attributed to social protection (in other words, this has evolved — increased — by about almost the same on average elsewhere). The gap in health spending between France and that of its peers has also barely increased. Instead, France now spends about 1 per cent of GDP more than its peers on “economic affairs” — this is spending on industry, labour markets, energy and so on, marked in red and green in the chart — where before 2012 it spent about the same. Drilling further down, it seems a good chunk of this relates to labour markets (the Eurostat category is “General economic, commercial and labour market affairs”). The rest is made up of small increases along a lot of different categories.

What about the revenue side? Revenue-to-GDP has gone up both in France and in Europe generally. But in the first decade of the century, France raised 5 to 6 per cent of GDP more than the European average, while in the past decade it has been 6 to 7 per cent. This change is, if anything, stronger when looking at taxation only. And strikingly, France used to take in slightly less in taxes on income than the European average and is now taking in more. (See chart below.) Both individual taxpayers and companies are contributing significantly more in income and profit taxes than they used to.

What does all of this add up to? It does not give much credence to the leftwing attack line on President Emmanuel Macron that he has damaged public finances by cutting taxes. Today’s challenge has arisen because of a long-term worsening of the deficit (relative to peers) worth about 1 per cent of GDP — which breaks down to a 2 percentage point worsening due to spending and a 1 percentage point improvement in the tax take.

And there is an intriguing underlying narrative suggested by these numbers. A big source of the spending drift, relative to European peers, seems related to labour markets. At the same time, direct tax revenue from individual and corporate economic activity has gone up significantly — roughly since the beginning of the labour market reforms started when Macron was still an economy minister. If France’s ever-improving employment numbers are anything to judge by, these reforms have worked very well — and it looks like they have done some good for the public finances too.

Jean Pisani-Ferry, an influential French economist and sometime Macron adviser, has said that the president’s “gamble” — that reforms could improve employment and this would fix the public finances — has failed. But I’m not so sure. It may have succeeded, but it has not been enough, given the other stresses on the public purse.

The question, then, is what to do. There is much talk today of tax rises in France. But as we have seen, the tax take has gone up. And it looks like growth-friendly reforms have, in isolation, been fiscally helpful. So maybe it is still worth looking for ways to reduce both spending and the taxes most damaging to economic activity (such as a high tax wedge on labour income). Could France be where Arthur Laffer just may have a point?

Other readables

• The EU needs a foreign economic policy, says Mario Draghi. I reflect on what that might look like.

• The Washington Post has an excellent mapping out (literally) of eight paths to victory (or seven — and one path to a tie) in the US presidential election.

• Kamala Harris promised a pragmatic economic philosophy in a speech yesterday.

• The EU is a “Barbieland”, a new European Council on Foreign Relations study contends — a place that is not the utopia European political leaders believe it to be. The study highlights the political “‘under-participation’ in Europe of groups such as non-white and Muslim Europeans, central and eastern Europeans, and young EU citizens”.