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Government: A Drag on the European Economy by Sven R. Larson

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Government: A Drag on the European Economy

Over the 20 years from 2000 to 2019, the U.S. economy outgrew the 27-member European Union by a solid 19%, adjusted for inflation. These numbers, which are sourced from Eurostat and the U.S. Bureau of Economic Analysis, are quite impressive, especially considering that during President Obama’s eight years in office, annual growth in gross domestic product, GDP, never reached 3%.

From 1996—the first year with EU-specific macroeconomic data—to 2019, the U.S. economy saw 17 years of 2%-or-higher GDP growth. By contrast, the EU GDP exceeded that level only 13 times. In the last ten years before the pandemic broke out in 2020, the U.S. economy expanded at 2.25% per year, on average, with the 27-member EU economy growing at only 1.6% per year. 

From 2010 to 2019, U.S. unemployment averaged 6.3%, dropping below 3.7% in the last year before the pandemic. By contrast, the EU economy never dropped below 6.7% unemployment (in 2019) with an average of 9.5%for the entire decade. 

America outperforms Europe

These differences between America and Europe are significant, and should be the subject of debate in Europe: what is it that the Americans are doing that Europeans could do better? Over time, even small differences in economic growth compound into large differences in the standard of living. Figure 1 shows how this works: it starts in 1995 with, respectively, $100 worth of GDP in the U.S. economy and €100 worth of GDP in the EU economy. Each amount of money then grows with the real, annual growth rates in the two economies:

Figure 1

Sources of raw data: Eurostat (EU); Bureau of Economic Analysis (U.S.).

By 2019, again the last year before the pandemic, the $100 in America had grown by almost 79%. The same amount in euros had grown by just over 50%. 

There are many candidates for explaining this difference, but there is one that stands out compared to all the others: the size of government. Between 2010 and 2019, government spending in the European Union was equal to 48.3% of GDP, on average, compared to 37.1% in the U.S. economy. 

This difference is big enough to explain the Atlantic economic growth gap, but the impact of government on economic performance is also visible within the EU. In 2016-2019, Belgium, France, and Sweden, three countries with a government that consumes 50-56% of their economies, experienced real GDP growth rates of 1.6-2% per year. During the same period of time, Lithuania, Poland, and Romania, whose governments equal 34-41% of GDP, had growth rates between 3.8% and 5.2% per year. 

More generally, in 2019: 

  • In the eleven EU member states with a government at 45% or more of GDP, the economy grew on average by 1.8%;
  • In the nine countries where government accounted for 40-45% of GDP, economic growth reached 2.6%, on average;
  • In the seven countries where government spent less than 40% of GDP, the average growth rate was an impressive 4.25%. 

In other words, it is clear that the larger government grows, the more slowly the economy expands. However, there are exceptions. Croatia, where government spends an average of 46.5% of the economy, GDP expanded by more than 3.1% per year (adjusted for inflation) in 2016-2019. The Hungarian economy, where government is similar in size, grew by 4.1% per year. 

Government: central economic planning

Government has a negative impact on the economy through spending, taxes, and its budget deficits. The most hard-hitting impact does not come through taxes, as conventional wisdom suggests, but through spending. The reason for this—rarely explored in the economics or public policy literature—is that government operates under a form of central economic planning. Its outlays are not based on the mechanisms and prices of free markets: instead, its spending is governed by ideological preferences, which determine what money is spent, where, and when.

There are plenty of examples of how this central planning works, and its negative effects on the economy. One of the less explored is mass transit, which is often touted as an area where government holds an inherent advantage toward the private sector. In real life, that is not the case. According to Randal O’Toole, an infrastructure expert with the Cato Institute, the socialization of American mass transit in the 1960s led to a staggering 50% decline in ridership per transit employee, an inflation-adjusted tripling of the cost per transit trip, and a 25% drop in the number of trips per resident.

These findings of O’Toole’s are not in any way tied to the American economy. His observations can easily be applied to Europe as well. Better still: the inefficiencies that O’Toole finds in mass transit are not unique to that sector either. For example, government misallocates resources in health care; sometimes the effects of those misallocations are referred to as “lack of timeliness” in delivering services. 

Government’s mismanagement of health care is more commonly known as “rationing” or “waiting lists.” The outcomes of this mismanagement are sometimes life-threatening, as patients with serious medical conditions are forced to wait longer than is medically advisable. However, waiting lists cause problems even for patients whose conditions are not potentially deadly. 

The rationing of elective surgery in countries with single-payer health care can leave patients in need of knee surgery waiting for up to 200 days. Their ties to the labor market weaken accordingly, but the erosion of labor skills is only one price that big-government economies have to pay for their inept governments. In Sweden, owners of small businesses are so frustrated with the government-run health care system that they resort to buying private health insurance for their employees

Despite a government monopoly that, since the 1950s, has promised a full coverage system of medical services on taxpayers’ tab, health care rationing is now so bad that private employers buy on the free market what they already paid for but aren’t getting with high taxes.

The cost of private health insurance under a single-payer system is a form of red tape. It is comparable to the costs for supplementary private services in other areas where government fails to deliver on its promises: private security where police cannot keep crime in check; private education where public education falls short of its promises; private income insurance where tax-paid benefits do not deliver.

By being forced to plug the holes in the titanic government with their own money, employers have less money to spend on improving and growing their businesses. Households have less money to spend in their local economies. Together with the efficiency losses through central economic planning, this red-tape mark up on taxes contributes to a significant drag on big-government economies. A classic study from 2003 by three economists at the European Central Bank reported remarkable efficiency losses in governments across the Western world. If their findings were translated into policy reform in the hardest-hit European countries, there would be potential for Europe to compete with the United States in terms of economic growth. 

The burden of high taxes

While government spending inflicts the most damage on the economy, taxes are not insignificant. Here, again, the U.S. comes out more competitive than its European counterpart, and it is not a new problem. While the tax burden on the United States economy has only grown modestly since the 1960s, the picture is quite different for Europe. A review of the OECD (Organisation for Economic Co-operation and Development) tax revenue data from 1965 for 15 European countries (the OECD does not publish data for all EU member states that far back) shows that the European tax level was comparable to the U.S. in the mid-1960s. Then taxes started rising in this core group of EU member states: by 1974 taxes exceeded 30% of GDP; in 1983 the ratio reached 35%.

In 2019, six EU member states had taxes at or above 50% of GDP: Belgium, Denmark, Finland, France, Greece, and Sweden.

For the past 20 years, European governments in general have taxed their economies 10-12 percentage points higher, as a share of GDP, than is the case in America. However, the impact of high taxes is a bit more complicated than the impact of government spending. The tax rate is only partly indicative of how a tax affects the economy, especially at the corporate level. A business may face a steep income-tax rate, but if the tax code comes with generous deductions for all sorts of itemized expenditures, that burden becomes a lot lighter. Conversely, countries with lenient taxes on corporations may impose heavy tax burdens on individuals, driving up the cost of labor for employers.

Taxes have a more direct and linear effect on the economy through family finances. The value-added tax, VAT, a European favorite, brings in about 26% of total tax revenue in the EU. It is also burdensome, adding to the cost of consumer spending across the entire economy. Americans find it hard to believe that in some EU countries there is a “sales tax,” or VAT, on theatre tickets or even apartment leases. 

The taxes on consumer spending are, of course, paid out of household incomes that have already been subject to income taxes. While those rates vary across the EU, from a low, flat rate in Hungary to more than 50% marginal tax in Sweden, the combination of high income taxes and high consumption-based taxes is generally a drag on the European economy.

So long as government spending and taxes remain lower in the United States, it will continue to outperform Europe economically. However, that may change, and the reason can be found in excessive American budget deficits. Those deficits, plainly, are not sustainable. As government keeps borrowing money to fund its deficits, it inevitably collaborates with the central bank to keep interest rates low. As rates remain low for an extended period of time, investment incentives get skewed. This leads to misallocation of capital, especially an over-investment in financial markets, and often real estate. 

Bluntly, it becomes easier to make money in financial markets than underlying fundamental economic variables would merit. Over time, this reduces the aggregate productive value of capital in the economy, which eventually leads to lower labor productivity and slower overall economic growth. 

It is possible that this effect on productivity has already begun taking a toll on the U.S. economy. However, even if it has not, it is likely to do so to a larger extent than in Europe. While debt-to-GDP ratios vary across Europe, from a minuscule 8.6% in Estonia (2019) to a monstrous 181% in Greece, the EU average is at 77%. This is well below the U.S. federal debt-to-GDP ratio, which currently stands at 129%. 

Another price for low interest rates, driven by monetary expansion, is inflation. At 7% for 2021, the rate of price increases is now taking a toll on economic activity across America. The Federal Reserve has responded by reversing its monetary policy: instead of accommodating budget deficits, it is now returning to a less expansionary position. This has already led to rising interest rates on government debt; as higher rates work their way out in the economy, businesses and consumers will find it more difficult to obtain and maintain credit. 

Over time, higher interest rates will help restore investment incentives in the U.S. economy, but before that happens they will have a mild negative effect on economic activity. This will happen primarily through a dampening of consumer spending, but a secondary effect will be higher costs of government debt. This can lead to attempts by Congress to raise taxes. 

Does this mean Europe will catch up? As the American saying goes, the jury is still out on that one. While government debt is less of a problem in the EU, its taxes are already high and growth-stifling government spending is large. None of this is going to improve without significant, structural reforms to permanently reduce the size of government. Until such reforms happen, the U.S. economy is likely to stay ahead, albeit narrowly.

Sven R. Larson is a political economist and author. He received a Ph.D. in Economics from Roskilde University, Denmark. Originally from Sweden, he lives in America where for the past 16 years he has worked in politics and public policy. He has written several books, including Democracy or Socialism: The Fateful Question for America in 2024.


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