Methods of integration

An integration process among a number of national economies is character­ized by the evaluation of benefits and costs. Benefits consist mainly of economies of scale and the internalization of reciprocal externalities.

EU integration has consisted of a collective action for delivering common policies with the characteristics of public or club goods to the member countries. So far, the most important achievements have been: (i) the Single Market, which is an area of free circulation of goods, services, capitals and individuals, separated by tariff as well as non-tariff barriers from the rest of the world; and (ii) The European Monetary Union (EMU), which has deliv­ered the euro as a club good after the fixed (but adjustable) exchange rate agreement established in 1979 by the European Monetary System (EMS) delivered the public good of monetary stability to its members.

Both these achievements have certainly provided the firms and economic sectors of the member states with the advantage of benefiting from economies of scale. The Single Market for internal free trade has spread over larger markets, and the single currency for external trade has signalled the end of expectations of exchange rate variations as well as the likely upgrading of the euro to the rank of second international reserve currency, competing with the US dollar. In addition, the EMU has given the participating countries the advantage of the internalizing the externality of frequent devaluations which caused considerable macroeconomic instability in Europe during the last decades. The cost of the EU integration process is more difficult to assess. In the past decades, an increasing heterogeneity across the EU member states has resulted from diverging fiscal policies due to public primary deficits and public debt accumulation.

However, two issues emerged connected to the lack of EU centralization of fiscal policies. First, the deflationary bias caused in the macroeconomic gov­ernance by the tight European Central Bank (ECB) monetary policy and by the restrictive orientation imposed on national fiscal policies by the SGP. Second, the absence of any internalization of the externalities provoked by the very different levels and composition of both income taxes and social expenditures.

In addition, the most recent EU enlargement is likely to result in further costs in the EU integration process. First, the EMU as a club good could be burdened by congestion costs. The higher average inflation of the accession countries might undermine the EMU monetary-fiscal policy mix as an ECB interest rate vote could result in a level that is too high for the incumbent economies’ macroeconomic equilibrium (de Grauwe, 2003). Second, the ex­tension to the accession countries of the EU common policies devoted to foster real convergence in the backward areas, could magnify the redistributive problems stemming from externalities. In particular, the welfare state reforms undertaken in the EMU countries are bound to take into account the struc­tural change in the labour markets which will be created by the migration of workers coming from the Eastern countries.

The interpretation of the EU integration points to two approaches to inte­gration: supranationalism and intergovernmentalism. The supranational approach to integration tends to pursue the idea of a European entity, defined in terms of social and cultural identity, which should be translated into a political and economic being. The intergovernmental approach instead con­ceives integration mainly as the coordination among national interests. In Table 16.1, various features of the EU institutions are classified under these approaches.

Table 16.1 Features of EU institutional bodies

The balance of power in the integration process has been proceeding as a ‘pendulum’ (Wallace, 1996). Sometimes, intergovernmentalism, mainly aimed at finding a mere compromise among the conflicting national interests, has prevailed and so the Council has gained power vis-a-vis the Commission. On other occasions, supranationalism has been promoted by allowing a some­what undefined common interest to prevail over the arrangement of national interests. Despite its composition on a national basis, like the Council, the ECJ has aptly endorsed the supranational attitude towards the EU integration process, in line with the scope of its responsibility. This was especially evident during a long stagnation of the integration process, in the 1970s, when political will was lacking and decision making impaired. In fact, after the Luxembourg compromise de facto impeded the regular application of the majority rule, decisions were made only after long-drawn-out negotiations whereby consensus was finally obtained by eliminating national vetoes in the Council.

In 2002 the constitutional design of the EU integration process was ad­dressed by the Convention on the Future Europe, which produced a Draft Treaty establishing a constitution to be submitted to the Intergovernmental Conference on the Future of the Union.¹ On the one hand, the convention can be regarded as an expression of the intergovernmental method. First, through its procedure: a constitution is not usually provided by an international treaty, although the existing treaties are regarded as having a constitutional status. Second, the EU’s identity, formerly seen as a ‘process creating an ever closer union’ and based on the European Community and its common policies, as stated in Article 1 of the TEU, has become an agreement on policy coordi­nation and on a limited number of ‘competences’ attributed to the EU by the member states. Third, if a state is defined by the relationship between repre­sentation and taxation, then the failure to reach unanimous agreement on the transition to majority voting on fiscal matters is a clue to the intergovernmen­tal grip over political integration.

Modes of integration: enhanced cooperation

Special attention has recently been given to the idea of enhanced cooperation, in that a proposed common policy could be endorsed and pursued by a group of member states, as a second-best solution, rather than waiting for the first best from participation by all member states. The veto power on the launch of an enhanced cooperation, conferred by the Amsterdam Treaty on non-partici­pating countries, has been removed by the Nice Treaty, as decisions and commitments taken in an enhanced cooperation are not part of the acquis communautaire, and so are not binding for the opting-out member states. When a common policy is decided by a subset of countries, the opting-out member states lose in terms of vote-trading power as well as in their power to block future initiatives.

The question is whether this should be acknowledged as a damage requir­ing compensation. In addition, should the opting-out countries be given the right to be consulted on the enhanced cooperation dealings, since they retain the option of a late access and might experience spillovers following its implementation? Moreover, a late participation could be conceived as free­riding wait-and-see behaviour, opting for participation if there are net benefits. A possible solution to the compensation dilemma is to compare enhanced cooperation with the two extremes of no common policy (decentralization) and cooperation among all member states (centralization).

This reasoning suggests that the more profound question about this method of integration deals with the tradeoff between the subsidiarity principle and the commitment of the treaties to a closer union. Were this principle to be applied, a stop to further integration would become an advantageous policy for member states favouring the status quo. If instead the viability of the process of integration prevails over the subsidiarity principle, then the correct procedure would be to allow enhanced cooperation and then negotiate to solve the compensation issue at the moment of the delayed accession. There was no compensation for those member states which declined to take part in the two major cooperative enterprises put forward outside the EU framework: the monetary integration process from the EMS to the EMU and the Schengen acquis from the Agreement to the Convention and its inclusion in the Amster­dam Treaty. Monetary union was initiated by a subset of countries which were subsequently joined by other member states, when it became evident that the exchange rate agreement was conveying the benefit of a slow but clear deflationary trend. This enhanced cooperation was successful in aggre­gating an increasing number of member states in the cooperative effort of establishing the public good of monetary stability. However, in the 1990s the prolonged tightness of both monetary and fiscal policies imposed by the need to comply with the Maastricht Treaty and participate in the EMU was probably responsible for the hysteresis effect in the EMU labour markets that yielded structural unemployment. The Schengen Agreement was signed by the found­ing EC member countries (with the exception of Italy), to eliminate controls at their common borders and allow free circulation. Many other countries joined later, including two outsiders: Iceland and Norway. The UK and Ireland never joined, but have taken part in some activities after the Schengen acquis was included in the Amsterdam Treaty. The latter status applies to the accession countries on a temporary basis. In addition to the enhanced cooperation initia­tives within the EC, this mode will also apply to the second and third pillars. The CFSP includes the organization of a common military force, either under the Western European Union (WEU) or linked to the North Atlantic Treaty Organization (NATO). Despite the pure public good feature of defence, the paradox might be that a subset of member states launches an initiative for an army with positive spillovers over the remaining non-contributing countries which are opting out for political reasons.

The decision to abolish the veto power by the opting-out member states makes enhanced cooperation a sort of substitute for the extension of majority voting to the most controversial EC areas (tax system, social policies and environment).

Modes of integration: open coordination

Open coordination differs from enhanced cooperation in that all member states are required to participate from the beginning. This mode consists in the formulation of objectives and procedures aimed at boosting convergence to a common standard in a particular domain.

The preamble of the Treaty of Rome places a common standard for labour and welfare conditions among the goals of the EC. The social policy started in the early 1960s was funded by the common budget with limited, ad hoc funds according to a ‘key’ included in the treaty, and was especially con­cerned with immigrants’ right to non-discrimination. Yet the European legislation of the Single Act and the Maastricht Treaty was concerned solely with competition policy, by stimulating deregulation, liberalization and priva­tization processes. Social policies² aimed at the catching up of disadvantaged or stagnating areas (cohesion funds and structural funds) have been incorpor­ated into the social cohesion policies. The convergence process was hampered by the depressed growth environment surrounding these policies. In 1999 the launch of the EMU definitively abolished the autonomy of national monetary and exchange rate policies, a process started by the need to comply with the EMS fixed exchange rates. Alternatively, the limited room for manoeuvre left to national fiscal authorities by the constraints of the SGP has undermined macroeconomic stabilization after negative demand and supply shocks, with negative implications for the EU growth rate. The Lisbon European Council (2000) then encouraged growth by the implementation of a series of microeconomic policies coordinated by Brussels and pursued at the national level. Education, training, research and development, social protection and social inclusion were declared appropriate domains for the implementation of open coordination. The aim is to commit national governments to ‘modernize the European social model’ by voluntary cooperation through the exchange of plans for active policies with such objectives as promoting equality of opportunity in the labour market, employability (to improve skills and labour incentives), entrepreneur spirit (to foster propensity to risk and investment by deregulation), adaptability (lower job protection), and common standards as for social inclusion.

In the future, these active policies put forward by a subset of the EU member states to improve the employment rate might be complemented by the revision of the rigid SGP rules. Since these rules are part of the European legislation and thus overrule national legislation, any attempt by countries who promote open coordination are induced to rely more on further deregula­tion than on re-regulation processes aimed at increasing employability by training programmes which might conflict with the 3 per cent deficit/GDP ceiling.

Mutual recognition versus harmonization

The principle of mutual recognition was introduced by the ECJ with the Cassis de Dijon judgment in 1979, which allows every good legally produced in one member state to circulate freely in all others. This principle has mainly been used for fostering trade in domains where information is available and consumer sovereignty may prevail, whereas harmonization is pursued when, due to health and safety reasons or severe asymmetric information, the matter cannot be left to the market. Mutual recognition is unlikely to evolve in complete harmonization because in many domains where sunk costs are considerable, the national interests of the member states mutually conflict and each country refrains from complying with the adoption of another country’s national standard as the EU common standard.

In the area of labour market institutions, partial harmonization has been endorsed by the EP encouraging a threshold as for the minimum wage, working day length, vacation periods and so on. The Commission is trying to harmonize the regulation of private pension funds in terms of transparency, portfolio management and precautionary requirements. The Social Charter of 1989 states a commitment by member states on health and safety issues. However, to enable the smooth development of the ‘negative’ integration consisting of the abatement of any obstacle to the free circulation of goods, services, capital and workers, there has been a virtual stasis in the harmoniz­ation on social protection. Mutual recognition in the labour market would mean allowing on the same market the existence of different wages and regulations linked to the rules existing in the worker’s country of birth or residence rather than according to the worker’s country of employment. In a country with a high wage and high job protection, mutual recognition would be likely to foster a downward pressure on wages and regulations. The ECJ has repeatedly stated that diversity of retributive and regulatory treatment of employees in the same working condition is illegitimate within a country, being at odds with the principles of equal treatment and competition. The convention recognizes European citizenship (art. 8), forbids discrimination and promotes social justice and social cohesion (art. 3).

Mutual recognition has been applied partially to welfare benefits. The wel­fare system broadly consists of social protection (health care, unemployment benefits, poverty subsidies), and social security (the pension system and inva­lidity). In the actuarially fair domains, where contributions correspond to benefits, each country is responsible for its own share of social insurance benefits in proportion to the contributions received although only one country actually pays (and is reimbursed by the others via a clearing system). Being actuarially unfair, health care and unemployment benefits are excluded, while retirement benefits can be cumulated across countries (although in the individual balance between contributions and benefits of the pension system there may be a certain degree of redistribution). The present EU welfare policy on the one hand has a limited harmonization - the introduction of a common standard in the area of absolute deprivation, such as a safety net against social exclusion and poverty - and on the other hand expects each member state to provide social protection according to its own tradition and coverage. Another goal is the progressive move towards actuarially fair national welfare systems. The presumption is that the welfare reforms aimed at reducing social expenditures will improve the balance between contributions (and the share of fiscal rev­enues devoted to social protection) and monetary and in-kind benefits. The application of mutual recognition to social protection would represent an in­centive to lower taxes and welfare benefits, as a country with high taxes and benefits is particularly exposed to system competition.

The fiscal system is a domain where spillovers are more widespread. While economic theory underlines the advantages of centralization in order to inter­nalize the reciprocal externalities, the negotiations over coordination are complex and even steps towards improving harmonization have been only partially successful, since under unanimity voting any harmonization pro­posal may be opposed by veto. As for personal income, taxation follows the system in the country of birth, even if taxes are paid in the country where the person actually works. This regime may become an incentive to workers’ mobility towards countries with high-tax and high-welfare benefits, since workers from low-tax countries would gain by being taxed in their own country and enjoying the high level of welfare services and in-kind benefits of their country of immigration (if citizenship is maintained, this would apply only to wages and salaries). The orientation in the member states has been towards the application of taxation in the country in which income (wages, profits) is received rather than in the country of residence.

Although the creation of the single market should have fostered coordina­tion in the taxation of goods, real harmonization of indirect taxation is still to come. In fact, the member states have resisted the Commission’s attempt to switch from the destination to the origin principle in both the excise and the value-added tax rates. The origin principle would amount to extending the logic of the single market to the fiscal domain, as it would imply that goods from all countries should be considered on an equal basis in each market. The main reason for the member states preferring goods to be taxed at the rate of the consumption country is to avoid fiscal competition, with an obvious cost in terms of a decrease in inflows.

As for financial assets, a centralized fiscal regime would respond to the need to internalize spillovers stemming from the high mobility of financial capital. Financial interests and dividends are taxed in the country but non­residents enjoy complete exemption. To progressively introduce the principle of residence, member states are required to exchange information on finan­cial assets in the portfolios of individual residents of another member state. Although the phenomenon of country bias (despite capital liberalization, the so called ‘home bias share’ that is, the continuing high share of domestic financial assets in the saver’s portfolio) mitigates the problem of capital flight, fiscal competition represents too dangerous a threat on public budgets. Under unanimity voting, the veto threat to any proposal of harmonization has brought about a provisional agreement consisting in the progressive conver­gence across tax bases and the option between two alternative regimes of capital taxation (to limit tax evasion by exchange of information or adopt a system of tax withholding, that is, taxation at the source). Yet, member states whose financial markets attract many capital inflows shopping around for the best fiscal treatment, are resisting the implementation of the agreement.