A coordinated mix of public investment and incomes policies for sustainable development in Europe

This policy brief presents the impact of a coordinated policy mix of increased public investment together with more progressive taxation and labour market policies to improve income distribution in Europe. Based on an econometric model for individual EU Member states, we simulate a policy scenario of a simultaneous increase in public investment by 1% of GDP along with more progressive taxation (increasing effective tax burden on capital by 1% and decreasing tax burden on labour by 1%) and an increase in the wage share by 1% of GDP in each country. The result is 6.6% higher GDP in the EU. Even private investment increases by 1.5% as a ratio to GDP (on average in Europe) as an outcome of this policy mix; i.e. public spending does not crowd out but rather crowds in private investment. Despite the rise in public spending, the budget balance in Europe improves (by 0.8% as a ratio to GDP) because the beneficial fiscal effects of higher economic growth and higher tax rates on capital prevail. Growth and private investment improves both in the periphery and core countries of Europe. The concerns regarding the inflationary effects of wage increases are also not supported by empirical evidence. This policy mix will lead to only a modest 1.5 percentage point increase in price level in Europe on average. Hence wage-led and public investment-led growth are complimentary and feasible. Such a coordinated policy mix, along with a properly designed industrial policy can ensure genuine regional convergence and social cohesion in Europe.