Sunday Wrap
The French fiscal and debt ratios are no worse than most other major economies, so why all the France-specific anxiety among rating agencies and commentators? We all need a MT fiscal plan.
Greetings from Clerkenwell,
With the French political stalemate continuing, the prospect of France entering 2026 without a budget hangs in the balance. Re-appointed PM Lecornu has until Wednesday, at the very latest, to submit a draft to parliament. If he succeeds in getting a workable budget through it will – almost certainly – include compromises with the left side of parliament, such as a wealth tax and/or adjustments to the pension reform. Without a budget, France will start next year with a technical extension of the 2025 budget – incidentally, the same way as it started this year.
As the political crisis dragged on, I received an increasing number of questions about the excessive French budget deficit and debt sustainability, many along the lines articulated mid-week by Le Monde: “There is now a high risk that the public deficit will remain uncontrolled and that the financial markets will penalize France”.
Without minimising the French political crisis, or the need for a medium-term fiscal plan, the French budget and debt situation really isn’t any worse than in most other major economies – and in France, at least, there’s an intense focus on the issue, which is more than one can say about many other places.
Put differently, much of the anxiety among credit rating agencies and many commentators is overdone. In contrast, markets seem to have a better understanding of the situation. To remind you, French 10-year yields have moved sideways for the past three months at around 3.5%. They remain 120bp below similar UK yields, and 60bp below US yields.
Specifically, in today’s note:
I’ll illustrate why the rating agencies and many commentators are wrong to be so disproportionately obsessed with France’s fiscal predicaments. The deficit is in the same range as other major economies (apart from Germany), and the debt is more easily financeable than elsewhere.
That being said, just like everywhere else, France needs a medium-term fiscal plan. Two weeks ago I argued that it should include a wealth tax, a view that triggered a large number of responses, mostly against. Today, with the increased probability that a wealth tax will indeed be included in the budget, I’ll double down on that issue.
1. France’s fiscal predicaments are not any worse than in most other major economies.
The political standoff in Paris means that the budget deficit will almost certainly remain excessive – and above 5% of GDP – next year. Public debt will therefore continue to rise as a proportion of GDP, surpassing 115%.
Yet, these numbers do not make France stand out compared with other major economies, except for Germany. The US deficit runs at around 6.4% of GDP (with public debt at 125% of GDP), Japan’s deficit is about 6.2% of GDP (and debt at 235% of GDP), China’s official deficit is 3% of GDP (debt at 95% of GDP), but including extra-budgetary funds the annual deficit is widely estimated to exceed 7% of GDP. Slightly better, the UK is running a deficit of about 4.8% of GDP, with the debt standing at some 96% of GDP.
In the US, China, and Japan there are no explicit – or credible – policies to reduce the deficits. As we were reminded on Friday, the US and China seem all focused on restricting trade between each other rather than addressing their lopsided domestic economic policies (we’ll all lose as a result). And in Japan, Sanae Takaichi was elected head of LDP on promises of further fiscal expansion. In the UK, the Labour government is at war with itself about how to cut its excessive deficit. So, I’m tempted to ask, why pick on France?
Of course, fiscal misery in other major economies is hardly a comfort for the elevated numbers, and political stalemate, in France. But also, in a historical perspective, the burden of the present French debt remains well manageable.
To illustrate this, it is necessary to appreciate that the debt/GDP ratio is a rather dubious ratio to focus on. Where I come from, you wouldn’t have graduated from high school if you didn’t understand the perils of mixing stocks and flows. And yet, that’s precisely what we are doing when talking about debt/GDP ratios.
Instead, to grasp the fiscal (and political) burden of debt, you need to consider primarily the interest payments due in any given period relative to the available resources in the budget in that period. To be sure, no single number or ratio tells the full story. You may also use GDP as the denominator, as proposed by e.g. Larry Summers, although GDP hints at potential new revenue, rather than actual revenue (using fiscal revenue as the denominator is a bit like the bird in hand, while using GDP is like the ten birds in the bush). Or you may use the primary expenditures as your denominator to illustrate the burden of debt payments relative to other expenditure needs.
On World Bank data for 2023 (the most recent year available on a fully comparable cross country basis) − which means that the ratios I’m about to quote are all a bit lower than they are now, but the relative differences are not significant − the French state spent 3.8% of its revenue on interest payments. At the peak in 1994 (before the euro’s arrival) the ratio was 7.2%. Both are well below the 9.0% the UK spent of its revenue on interest payments in 2023 (vs a peak of 9.9% in 2011), reflecting that the UK takes in a whopping 13pp of GDP less in taxes than France. Italy spent 8.9% in 2023, down from a peak of 26.9% in 1995 (the lira, the lira…). On the World Bank data, the US spent 18% of revenue on interest payments in 2023, but that year was an outlier. The ratio has typically been in the 12%-13% range in recent years – still a multiple higher than in France.
My point is this: in no conceivable scenario for the next several years will France need to allocate as great a share of its fiscal revenue to interest payments as e.g. the US, UK, or Italy – nor as great a share as it did during most of its pre-euro era. (Germany spends less than 3% of fiscal revenue on interest payments, and will in all reasonable scenarios continue to enjoy a very comfortable ratio.)
So, again, why all the anxiety about France and debt sustainability? Ah, you may say, the US, UK, and Japan all have their own central banks and currencies and – if push comes to shove – they’ll “just” print the money and reduce the (real value of the) debt that way.
But that’s an illusion. Trying to print yourself out of your debt troubles would first require that you take away the central bank’s independence. Granted, while inconceivable not so long ago, it no longer seems impossible to imagine in countries where the political regime questions recent decades’ policy set-ups. But even if we go down this road, to print yourself out of a debt burden would require that the debt has very long maturities. Granted, some of the major economies do have pretty long average maturities (which, of course, might invite an attempt in some places). But surely, printing money in an attempt to erode the real value of creditors’ claims would have inflationary consequences, which will be reflected in the long end of the curve. (Correct, I think the long end of the US curve will move higher!)
Therefore, this whole risky idea would only work after you have brought down your borrowing requirements (unless you introduce comprehensive and effective capital controls). But if you have managed to bring down your borrowing requirements, your debt and refinancing problems usually go away. Put differently, if you see the first condition (independence of the central bank) being questioned, the odds of an unravelling scenario, as opposed to a proper debt-correcting scenario, go up.
In contrast, it seems clear to me that the eurosystem provides a strong institutional protection against the risk of eroding independence of the central bank, and hence against any one government’s potential attempt to “just” print itself out of a debt problem. Therefore, markets have it right when they charge higher yields on UK and US debt, than on French sovereign debt.
2. The medium-term fiscal challenges, the contours of sustainability – and one more go at wealth taxation…
Again, in no way, shape, or form am I suggesting that France does not need a fiscal plan to align revenues and expenditures in a medium-term sustainable way, both economically, fiscally, and politically. But I am arguing that this need is no different from that of other major economies.
Consider this: As illustrated above, most major economies (apart from Germany) need to reduce their existing fiscal deficits by probably 2-3% of GDP. In addition, most of them – and all of Europe − face structural fiscal headwinds over the coming 5-10 years of at least another 3% of GDP. Demographics (causing higher pension and healthcare costs) have built-in claims on future budgets of 1%-2% of GDP; defence spending needs to be boosted by at least 1% of GDP; infrastructure investments by 0.5% of GDP; and climate-related outlays (ideally for prevention, but if not then for repairs) by maybe 0.5%-1.0% of GDP. (On top of all this comes the need for private investment in these areas, some of which may need fiscal incentives to get prioritised.)
In other words, most countries, France included, need to find at least 5%-6% of GDP over the medium term in some combination of additional resources, spending cuts and/or additional borrowing.
Without a doubt, for this to be feasible, political leaders need to seek a broad consensus in society on the relative contributions by different groups.
It was in this spirit that – two weeks ago in this note – I argued that, in spite of my fundamental dislike of wealth taxation, France should include a net wealth tax along the lines proposed by Professor Gabriel Zucman, at least for a period of time until sustainability has been restored. To remind you, Zucman proposes a net-2% tax on all assets above EUR 100 million, where “net” refers to net of any tax already paid on the income generated by these assets.
My reluctant endorsement of a wealth tax triggered a large number of responses, mostly opposing my view, using – if I may say – pretty traditional anti-tax arguments, such as “taxes limit growth and prosperity” (not necessarily true, see Scandinavia), “taxes are distortive” (true, all taxes are, but they are necessary in a civilised society), and “wealth taxation has limited revenue effects” (everything is relative).
The Economist’s “Free Exchange” column (October 4-10th) included a pretty fierce rejection of wealth taxation, arguing that the “arguments [in favour] fail on the grounds of durability, utility and naivety.” (But at least, when rejecting my arguments, they put me in the fine company of Olivier Blanchard.)
I wasn’t persuaded by their arguments. I’ll take them quickly in turn:
Their “durability” claim is that while a wealth tax is popular now (86% in favour in France), that may change in the future, leaving France “with a tax that is both economically damaging and politically counter-productive.” Well, taxes are rarely popular so if you have 86% support, it’s a tall order to reject it if you care about social cohesion. And is a wealth tax really “economically damaging”? That surely depends on the alternative. This 2019 NBER paper by Fatih Guvenen et al (thanks to Martin Sandbu for the pointer), for example, shows that a net wealth tax is productivity-enhancing relative to capital income taxation: https://www.nber.org/papers/w26284.
And is it really right to dismiss the “utility” of wealth taxation (i.e. the revenues are not enough to be worth it)? If Zucman’s proposal generates EUR 30bn a year (the low end of his estimate), then that would finance 10%-12% of the deficit. Even half of that would be worth the effort, I think.
Finally, are we supporters of a wealth tax naïve because we “underestimate the risks of letting the wealth-tax cat out of the bag”? Personally, I’ve always found the argument of “letting the cat out of the bag”, as to why a policy proposal should not be considered, as a bit desperate. Certainly, it never won the argument in any of the many policy meeting I was in during my ten years at the IMF and World Bank. And, for example, would it have been a good argument against the introduction of VAT across Europe in the late 1960s? I think not.
A more analytical push-back to my arguments came from the Financial Times’ Martin Sandbu. He has two important objections to my fundamental dislike of wealth taxation.
First, Sandbu called my characterisation of wealth taxation as “double taxation” a “misunderstanding” because “there is no end to the circular flow of funds, there is no such thing as a single instance of taxation. Money is taxed when exchanged for goods (VAT), then the same money is taxed when passed on to the seller’s workers, investors or retained … then when it is spent again (VAT again) and so on ad infinitum. What matters is the total tax take out of the flow, not the number of instances.”
I stand corrected on the issue of double-taxation – and I agree that the “total tax take out of the flow” is of great importance. This does, however, raise questions whether a wealth tax is right for France, compared with e.g. the US, UK, and Germany. According to the IMF, total tax take in France is 51.5% of GDP, vs 31% in the US, 39% in the UK, and 46% in Germany.
Second, Sandbu helpfully points to my hypocrisy when it comes to my dislike of taxing stocks rather than income. He reminds me that “we have completely unproblematic recurrent taxation on stocks of assets”, e.g. of estate and inheritance. And those are taxation of gross assets, as opposed to Zucman’s much neater proposal of a net tax of wealth (netted for taxes paid on the generated income).
Sandbu concluded our email exchanges (which he kindly agreed that I could quote) with this: “A system where you have a comprehensive net wealth tax and no inheritance or property tax (real estate would obviously be covered by the net wealth tax) would be superior to most systems. I think you might as well scrap capital gains tax too - it’s extraordinarily game-able and distortive, and you can claw the little revenue it raises back by calibrating the net wealth tax right.” I think there’s a lot of truth in that.
I thank everyone for having commented on my original note on wealth taxation two weeks ago (and on all the other notes and topics). If nothing else, it has cemented my view that to adequately address the fiscal challenges not only in France, but in most major economies, an open-minded and comprehensive approach to fiscal policies – and a public debate – will be needed.
This coming week, I’ll be in Washington DC for the IMF annual meetings. My calendar is full of great meetings, but if you are there as well and want a meet for a chat about Europe, the world, life at ‘Independent Economics’ -or about my most recent vacation on Ile de Re, do reach out and we’ll find the time.
Best
Erik