Exploring new avenues: innovative financing at a global level
At its meeting in October 2009, the European Council agreed on the need for a coordinated exit from fiscal stimulus policies and for fiscal consolidation. But at the same time Europe, and the world, is likely to face enormous financing needs in the coming decades, to meet the costs of financial stability, climate change and development. The Council therefore invited the Commission to examine the potential contribution of innovative financing mechanisms in response to which Commission, including ECFIN, staff have recently published a working document on ‘Innovative Financing at a Global Level’.
The global financial and economic crisis has strained public finances worldwide. As a result of the massive fiscal intervention measures taken, EU-wide government deficits are expected to reach 7.5% of GDP in 2010, while the EU average debt to GDP ratio – assuming constant policies – is projected to increase to 120% by 2020.1European Commission Forecast – autumn 2009, European Economy 10/2009, and Sustainability Report 2009. The total cost of restoring public finances could exceed EUR 800 billion over the next few years. On top of the short-term financing needs related to the crisis, age-related public expenditure in the EU is expected to increase by about 4¾ percentage points of GDP by 2060.
Global challenges with budgetary implications
Public finances will come under further pressure due to the global challenges of development and climate change. To achieve the Millennium Development Goals (MDGs) by 2015, the EU pledged to increase its official development aid (ODA) to 0.7% of Gross National Income (GNI) by 2015, which could imply a doubling of the EU’s ODA from EUR 50 billion in 2008 to EUR 100 billion in 2015. Financing climate mitigation and adaptation measures in developing countries will be another drain on government coffers. Developed countries have agreed to provide funding of USD 30 billion from 2010 to 2012, and the goal of mobilising jointly up to USD 100 billion a year by 2020 from various sources.
Innovative financing
While these challenges for public finances need to be addressed mainly by reductions in expenditure and increases in tax collection, innovative sources could also have an important role to play. ‘We have to look at a broad range of instruments in order to meet these challenges,’ says Peter Grasmann, head of unit for Financial Integration and Governance within ECFIN. Innovative financing is public finance that is raised in new, non-traditional ways. This can entail new instruments for raising revenues or new approaches to already existing fiscal instruments. It does not include mechanisms which are exclusively private.
A potential advantage of innovative financing is that it may enjoy greater political acceptance, particularly when the fiscal burden is imposed on groups or sectors that are perceived as not currently shouldering their fair share. Acceptance may also be higher when revenues are earmarked to support global public goods such as climate change mitigation actions. Earmarking, however, can lead to budgetary inflexibility and the suboptimal use of resources.
‘We need to assess the relative merits of the various options objectively before decisions are taken to implement some of them,’ says Martin Hallet, head of sector in ECFIN’s unit for globalisation and development policy. ‘The working document doesn’t focus on how the funds might be actually used.’
Ideally, innovative financing should be implemented at the global level since most of the challenges facing the world will require burden-sharing and since the tax base of an innovative source is often highly mobile. In the latter case, global cooperation is necessary because companies or individuals may simply relocate their economic activities to avoid or evade tax.
Innovative financing related to the financial sector
One of the prime candidates for innovative financing is the financial sector. Member States’ support to the financial sector amounted to around 13% of EU GDP in 2009 or more than EUR 1.5 trillion. Such massive public sector support has created the widespread view that financial institutions should help bear the costs of the bailing out the sector and reducing systemic risk.
A financial transaction tax (FTT) is conceptually similar to a Tobin tax but could be levied on broad classes of transactions, not just on foreign exchange transactions. According to figures by an Austrian research institute, a general FTT rate of 0.1% could raise between 0.8 and 2.0% of global GDP or between EUR 327 and 845 billion in absolute terms. The premise that taxing transactions reduces systemic financial risk may be flawed, however. ‘It was excessive risk-taking, and not excessive transactions, that caused the crisis,’ states Grasmann.
Rather than taxing transactions, another approach is to tax leverage. The ‘stability fee’, which Sweden introduced in 2009 and which the Swedish Minister of Finance Anders Borg proposed to adopt at the EU level, is levied on certain balance sheet positions on a consolidated basis in order to reduce leverage and bank size. The US proposal for a ‘Financial Crisis Responsibility Fee’ is similar to the Swedish fee but is constructed in such a way that it falls only on the largest financial companies with the largest leverage, which are presumably those that pose the greatest systemic risk.
A levy on liabilities could generate revenues of between EUR 11 and 50 billion, depending upon the tax rate and other assumptions. Moreover, since the levy targets balance sheets rather than more mobile financial market transactions, relocation and avoidance of tax could be less of a problem. Aside from its revenue-raising potential, a levy could limit the excessive risk-taking which usually goes along with high leverage and is partly to blame for the recent crisis. The downside of such a tax, however, is that bankers might shift the tax burden to companies and consumers in the form of higher borrowing costs which would in turn dampen economic activity.
Innovative financing related to climate change
Putting a price on emissions of CO2 and other greenhouse gas emissions is another promising source of innovative financing. Moreover, imposing a price on greenhouse gas emissions can offer a ‘double dividend’: it has the advantage of dealing with climate change externalities while providing revenues at the same time.
A single carbon price globally would be the ideal, but would require a degree of international cooperation that may not be immediately achievable. In any case, the EU currently has a cap-and-trade scheme, the EU Emissions Trading Scheme (ETS), which is the biggest carbon market in the world. Some Member States have already taken advantage of their right to auction a percentage of their allowances, and by 2013 auctioning allowances will become obligatory. By 2020 total annual revenues from auctioning allowances could amount to EUR 25.8 billion. The only major drawback of a price on carbon is the risk of carbon leakage: carbon-intensive industries may relocate to countries which have only a low or no price on carbon emissions.
Cap-and-trade schemes may be difficult to apply to small or diffuse emissions sources such as transportation. In such cases, carbon taxes may be an option for complementary action. The Nordic countries have introduced taxes on CO2 emissions, and Ireland and France are planning to follow suit. The UK, the Netherlands and Germany have introduced taxes on carbon-based energy products. While these initiatives should be applauded, introducing different ways of taxing carbon emissions across EU Member States could hamper efficiency and competitiveness within the Single Market. A Community framework for taxation of carbon emissions could help to address these concerns.
Innovative financing for development
Innovative sources of financing have a long tradition in the development field, and are important to ensure the Millennium Development Goals are reached by 2015 on which progress will be reviewed in a UN High-Level Plenary Meeting in September this year. The main mechanisms for innovative financing in development policy are frontloading public finance and leveraging private finance. The problem with frontloading is that it spends money today by postponing budgetary pain until tomorrow. On the other hand, frontloading can be economically efficient if investing today – in climate adaptation measures, for example – helps a country avoid much higher costs in the future.
Given the current disarray of public finances and the enormous future financing requirements, 2010 should be the year for advancing and implementing the innovative financing agenda within both the EU and G20, and indeed both the informal ECOFIN on 16 and 17 April and G20 Finance Ministers meeting on 23 April are set to discuss how the financial sector can contribute its fair share to the fiscal costs of financial crises.
