The impact of public finances on the real economy is multiple and complex. Nonetheless, there is broad agreement on three main channels through which public finances can enhance potential growth and employment.
Governments contribute directly to growth and employment by enhancing factor accumulation through investment in physical (infrastructures), human (education and training) and knowledge (research and development, and innovation) capital, and, to a lesser extent, social spending. This has a beneficial effect on long-run output and growth potential. However, if higher public investment is financed through a rise in distortionary taxes or if it increases deficits and consequently public debt, it may crowd out private investment.
By influencing people’s and businesses’ decisions on work, saving and investment, tax and benefit systems affect the functioning of the real economy. Welfare systems play an important role in correcting market failures and ensuring social cohesion, and, via these channels contribute to growth and employment. Efficient social protection can be viewed as a 'productive’ factor. However, it is necessary to ensure that tax and benefit systems are conducive to higher participation and employment rates.
Sound public finances contribute to macroeconomic stability and support monetary policy in maintaining stable prices at low interest rates. Both effects are conducive to private investment and saving. Sound public finances, by reducing public debt and consequently the interest burden, create room for a reduction in distortionary taxes and/or an increase in productive public spending. Finally, sound public finances will also enhance growth and employment in the long term by helping countries cope with the substantial pressure to increase public expenditures, especially on pensions and health care as a result of ageing populations.
Public finance developments in the EU, including the evolution of the EU fiscal surveillance framework, are regularly monitored and analysed by DG Economic and Financial Affairs. The results of the analysis are published each year in the 'Public Finances in EMU' report.