The transition from centrally planned to free-market economies in 1989 initiated a period of social and economic upheaval in post-communist countries, which affected healthcare quality, expenditures, and outcomes. We use data from the Life in Transition Survey (LiTS) to demonstrate that in spite of improvements across various measures of these facets of the healthcare system, it remains the first choice for additional government spending among the public in all countries of the region included in this study. Preferences in priorities for extra budget spending were similar among men and women in respective countries, but the preference for additional healthcare spending was stronger among women than men. The transition countries are compared with Germany and Italy – two Western European LiTs survey participants, countries with higher spending, and better healthcare outcomes.
Across the globe, the outbreak of the COVID-19 pandemic has brought a new spotlight to the preparedness of healthcare systems for profound shocks (Anser et al, 2020). Critical care is a particularly costly element of healthcare provision, and thus, under-resourced systems are uniquely susceptible to spikes in mortality resulting from an oversaturation of intensive care units during an epidemiological crisis of this sort. (Fowler et al, 2008; Mannucci et al, 2020) Considering the widespread discussion surrounding health system capacity and the necessity for implementing economically painful lockdowns when those limits are reached, pressure from society to increase public spending may grow even further. With these developments in mind, in this policy paper, we confront past expressions of preferences regarding public expenditures with changes in government spending on healthcare between 2006 and 2017. The analysis draws on the one hand on the data from the Life in Transition Survey (LiTS), and on the other on publicly available data on government expenditures and outcomes.
In the context of preferences for additional public spending, we present a descriptive summary of trends in government expenditures on healthcare in Armenia, Belarus, Estonia, Georgia, Latvia, Lithuania, Moldova, Poland, Russia, and Ukraine. We include Italy and Germany as wealthier Western benchmarks, for which the data became available in the second wave of the survey in 2010. Data on public healthcare spending shows that despite a clear and strong public preference for increased investment in healthcare provision, additional spending as a proportion of total government expenditures between 2006 and 2017 has been moderate in most countries, and even negative in some. It must be underlined that expenditures are not always reflected in healthcare outcomes, quality, and coverage. Issues of efficiency, system design, and underlying health conditions of the population play a significant role in the returns on investment. For instance, the United States has spent drastically more per capita on healthcare than any other country and yet ranked lowest in the Healthcare Access and Quality (HAQ) Index among comparable countries (Fullman et al, 2016). However, due to the focus of the survey on government spending, we emphasize government expenditures on healthcare as a pertinent measure, especially in relation to overall GDP, per capita spending, and the public budget as a whole.
There is mounting evidence that one of the most important elements in the mitigation of COVID-19 mortality is the ability to expand system capacity and acquire the necessary equipment (e.g. respirators, ventilators) while ensuring that there is equitable access to measures for spread prevention (e.g. testing) (Khan et al, 2020; Ranney et al, 2020; Wang and Tang, 2020). The increasing pressure on healthcare systems, coupled with the additional fiscal strain resulting from the economic fallout of the pandemic, could lead to further divergence between public preferences and government spending on healthcare.
Healthcare Systems During the Transition
The ability of transition countries to absorb the risks and short-term economic shocks associated with pivoting from a centrally planned to a free-market economy has had dramatic implications for healthcare systems. Although countries in this region were divergent in terms of underlying health conditions, levels of expenditures, and health outcomes, most of them fell victims to deficient funding and additional health risks associated with the initial increases in poverty that were commonplace (Adeyi et al, 1997)
Compared to other transition countries, Georgia and Armenia faced a sharper economic collapse as well as armed conflicts, which caused scarcity in the availability of public healthcare providers and spikes in out-of-pocket expenses. Belarus was slower in the implementation of economic reforms and faced issues of fiscal sustainability further down the line (Balabanova et al, 2012). However, following this short tumultuous period, countries transitioning away from centrally planned economies have generally invested heavily in healthcare since the early 1990s. In many cases, these investments were facilitated by rapid GDP growth and accompanied by significant improvements in life expectancy. For example, between 1989 and 2012, Latvia, Lithuania, and Poland increased their per capita healthcare expenditures by more than 1,000 PPP per year, with an increase in life expectancy ranging from 1.7 years in Lithuania to 5.8 years in Poland (Jakovljevic et al, 2015). Despite heterogeneous and extensive reforms in many of these countries, as well as mixed results in measurements of efficiency and outcomes, healthcare expenditures consistently rank as the top priority for further government spending among both men and women in each country. This consistency lends itself to further policy considerations.
Preferences for Government Spending in Transition Countries
As is demonstrated by Figure 1, in 2016, healthcare was the most common answer to the question – “Which field should be the first priority for extra government spending?”- for all ten post-transition countries included in our analysis (the other options were: education, housing, pensions, assisting the poor, public infrastructure, the environment, and other). The survey was carried out on a representative sample that covers approximately 1,000+ respondents from each of the 29 countries in wave I and up to 1,500+ respondents from each of the 34 countries in wave III (EBRD: LiTS, 2020). Despite intercountry differences, in 2016 healthcare persisted as the top priority for both men and women in every transition country we studied apart from Belarus. While healthcare remained the top priority on average, men expressed a higher preference for additional investment in education. In the countries where preferences for health were particularly strong, healthcare was the first priority for as many as 53.5% of Latvians, 47.7% of Poles, and 43.9% of Moldovans (Figure 1a). Notwithstanding some fluctuations in scale, these preferences were not only common across countries but also across time, with people expressing very similar preferences in the first two waves of the survey in 2006 and 2010. (See Annex Figure A1 and Figure A2). While healthcare remained a popular choice in Germany and Italy, spending on healthcare as a percentage of GDP was nearly twice that of any transition country in Germany. There, education outweighed healthcare among men and women in both available waves (II and III), while pensions surpassed healthcare among men in the latter wave. In Italy, despite a more comparable level of healthcare spending relative to the transition countries, a drastic shift took place as healthcare fell from being the first priority by a large margin of 24.9 percentage points (pp) in 2010 to becoming the second priority after pensions in 2016. This can likely be attributed to the prominence of pensions as a major political campaign issue following the austerity-driven reforms of 2011 (Alfonso and Bulfone, 2019).
Figure 1: 1a (left) : Preferences for additional government spending, 2016. / 1b (right): Preferences for additional healthcare spending by gender, 2016
Moreover, it is evident that men and women within countries have rather similar preferences, as far as extra government spending is concerned. Not only is healthcare the first priority in all ten transition countries, but their second, third, and fourth choices are also very similar. When digging deeper into the differences that do exist, in every country except for Georgia women had a stronger preference for healthcare than men, and by as much as 8.8 pp, 8.4 pp, 7.8 pp, and 7.9 pp in Latvia, Germany, Belarus, and Russia respectively (Figure 1b). Conversely, in every case except for Georgia and Ukraine, men had a stronger preference for additional spending on education than women, most notably in Armenia – by 7.8 pp, Germany – by 5.7 pp, Lithuania – by 4.6 pp and Poland – by 3.9 pp. It is apparent that despite rapid investment in healthcare over the first two decades of the transition, there remains a widespread desire for further expansion of expenditures in this area.
Trends in Government Expenditures, 2006-2017
Considering the primacy of healthcare as the priority for additional government spending in all ten studied transition countries, we look at trends in aggregate statistics on government expenditures on healthcare over the surveyed period to explore the extent to which these preferences have been reflected in government spending. Taking the most basic measure into account in Figure 2a, i.e. public health expenditures as a percentage of GDP, among the transition countries only Georgia and Estonia have significantly increased their healthcare expenditures, by 1.6 pp and 1.2 pp, respectively. Lithuania, Poland, and Russia saw more moderate increases in the range of 0.6 pp and 0.2 pp. Other countries have remained essentially stagnant, apart from Moldova and Ukraine which saw a notable drop of 0.8 pp. Considering that this measure is sensitive to fluctuations in GDP growth, we also consider public health spending as a proportion of all government expenditures (see figure A3 in the Annex), which is a better indicator of government priorities for additional spending from 2006 until 2017. Georgia was the only transition country with a significant increase in healthcare spending proportional to total government expenditures, nearly doubling it from 5.2% to 9.5%. Belarus, Estonia, Lithuania, Poland have implemented a more moderate redirection of the budget towards healthcare, increasing proportional expenditures by a factor of 1.26, 1.15, 1.21, and 1.21 respectively. In spite of public preferences, Armenia decreased the proportional share of the budget dedicated to healthcare by as much as 2.6 pp, Moldova, Russia, and Ukraine by 1.3 pp, and Latvia by 0.8 pp. Regardless of the direction of the trend, notwithstanding some slight convergence, no transition country spent as much of its budget on healthcare as Italy and Germany. The latter spent nearly two to four times as much on healthcare as a proportion of total expenditures compared to the studied transition countries, and this gap has been widening relative to all of those included in the analysis, apart from Georgia.
Figure 2: Public healthcare expenditures (% of GDP)
While expenditures per capita are less indicative of government priorities in the budget, they are a better comparative measure for assessing the changes in healthcare provision, barring differences in efficiency. This comes with a huge caveat, namely that it is well established in the literature that additional healthcare expenditures often translate into “small to moderate” direct improvements in healthcare quality and outcomes due to inefficient spending or underlying factors (e.g. lifestyle choices, poverty) that are not addressed by investment in the healthcare system itself (Hussey et al, 2013; Self and Grabowski, 2003). Nevertheless, this measure is more likely to translate to an improvement in the quality of care each person receives, and the data paints a more positive picture considering the clear preference of both men and women for higher spending. In Figure 3 we present healthcare expenditures per capita in USD, and apart from Italy and Ukraine, all of the countries have significantly increased spending between 2006 and 2017. While expenditures per capita in transition countries are dwarfed by Germany and Italy, Estonia, Georgia, and Lithuania have more than doubled their expenditures, and Armenia has more than tripled. Belarus, Latvia, Poland, Moldova, and Russia have also significantly increased their per capita spending on healthcare, by factors in the range of 1.54 and 1.91. However, while expenditures per capita is one indicator of improving healthcare quality, it does not identify government priorities and is largely dependent on overall economic growth (Fuchs, 2013; Bedir, 2016).
Figure 3: Health care expenditure per capita, USD
In every country we include, increasing healthcare expenditure per capita is accompanied by advancements in many measures of healthcare outcomes for men and women. Between 2006-2017, life expectancy at birth increased across the board, with men in Russia experiencing the greatest improvement of 7.1 years (Figure 4a). These are promising trends – for women, life expectancy at birth improved by a larger margin in each transition country than in Germany or Italy, and the same can be said for men in every country apart from Armenia. Furthermore, the Healthcare Access and Quality (HAQ) index, which is composed of 32 indicators related to preventable causes of mortality, has improved across all 12 countries between 2005-2016. The change was most notable in Armenia, Belarus, Estonia, and Russia, constituting as much as 8.7, 10.2, 8.9, and 8.9 points out of a hundred, respectively (Figure 4b). These trends indicate convergence in the quality of healthcare as they significantly outpaced improvements in the HAQ index in Italy (3.1 points) and Germany (3.9 points). As of 2016, among the countries of interest, Georgia (67.1 points) and Moldova (67.4) had the lowest scores, while Germany (92.0) and Italy (94.9) scored highest, as could be expected based on healthcare spending measures presented in Figures 2 and 3.
Figure 4: 4a (left): Change in life expectancy, 2006-2017 / 4b (right): HAQ index
However, as presented in Figure 5, there is no clear relationship between the strength of the preference for additional healthcare spending and the scale of expansion in spending. Taking three of the four countries (Armenia, Belarus, and Russia) with the greatest improvement in the HAQ index as an example, there was virtually no change in healthcare spending as a percentage of GDP over the same period. These countries were also different in terms of how strong the preferences were for additional spending on healthcare as the first priority in 2006.
Figure 5: Public preferences and government healthcare spending (% of GDP)
As we have demonstrated in this brief, in the ten post-communist countries for which we have analyzed LiTS data, there was a consistent and common preference for healthcare as the first priority for extra government spending between 2006 and 2016. We also find that in each country except Georgia, on average, women had a stronger preference for additional public healthcare spending, supporting a wealth of literature that suggests that women utilize healthcare services more frequently and spend more out of pocket on healthcare than men (Owens, 2008; Cylus et al, 2011; Williams et al, 2017). However, over the period we study, these preferences have not translated directly into a reallocation of budgetary resources. The countries with the strongest preferences for additional healthcare spending in 2006 did not experience the highest increases in any of the discussed measures of public healthcare expenditures since then.
People living in Italy and Germany chose an increase in public spending on healthcare as their first priority less frequently than residents of post-transition countries. Better understanding these differences requires further research, but there is likely a combination of factors that play into this effect. For one, wealthier Western countries performed better when looking at simple measures of healthcare outcomes such as life expectancy and deaths from non-communicable diseases (WHO, 2020), and hence other priorities may have gained in salience. Furthermore, they allocated a greater proportion of the public budget towards healthcare. This in part stems from the significant challenges associated with the transition following 1989. Healthcare systems in post-communist countries experienced a fiscal shock when joining the global economy, with the loss of centrally controlled price mechanisms causing an increase in the relative prices of healthcare inputs such as medicines and equipment (Obrizan, 2017). This was exacerbated by a shrinking capability of governments to spend more on healthcare related to the general economic shocks at that time and led to the passing over of costs to patients in the form of out-of-pocket expenses (Balabanova, et al. 2012). Although access to healthcare and the quality of that care have improved after the transition (Romaniuk and Szromek, 2016), these have failed to converge towards Western European countries on a number of substantial measures up to this point. Before the commencement of the COVID-19 pandemic, government healthcare spending did not reflect the preferences of the public in any of the ten studied transition countries. The outbreak of the pandemic has not only intensified the pressure on the healthcare system but also brought about a number of negative economic consequences. This combination can be expected to simultaneously increase the strain on the public budget and necessitate difficult decisions of reallocation at a time when fiscal sustainability during a global recession is already being brought under question (Creel, 2020).
- Adeyi, O., Chellaraj, G., Goldstein, E., Preker, A. and Ringold, D., 1997. Health status during the transition in Central and Eastern Europe: development in reverse?. Health Policy and Planning, 12(2), pp.132-145.
- Afonso, A. and Bulfone, F., 2019. Electoral coalitions and policy reversals in Portugal and Italy in the aftermath of the eurozone crisis. South European Society and Politics, 24(2), pp.233-257.
- Anser, M.K., Yousaf, Z., Khan, M.A., Nassani, A.A., Alotaibi, S.M., Abro, M.M.Q., Vo, X.V. and Zaman, K., 2020. Does communicable diseases (including COVID-19) may increase global poverty risk? A cloud on the horizon. Environmental Research, 187, p.109668.
- Balabanova, D., Roberts, B., Richardson, E., Haerpfer, C. and McKee, M., 2012. Health Care Reform in the Former Soviet Union: Beyond the Transition. Health services research, 47(2), pp.840-864.
- Bedir, S., 2016. Healthcare expenditure and economic growth in developing countries. Advances in Economics and Business, 4(2), pp.76-86.
- Creel, J., 2020. Fiscal space in the euro area before Covid-19. Economics Bulletin, 40(2), pp.1698-1706.
- Cylus, J., Hartman, M., Washington, B., Andrews, K. and Catlin, A., 2011. Pronounced gender and age differences are evident in personal health care spending per person. Health Affairs, 30(1), pp.153-160.
- Fuchs, V.R., 2013. The gross domestic product and health care spending. N Engl J Med, 369(2), pp.107-109.
- EBRD, 2020. Life in Transition Survey (LiTS). European Bank for Reconstruction and Development.
- Fowler, R.A., Adhikari, N.K. and Bhagwanjee, S., 2008. Clinical review: critical care in the global context–disparities in burden of illness, access, and economics. Critical Care, 12(5), p.225.
- Fullman, N., Yearwood, J., Abay, S.M., Abbafati, C., Abd-Allah, F., Abdela, J., Abdelalim, A., Abebe, Z., Abebo, T.A., Aboyans, V. and Abraha, H.N., 2018. Measuring performance on the Healthcare Access and Quality Index for 195 countries and territories and selected subnational locations: a systematic analysis from the Global Burden of Disease Study 2016. The Lancet, 391(10136), pp.2236-2271.
- Global Burden of Disease Collaborative Network, 2018. Global Burden of Disease Study 2016 (GBD 2016) Healthcare Access and Quality Index Based on Amenable Mortality 1990–2016. Seattle, United States: Institute for Health Metrics and Evaluation (IHME).
- Hussey, P.S., Wertheimer, S. and Mehrotra, A., 2013. The association between health care quality and cost: a systematic review. Annals of internal medicine, 158(1), pp.27-34.
- Mannucci, E., Silverii, G.A. and Monami, M., 2020. Saturation of critical care capacity and mortality in patients with the novel coronavirus (COVID-19) in Italy. Trends in Anaesthesia and Critical Care.
- Jakovljevic, M.B., Vukovic, M. and Fontanesi, J., 2016. Life expectancy and health expenditure evolution in Eastern Europe—DiD and DEA analysis. Expert Review of Pharmacoeconomics & Outcomes Research, 16(4), pp.537-546.
- Obrizan, M., 2017. Does EU membership prevent crowding out of public health care? Evidence from 28 transition countries.
- Owens, G., 2008. Gender differences in health care expenditures, resource utilization, and quality of care. Journal of Managed Care Pharmacy, 14(3), pp.2-6.
- Ranney, M.L., Griffeth, V. and Jha, A.K., 2020. Critical supply shortages—the need for ventilators and personal protective equipment during the Covid-19 pandemic. New England Journal of Medicine, 382(18), p.41.
- Romaniuk, P. and Szromek, A.R., 2016. The evolution of the health system outcomes in Central and Eastern Europe and their association with social, economic and political factors: an analysis of 25 years of transition. BMC health services research, 16(1), p.95.
- Self, S. and Grabowski, R., 2003. How effective is public health expenditure in improving overall health? A cross–country analysis. Applied Economics, 35(7), pp.835-845.
- Wang, Z. and Tang, K., 2020. Combating COVID-19: health equity matters. Nature Medicine, 26(4), pp.458-458.
- Williams, J.S., Bishu, K., Dismuke, C.E. and Egede, L.E., 2017. Sex differences in healthcare expenditures among adults with diabetes: evidence from the medical expenditure panel survey, 2002–2011. BMC health services research, 17(1), p.259.
- World Bank, 2020. Data Bank: World Development Indicators. Washington D.C., World Bank Group.
- World Health Organization, 2020. Global Health Observatory (GHO) data.
Note: Annex included in the attached PDF.
Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.
The member states of the European Union coordinate on many policy areas. The joint implementation of public good type projects, however, has stalled. Centralized fiscal spending in the European Union remains small and there exists an overwhelming perception that the available funds are inefficiently allocated. Too little commitment, frequent rounds of renegotiation and unanimous decision rules can explain this pattern.
Currently, the EU allocates only about 0.4% of its aggregate GDP to centralized public goods spending (European Commission (2014)). This is surprising given the fiscal federalism literature’s classic predictions of efficiency gains from coordinated public goods provision (see for example Oates (1972) and the more recent contributions of Lockwood (2002) and Besley and Coate (2003) for a discussion). Yet, recent proposals to expand centralized fiscal spending in the EU have been met with skepticism if not outright rejection. The most frequently cited argument claims existing funds are already being allocated inefficiently and any expansion of centralized spending would turn the EU into a mere transfer union (Dellmuth and Stoffel (2012) provide a review).
Centralized fiscal spending in the EU is provided through the “Structural and Cohesion Funds”, which are part of the EU’s so called “Regional Policy” and were initially instituted in 1957 by the Treaty of Rome for the union to “develop and pursue its actions leading to the strengthening of its economic, social and territorial cohesion” (TFEU (1957), Article 174). At that point, the six founding members agreed it was important to “strengthen the unity of their economies and to ensure their harmonious development by reducing the difference existing between the various regions and the backwardness of the less favoured regions” (stated in the preamble of the same treaty). A reform in 1988 has further emphasized this goal by explicitly naming cohesion and convergence as the main objectives of regional policy in the EU.
Today, actual fiscal spending in the EU is far from achieving this goal. The initially agreed upon contribution schemes are often reduced by nation specific discounts and special provisions as the most recent budget negotiations for the 2014-2020 spending cycle showed yet again. Moreover, the perception is that available funds are being spent inefficiently (see for example Sala-i-Martin (1996) and Boldrin and Canova (2001)).Figure 1. 2011 EU Structural and Cohesion Funds
Figure 1 shows the national contributions to the structural funds as well as EU spending from that same budget in each member nation in per capita terms (data published by the European Commission). If fiscal spending was efficiently structured to achieve the above mentioned goal of convergence, one would observe a strong negative correlation between contributions and spending. The data shows, however, that while some redistribution is clearly implemented, rich nations still receive large amounts of the funds meant to alleviate inequality in the union (see Swidlicki et al. (2012) for a detailed analysis of this pattern for the contributions to and spending of structural funds in the UK).
What prevents a group of sovereign nations from effectively conducting the basic fiscal task of raising and allocating a budget to achieve an agreed upon common goal? In a recent paper, we theoretically examine the structure of the bargaining and allocation process employed by the EU (Simon and Valasek (2013)). Our analysis suggests that efficiency both in terms of raising contributions and allocating fiscal spending cannot be expected under the current institutional setting. While poorly performing local governments, low human capital in recipient regions, and corruption might all play a role in creating inefficiency (see for example Pisani-Ferry et al. (2011) for a discussion of the Greek case), improving upon those will only solve part of the problem.
We demonstrate that the inefficiency of EU spending in promoting the goal of convergence can be explained by the underlying institutional structure of the EU, where sovereign nations bargain over outcomes in the shadow of veto. Specifically, we model the outcome of the frequent negotiation rounds employed by the EU as the so-called Nash bargaining solution, explicitly taking into account the possibility for each member nation to veto and to withdraw its contribution (as the UK threatened in the most recent budget negotiations). It turns out that it is precisely the combination of voluntary participation, unanimity decision rule and the lack of a binding commitment to contribute to the joint budget that generally prevents efficient fiscal spending. In such a supranational setting, the distribution of relative bargaining power arises endogenously from countries’ contributions and their preferences over different joint projects. This creates a link between contributions to and allocation of the budget that is absent in federations, where contributions to the federal budget cannot simply be withdrawn and spending vetoed. Since the EU members lack such commitment, this link will necessarily lead to an inefficient outcome.
Why Does the EU Have These Institutions?
If the currently employed bargaining process cannot lead to an efficient outcome, why then did the EU member nations not institute a different allocation process right from the start? Of course, agreeing on a binding contract without the possibility for individual veto is politically difficult. More complicated bargaining processes may also be much more costly in terms of administration than is relying on informal negotiations and mutual agreement. Our analysis suggests another alternative: If the potential members of the union are homogeneous with respect to their income and the social usefulness (or spillovers) of the projects they propose to be implemented in the union, then Nash bargaining will actually lead to the budget being raised and allocated efficiently. The intuition behind this result is simple: If all countries have the same endowment, their opportunity costs of contributing to the joint budget are the same. Moreover, symmetric spillovers do not give one country a higher incentive to participate in the union than the other. Consequently, all countries have the exact same bargaining position. Thus, equilibrium in the bargaining game must produce equal surpluses for all nations. At the same time, with incomes and spillovers perfectly symmetric, the efficient allocation also produces the same surplus for each nation, so that it coincides with the Nash bargaining solution. It is important to notice, though, that symmetric income and spillovers do not imply homogeneous preferences: Each nation can still prefer its “own” project to the others. Instead, symmetry leads to a perfectly uniform distribution of bargaining power in equilibrium. Moreover, our analysis shows that efficiency is achieved if the union budget is small relative to domestic consumption and member countries have similar incomes.
This resonates well with the history of the European Union. In fact, the disparities between the founding members were not large, so that the current bargaining institutions could reasonably have been expected to yield efficiency. Only the inclusion of Greece, Ireland, Portugal and Spain created a more economically diverse community (European Movement (2010)). Our model shows that as the asymmetries between member countries or the importance of the union relative to domestic consumption grow, Nash bargaining leads to increasingly inefficient outcomes. Figure 2 shows this effect for a union of two nations. Keeping aggregate income constant and assuming symmetric spillovers between the two nations’ preferred projects, we vary asymmetry in their domestic incomes. The graphs show the Nash bargaining outcome (marked with superscript NB) compared to the generally efficient solution. As country A’s income increases, so does its outside option (i.e. all else equal, the higher the income, the less a country would lose if the joint projects were not implemented). Thus, country A’s bargaining position relative to country B increases in equilibrium, leading to an inefficient outcome. The allocation of funds to the union projects (upper right panel) depicts this channel very clearly: While the efficient allocation is independent from the distribution of national incomes, the Nash bargaining solution reflects the changing distribution of power. Nation A is able to tilt the allocation more toward its own preferred project the higher its income. Moreover, it is able to negotiate a “discount” for its contribution. While its contribution (labeled xa) does increase with its income (labeled ya), country A still pays less than would be budgetary efficient given its higher income (upper left panel). As a result of the inefficiencies introduced by the bargaining process, aggregate welfare in the union declines as asymmetry grows. Again, it is worth noting, that the loss in aggregate welfare is relatively small when asymmetry is small, but grows more than proportionally as the countries become more and more unequal (lower right panel).Figure 2. The Effect of a Union of Two Countries
This has troubling implications for the EU, as income asymmetry has increased with every subsequent round of expansion while the bargaining procedure for the fiscal funds has essentially stayed the same. It is not surprising then that a larger and more asymmetric EU has resulted in supranational spending that is increasingly inefficient.
The EU as a “Transfer Union”
We go on to show that the level of redistribution inherent in the Nash bargaining solution depends crucially on the overall size of the budget the union intends to raise. Increasing the EU’s budget for centralized fiscal spending would indeed lead to more “transfers” to low income members (in terms of net contributions), bringing the EU closer to the original goal of convergence. In fact, the EU could pick a budget such that inequality in terms of total welfare between member nations is completely alleviated. Such an outcome necessarily implies that the net gain from being part of the union for high-income nations is lower (albeit still positive) than for low-income members. However, this in turn has consequences for the endogenous distribution of bargaining power: Richer nations would be able to assert even more power and push even further for their own preferred projects, rendering the allocation of funds across projects less efficient. This trade-off between equality and efficiency implies that complete convergence is not necessarily socially desirable.
Arguably, this trade-off might be more important for a transition period than in the long run. If fiscal spending does not only lead to convergence in instantaneous welfare, but also has a positive effect on long-run performance and GDP growth, income asymmetries across countries will decrease even if the allocation of spending across projects is not entirely efficient. Less inequality in turn will lead to a more efficient allocation process in the future and endogenously reduce the level of necessary transfers. However, whether the growth effect of the EU’s structural funds is indeed positive remains a much-debated empirical question (see for example Becker et al. (2012)).
Institutions Fit for a Diverse Union
As the EU has expanded from the original six nations to the current 27, there has been a concurrent evolution of decision-making rules. A qualified majority rule is now used in many areas of competency. We show that the allocation of fiscal spending could also benefit from the implementation of a majority rule. Efficiency would be improved as long as the low-income member nations endogenously select into the majority coalition while their contributions to the budget remain relatively low. In connection to this, the EU might benefit from enforcing rules specifying contributions as a function of national income (such rules exist, but are easily and often circumvented), forcing wealthier member nations to pay more. An exogenous tax rule without the possibility to negotiate a discount, for example, may indeed improve overall efficiency.
It is important to note, however, that a unanimous approval of such a change is unlikely. The institutional mechanism of Nash bargaining is an “absorbing state” after the constitution stage, in the sense that not all member nations can be made better off by switching to an alternative institution. Therefore, the discussion of alternative institutions and decision making processes is particularly relevant when considering new mechanisms that increase fiscal spending at the union level, such as the proposed EU growth pact. If the same bargaining process remains to be employed even for new initiatives, even though a majority rule is preferable and implementable relative to the status quo, the opportunity for the EU to achieve efficiency in its fiscal spending is lost.
- Becker, S. O., Egger, P and von Ehrlich, M (2012) “Too Much of a Good Thing? On the Growth Effects of the EU’s Regional Policy”, European Economic Review 56: 648 – 668
- Besley, T. and Coate, S. (2003) “Centralized versus Decentralized Provision of Local Public Goods: A Political Economy Approach” Journal of Public Economics 87: 2611 – 2637
- Boldrin, M and Canova, F (2001) ”Europé’s Regions – Income DIsparities and Regional Policies” Economic Policy 32: 207 – 253
- Delmuth, L.M. and Stoffel, M.F. (2012) “Distributive Politics and Intergovernmental Transfers: The Local Allocation of European Structural Funds” European Union Politics 13: 413 – 433
- European Commission (2014) Data available at http://ec.europa.eu/regional_policy/what/future/index_en.cfm
- European Movement (2010) “The EU’s Structural and Cohesion Funds” Expert Briefing, available at http://www.euromove.org.uk/index.php?id=13933
- Lockwood, B. (2002) “Distributive Politics and the Cost of Centralization” The Review of Economic Studies 69: 313 – 337
- Oates, W.E. (1972) “Fiscal Federalism” Harcourt-Brace, New York
- Pisani-Ferry, J., Marzinotto, B. and Wolff, G. B. (2011) “How European Funds can Help Greece Grow” Financial Times, 28 July 2011.
- Sala-i-Martin, X (1996) ”Regional Cohesion: Evidence and Theories of Regional Growth and Convergence”, European Economic Review 40: 1325 – 1352
- Simon, J. and Valasek, J.M. (2013) “Centralized Fiscal Spending by Supranational Unions” CESifo Working Paper No. 4321.
- Swidlicki, P., Ruparel, R., Persson, M. and Howarth, C. (2012) “Off Target: The Case for Bringing Regional Policy Back Home” Open Europe, London.
- TFEU (1957) “Treaty Establishing the European Community (Consolidated Version)”, Rome Treaty, 25 March 1957, available at: http://www.refworld.org/docid/3ae6b39c0.html