Is France changing?

President François Hollande has big problems with the necessary reforms. If he keeps practicing the art of compromise and diversions, France will keep sliding down the economic ladder. A commentary by Charles Wyplosz.

Charles Wyplosz
«Bringing spending down to, say, German level would most likely boost productivity, and help with the budget deficit.»

Faced with a dismal economic performance, rising public debt, a budding tax-revolt and public opinion ratings at historical lows,  President François Hollande created a massive surprise when he presented the customary New Year good wishes to his gloomy French citizens. He announced what he called a Responsibility Pact with firms: in exchange for reduced corporate taxation, firms would create jobs. He would also substantially cut public spending and alleviate the regulatory burden that hampers economic activity. He even dubbed this new orientation “supply-side socialism”, combining two words that, in France at least, are considered as mutually incompatible.  Coming from a man who spent the first eighteen months of his Presidency reneging on his electoral promise of ending austerity, he has raised taxes, in particular on firms and wealthy people, increased spending on social programs and resisted calls to roll back the public sector. The turnaround is indeed stunning. The question is what exactly he plans to do and whether he really intends to do it. One month and a couple of public speeches later, we do not have answers yet, but skepticism is rising. 

Start with the numbers. They are not firmly set but the plan is to trim some 6% of labor costs by reducing overhead taxes paid by firms to finance the allowances paid to families of two children or more, a system often seen as a key reason why the population has not been declining as in much of the rest of Europe. This is big, until you realize that various labor taxes amount to about two-third of labor costs; obviously, there is much space left to reduce labor costs. The plan also assumes that wages net of taxes will remain unchanged. But the leader of the largest trade union has already indicated that labor taxes are just a part of what workers earn, suggesting that the tax reduction should be accompanied by an equal increase in wages net of taxes. This would leave labor costs unchanged, defeating the President’s aim.

High public spendings

Financing the tax reduction is the next logical question. The answer seems to do it through spending cuts, which would indeed give the policy a supply-side flavor. The President has mentioned a reduction of the public budget worth 2.5% of GDP by 2017, the year of the next presidential election. Here again, this looks big, but keep in mind that public spending stands at 57% of GDP (only slightly less than in Denmark and 10% higher than the OECD average). In Germany, public spending is about 44% of GDP, in Switzerland it is 34%. There is little doubt that much of French public spending is unnecessary, and some of it is likely to have a negative value added, for example civil servants imposing regulation as a way of justifying their jobs. Bringing spending down to, say, the German level would most likely boost productivity, and help with the budget deficit. At the speed announced by Hollande, it will take a decade or more to get there.

To make matters worse, the President is recycling previous announcements. A program adopted a year ago, the tax credit for encouraging competitiveness and jobs or CICE by its acronym in French, already involves a reduction in labor taxes. It is unclear how the two measures will relate to one another but it has been indicated that they will not be cumulative. The CICE has not had much success so far because it only concerns lower salaries and its implementation is so complicated that many small and medium-sized firms are simply not applying. Similarly, the government already announced that it would reduce some of its spending in 2014.

Still, does it represent a strategic turn? The President claims that it is just an acceleration of his strategy, not a U-turn. In a way, that is true given the previous announcements. Still, his first year and a half in office has seen decidedly anti-supply side policies. Indeed, the left of the political spectrum is incensed at what they consider treason. In fact, there are good reasons to see this as the end of the first phase of the Hollande Presidency, which did not go well. Growth has been virtually nil, the budget deficit has hardly been reduced and the public debt is headed to 100% of GDP. Somewhat foolishly, he announced in Spring that unemployment would start receding by year’s end. In spite of a large public-financed temporary job program, unemployment is growing. He could no just carry on. With his back against the wall, he adopted the time-honored tactic of diversion.

In November already, at the height of the tax revolt, his Prime Minister tried the same tactic when he suddenly announced a complete overhaul of the tax system. It could not work. Tax reforms are famous for being long and complex, as well as political dynamite. The Responsibility Pact is a way of burying the tax reform and the relentless upward drift of unemployment under a seemingly bold initiative. Will it fare better?

Undermining incentives

In fact, it is already faltering. Within his party and among trade unions, reducing the tax burden on labor is seen as a present to corporations, which is amazing. While the whole idea of supply-side policies is to create incentives for firms to invest and hire, the public debate is now about what corporations will give in return for the present that they are handed in. Hollande has already announced that he will indeed require payback by corporations. But what can he ask? More jobs, for sure, but that cannot be decreed. He has talked about setting up a “Payback Council” that will monitor job creation, suggesting that the tax relief might be rescinded if the Council is unhappy. This is already scaring firms, which initially reacted with glee to the new orientation of economic policies. By creating uncertainty, the payback debate is undermining the incentives to invest and hire. More importantly, perhaps, it suggests that the President is not wed to business-friendly measures. It also previews a deep and divisive debate within his electoral base between those who understand the need to switch away from policies that have choked the corporate sector and those who see the world through the lenses of class warfare.

The question then is where Hollande will settle. He probably does not know himself yet. Throughout his long political career, he has displayed great skill at always being in the center of gravity by inventing creative compromises. This might be clever politics but, in this case, it will be poor economics. Of course, he can emerge from his chastening experience of economic adversity as a new man, ready and willing to pursue a clear strategy and determined to confront his foes. This would indeed be a major turnaround, not just for him but for France as well. It would mark the long-awaited shift of the French Socialists from a culture deeply hostile to corporations and to finance, which as a candidate Hollande identified as his true enemy, to a classic European Social-Democratic party. It would most certainly lead to deep restructuring of the other mainstream parties. If not, Hollande will keep practicing the art of compromise and diversions, and France will remain largely unreformed and keep sliding down the economic ladder.