Rethinking fiscal policy is everyone’s business – here’s why

In an ideal world, governments use fiscal policy to keep the economy rolling while meeting societal and environmental needs. In the real one, the EU’s fiscal policy is radically unfit for a world drowning in crises. In fact, it aggravates these crises. Changing the course will require forgoing arbitrary rules, a few myths and an outdated economic mindset. 

The European Environmental Bureau and the European Youth Forum’s ongoing webinar series “Fiscal Policies for a Sustainable Future”, aimed at youth and environmental activists, explores fiscal policy, its links to the climate crisis and reform proposals for the EU’s economic governance framework. Here, we review the key insights from the first webinar. 

While we’d like governments to spend money on the good stuff, sometimes they fail to. Take, for instance, the billions spent on subsidies to fossil fuels amid the climate emergency, taxes that drive inequality, and fiscal rules that constrain essential spending. This is why everyone should know what’s wrong with the fiscal policy today and how to change it.

Back to the basics 

Fiscal policy is essentially about taxation, spending and borrowing. First, governments collect taxes through several streams. The EU gets half of its tax revenues from labour, 28% from consumption, and one-fifth from taxes on capital. The governments then spend money on healthcare, education, the environment, social protection and other priorities. They can also borrow money when such a need arises.

Governments use fiscal policy to manage the business cycle: the rise and fall in economic activity over time. A single business cycle has four phases: expansion, peak, contraction, and trough. Expansionary fiscal policy pushes governments to increase the money supply through more spending or cutting taxes during contraction or recession to increase the total amount of goods and services demanded in an economy, while contractionary fiscal policy is the opposite: governments should decrease the money supply by cutting spending or increasing taxes.

This way of managing the business cycle has its downsides. Increasing spending without regard for its broader impact on society and nature can easily lead us to the wrong place. And spending cuts often happen at the expense of essential public services. The current short-term focus and narrow goals driving fiscal policy prevent governments from grasping the perfect storm of their own making.

The rules that get us nowhere 

Today’s fiscal policy is largely driven by Maastricht rules that limit government debts to 60% of the GDP and the budget deficit to below 3%. Further, the Stability and Growth Pact, introduced in 1992, was created to prevent the negative impacts of unpaid debt and provides more detail on those rules. The problem is that there isn’t much science behind them, but there are enough arbitrary assumptions. 

For example, a common assumption is that more debt puts a greater burden on future generations. New coal power plants surely do, but investing in climate action has the opposite effect, making people less vulnerable to extreme weather and preventing the need to spend many times more on reversing the damage.  

Instead of preventing crises, the EU fiscal rules constrain spending on essential social and environmental goals, leaving agendas such as the European Green Deal underfunded.  

More broadly, rather than investing in our shared future, governments prefer an economy that is stable at the surface but vulnerable, unfair and inefficient at its core. Today’s fiscal policy destabilises the struggling economy and inevitably leads us to austerity, putting an extra burden on those suffering the most. This undermines the government’s capacity to meet the challenges of our time and support the effective functioning of society. 

And things turn particularly bad when we face a crisis like no other. 

Public finances meet the climate emergency 

Fiscal policy and the climate crisis are tightly linked.  

Floods, droughts and food shortages caused by the disrupted climate directly impact the economy. For example, public money is spent on recovery from extreme events, dealing with climate migration and growing healthcare needs. Money must also be spent adapting buildings, infrastructure and ecosystems to the changing climate.  

As environmental protection accounts for only a small fraction of the EU public spending, we are not on track with our climate commitments. Recent estimates show an 855bn green funding gap in meeting the EU’s 2030 environmental goals, excluding transport and the just transition needs. And it is very unlikely that the private sector will close the gap, as 60% of green investments lack a business case until 2030. 

As private actors stumble on necessary action, governments urgently need to increase spending on environmental and social goals. Yet they keep bumping against the same old rules serving illusionary goals. This is why rethinking the fiscal rules guiding government action is a must.  

Getting fiscal on track with people and nature 

The various problems of the EU fiscal rules have been recognised, and the ongoing review process provides room for hope. There is no shortage of proposals for alternative and future-fit fiscal frameworks. What we need is political willpower to bring those proposals to life.    

The Fiscal Matters coalition, which the EEB and EYF are part of, has put forward an ambitious vision for reforming the EU economic governance and fiscal framework with a shift from the Stability and Growth Pact towards the Wellbeing and Sustainability Pact to refocus fiscal rules around helping humans and nature to thrive together. The coalition demands more flexibility and a greater focus on spending quality to safeguard the economy from long-term risks and support achieving sustainability goals.  

Other necessary changes include the green and just tax reform. A more progressive tax system in the EU should reduce the tax burden on low-income and young people and increase taxes on capital and wealth. For example, a minimum corporate tax on a company’s profits could help prevent the use of tax havens. We also need to start taxing pollution and resources more heavily to prevent nature’s destruction and have more money to restore it. 

Investing in employment beyond green jobs, which have benefitted relatively few people and regions, would help redirect the economy towards a sustainable path. And job guarantee schemes could help ensure that all people in the EU have access to education, training, or meaningful employment. 

As the EU is out drawing the contours of the future economic governance and fiscal framework, we all have a chance to contribute. And it makes sense for everyone to know how to bring the necessary changes into life. 

Watch the recording of the first webinar from the “Fiscal Policies for a Sustainable Future” series, covering the basics of fiscal policy in a changing world and attended by more than 80 people, or register for the next one to be held on March 28, 2023.