05 May 2020

Vox - Garicano: Towards a European Reconstruction Fund

The idea that Europe’s response to the economic crisis should be based on the issuance of common perpetual bonds has been slowly gaining ground, but proposals that entail substantial increases to member states’ debt risk hampering growth for decades to come.

This column argues that the time has come for genuine European spending financed through European borrowing. It examines the legal and financial issues around the possible implementation of a proposal for the Commission to issue consolidated annuities (‘EU Consols’) to finance a €1 trillion economic reconstruction package.

After being first proposed by Francesco Giavazzi and Guido Tabellini (2020), the idea that Europe’s response to the economic crisis should be based on the issuance of common perpetual bonds has been slowly gaining ground. They first highlighted that issuing at ultra-long or perpetual maturities would take advantage of the low-yield environment, eliminate refinancing risk, and send a strong signal of European unity to the market. 

Nevertheless, their proposal would entail a substantial increase to member states’ debt. Both authors suggest member states should issue perpetual bonds backed by their joint tax capacity. Given how high debt levels are in many countries, this would threaten to hamper growth for decades to come. It operates under the same logic as the three instruments (the ESM, the EIB, SURE) in the Eurogroup's deal – namely, that European issuances should only be used to generate more debt in member states. 

The time has come for genuine European spending financed through European borrowing. To this end, Guy Verhofstadt and I recently proposed that the Commission issue consolidated annuities (or ‘EU Consols’) to finance a €1 trillion economic reconstruction package (Garicano and Verhofstadt 2020). Our proposal, in line with the European Parliament’s 17 April resolution,¹ would see the money spent (and not lent) along the EU budget's future-oriented priorities. We propose that to prevent any increases in the financial contributions of member states, the additional EU-level (interest) expenses must be paid for with new revenue sources at the EU level.

Since then, this proposal has been taken up by the Spanish government and is one of the contending landing zones for the Reconstruction Fund debate. Building on our previous articles, in this column I expand on the proposal’s legal and financial implementational aspects.

The economics

The grand bargain that we put forth to member states is that they can keep their contributions to the EU’s next seven-year budget – a matter of constant bickering – at current levels. In exchange, we ask them to drop their reluctance to allow the creation of new, modern EU-wide streams of revenues that could bring between €26 billion and €38 billion a year. These new revenues would be used to pay the interests on the EU Consols. Of the potential sources of revenue that have been discussed (including the Financial Transactions Tax and the Carbon Border Adjustment Mechanism), we put to use four that have already been designed and proposed by the Commission:

1. The Emissions Trading System (ETS): Today, all of the revenues from the ETS are kept by member states. To ensure that they do not lose any existing revenues, we follow President Michel's February proposal: only ETS revenues in excess of the average amount member states received in the 2016-18 period (about €8 billion) would flow into the EU Budget. ETS revenues are the most volatile of our proposal, but we can work with existing estimates of €20 billion in total annual revenues in Phase IV of the program (WWF 2020). For reference, in 2018, it generated €15 billion, growing more than 150% with respect to 2017. Net, the ETS would entail €12 billion in annual EU revenues. 

2. Plastic-based contribution: The European Court of Auditors estimates this would amount to €7 billion a year from a €0.8 per kilo call rate. Applying the maximum call rate allowed for in the proposed Regulation (€1.0 per kilo), we can increase revenues by 25% to yield around €9 billion a year.

3. Digital tax: The Commission's 2018 proposal for a 3% tax on revenue on large tech companies is the only new revenue we propose that has not been formally proposed as a new ‘Own Resource’. Assuming a 100% call rate on the revenue estimates of the 2018 proposal, the digital tax could bring in around €5 billion. According to the Commission’s impact assessment, however, potential revenues could be as much as €10 billion (European Commission 2018).

4. Common Consolidated Corporate Tax Base (CCCTB): Approving the CCCTB as proposed by the Commission in 2018, and applying a 3% call rate on member states’ revenues, would generate €12 billion a year, according to the European Court of Auditors. This would be the only new revenue to the EU budget that would reduce existing revenues that member states already have. However, we would expect this reduction to be offset by a general increase of revenues due to the harmonised tax rates.

Taking into account the perpetual nature of the Consol's principal, how much leverage could these new sources of funding allow for? We see three main precedents of publicly syndicated long-term bonds that could help us ballpark the coupon of the EU Consols:

1. Israel in 2020: Israel secured $1 billion in dollar funding through 100-year bonds to combat the COVID-19 crisis. Five times oversubscribed due to the unprecedented context and nature of the issuance, they priced at a 4.5% coupon.

2. Austria in 2017: Austria raised €3.5 billion by issuing a 100-year bond at a 2.1% coupon, which now trades at a 1% yield. It is the sovereign bond with the longest maturity in the EU.

3. European Stability Mechanism (ESM) in 2018: The ESM issued almost €1 billion in 40-year bonds at a 1.85% coupon, which now trades at a 0.7% yield. It is the longest-dated debt issued at the European level.

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