EU vs. USA: The Great Divide

Back in 2004, Swedish economists Fredrik Bergström and Robert Gidehag published an excellent analysis of the economic gap between Europe and the US. They showed that if EU countries were part of the United States, Luxembourg would be, after DC and Delaware, the third richest state while all other countries would be ranked in the bottom third of the overall ranking. GDP per capita of France, Germany, UK, Italy and Belgium is comparable to Alabama and Oklahoma's GDP per capita.

The great divergence between the US and EU began in 1970s when productivity growth rates remained fairly steady in the US and slowed significantly in the EU. The major factor behind slow productivity growth in Europe was an increased regulation of labor and product markets. During that period, EU countries experienced strong growth of the unionization, tax burden and government spending.

Bureau of Labor Statistics presented international data on labor force participation for the US, Canada, Australia, Japan and six European countries. In 2008, the lowest participation rate of the labor force was found in Italy (49 percent), France (56 percent) and Germany (58.6 percent). Low rate of labor force participation can be attributed to tax wedge and over-regulation of the labor market which encouraged households in these countries to relocate working hours from formal into informal sector of the economy such as household production; which is very difficult to survey.

Historically, EU countries have had relatively high tax wedge on labor costs which is an important measure of tax burden of the labor supply. In 2008, tax wedge in the US represented 28 percent of labor costs. Moreover, it exacerbated a decreasing trend since 1999. Compared to the US, tax wedge in the EU was significant in Belgium (50.3 percent), Germany (47.3 percent), France (45.5 percent) and Austria (44.4 percent). More importantly, tax wedge in these countries has increased from 1999 onwards.

Part of the difference in tax burden between the US and EU can be explained by high government spending as a share of the GDP on aging-related entitlements and inefficient public sectors in the Continental Europe. In 2009, government spending as a share of the GDP was very high in Sweden (52.5 percent), France (52.3 percent) and Denmark (51 percent) compared to 34.7 percent in the United States where the ratio of government spending-to-GDP is likely to increase in the coming years due to additional entitlement spending and $787 of federal stimulus. Considering the efficiency of public sectors, in 2003, Ludger Schuknecht, Antonio Alfonso and Vito Tanzi published an analysis of public sector efficiency for 23 industrialized countries. The authors showed that public sector performance in Nordic countries and Netherlands is high and efficient compared to inefficient and cumbersome public sectors in countries of Continental and Mediterranean Europe.

The question is what is the real gap between Europe and the US and how should Europe catch-up the US level of income per capita. In 2008, US GDP per capita (PPP-adjusted) was about 40 percent higher than in EU15. The only feasible means of catching up the US is that EU should grow faster than the US. If Europe grew by 1 percentage point faster than the US economy on the permanent basis, then it would catch-up the average US level of income per capita in 34 years. If the EU grew by 2 percentage points faster than the US, the gap would be reduced to 17 years. If the US economic growth will be higher than in the EU, the gap between the continents would further widen.

Currently, the macroeconomic forecast for the European Union is not favorable compared to the US. European Commission forecasted 0.7 percent growth rate in 2010 while the Federal Reserves forecasted 2.5 to 3.3 percent growth rate in this year for the US.

To stimulate economic growth, European policymakers should boost the reduction of government spending and tax burden and a full-fledged liberalization of labor and product markets which could boost human capital as the main engine of economic growth. Without a prudent setup of pro-growth policies already recommended by Andre Sapir et al. in 2003, it is very unlikely for the European Union to ever catch-up the US level of income per capita.