Patrick Artus, chief economist at Natixis
A raft of economic indicators show France deteriorating rapidly compared to its eurozone neighbours, largely attributed to structural problems concerning profitability, competitiveness and product sophistication.
But as non-residents remain buyers of French government bonds – allowing France to finance its external borrowing requirements despite the low return on physical and financial capital – these investors need to take into account the wider repercussions of a faltering economic recovery.
Although President Francois Hollande recently announced another set of supply-side reforms, we believe that the French government needs to move beyond these long-term structural changes – necessary though they may be. In fact, Hollande would do well to introduce additional measures that will have a significant effect on the expectations and decisions of investors in the short-term, largely by restoring employment and investment.
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The proposed structural reforms are essential, but too slow
It would be difficult for international investors to be unaware of France’s structural problems. These stem from low potential growth, high fiscal deficits, squeezed industrial profit margins – which are creating problems for foreign trade and perpetuating deindustrialisation – and a non-competitive labour market.
And if these trends continue, significantly worsened financing conditions could be felt by the government, as well as by banks, companies and households. Meanwhile, dire growth prospects could impact the performance of the equity market and lead to investor pessimism. Before all this becomes a reality, the need to act is paramount.
Of course, there are numerous structural reforms currently underway – albeit slowly. Tax reforms have been put in place to reduce the burden of social contributions on companies. Meanwhile, cuts in government spending are aimed at trimming the overall tax burden. And vocational training and the education system will soon be given a boost – helping to improve competitiveness. Also, closed professions are being opened up in a bid to increase competition, which should increase supply as well as lower the price of high-end services.
Lastly, much-needed reforms are being made to the labour market. With no current link between unemployment and wage growth in France, there are hopes that wage formation can be brought in line with the macroeconomic situation. Additionally, the government plans to replace the Labour Code with company-wide agreements.
Other measures: improve the French economy by focusing on employment and investment
There is relative market consensus on the structural reforms listed above. But most seem too limited, while others are unlikely to be carried out. Indeed, endeavours must be made to unlock growth in the short-term. We point to three potential measures that could positively impact the French economy, as of 2014.
First, all remaining employer social charges on the lowest wages should be eliminated. It is well-known that the sensitivity of employment to the cost of labour is high for low-skilled employment. Reductions in social charges at this level (for a cost of EUR 20 billion) have saved 200,000 to 400,000 jobs. With a further reduction in charges by around EUR 7 billion, 100,000 jobs could potentially be created.
Second, a law should be enacted that prohibits any change in corporate taxation or regulations for several years, particularly focused in such sectors as safety as well as the labour market. This could reduce the uncertainty currently causing corporate pessimism and a freeze in corporate spending. Since the financial crisis, the tax burden on companies has sharply fluctuated.
Third, tax measures should be introduced that are designed to incentivise companies to invest. Under-investment is a major issue for the French economy as it is preventing a recovery in productivity and technological progress.
The possibilities here include accelerated depreciation and the introduction of a very low corporate tax rate for reinvested profits. Indeed, a 10% reduction in the tax rate on retained earnings would cost EUR 13 billion per year, and would represent 6.5% of investment.
Of course, it would be necessary to finance the cuts in social security contributions and corporate taxation (i.e. about EUR 20 billion per year), which could be achieved through abolishing superfluous tax exemptions or by pushing back the retirement age (government spending on pensions accounts for 14% of GDP). Taking into account contributions, the retirement age should be pushed back by about one year.
Having the imagination to do more than structural reforms
It is therefore important for Hollande to go above and beyond the structural reforms he has recently proposed. As mentioned, he could do this by further reducing the cost of low-skilled labour, creating jobs for the low-skilled unemployed, providing tax incentives for companies to invest, and covering those expenses by an accelerated pension reform – which could involve extending the retirement age.
Pushing back the retirement age usually leads to a fall in savings and a rise in consumption, as it becomes less necessary to save for retirement. Raising VAT, on the contrary, depresses consumption.
Certainly, there is a disconnect between the relative deterioration in France’s financial markets – where the slight underperformance in the equity market isn’t of much concern as non-residents remain massive buyers of French government bonds – and the deteriorating situation of the country’s economy, due to significant structural problems.
However, if suitable reforms are not implemented soon to restore employment and investment, there is a possibility the financial markets will also be dramatically affected soon.