OECD’s Jens Arnold: raising VAT rates “lesser evil” for economic growth

The Czech economy has now been in recession for 15 months, which is the longest period since the late 1990s. The ongoing crisis in the eurozone, low household demand as well as the government’s austerity measures are all considered to be the major factors behind the faltering economy. Last week, the Prague-based Banking Institute – College of Banking held a conference focusing on ways of restarting economic growth. One of the keynote speakers was Jens Arnold, a senior economist at the international economic organization OECD. He suggested that raising the VAT rates, as the Czech government did, would not be as detrimental to the GDP’s growth as some Czech economists, and critics of the government believe. Mr Arnold also made a case for less restrictive policies in the services and labour sectors. I sat down with Jens Arnold and asked him how liberalization could help boost growth.

Jens Arnold, photo: archive of Jens Arnold

“I don’t know if you want to call this liberalization. In the specific case of the services sector reform where the Czech Republic made substantial progress, you could call it liberalization. But liberalization does not necessarily mean that you give all the power to market forces. There are elements, particularly in the services sector, where public policy has to intervene so as to make competition feasible. That’s the case of a local loop in telecommunications or other network industries where you really have to get in as a regulator to make competition possible. So in this sense, liberalization should not be misunderstood as zero intervention.”

But when you spoke about the labour market, you said that high levels of protection of individual jobs can hinder the development of the economy. So that would mean you advocate liberalization in the sense of less regulation of employers.

“Yes, that would indeed mean that. But you also have to think clearly of the details and of what you want to observe. However, it’s without a doubt true that you reduce the incentives to hire people if you have very strong employment protection legislation.

And you can ask the question: is it ultimately the jobs you want to protect – meaning the combination of a person on a given task – or do you want to protect the person? In this respect, for example the Scandinavian countries have found a way of combining high flexibility on the labour market with a strong degree of individual protection in case of people losing their jobs. So if that is the ultimate objective, there are ways to get there without inflicting as much distortion and inflexibility on the economy as you would through strict employment protection.”

In the Czech Republic, weakening household demand is seen as one of the biggest problems of the economy. Wouldn’t lower protection of jobs worsen the situation?

Photo: European Commission

“I think we have no clear evidence on this issue and we don’t all that much about it. But in principle, you would think that household consumption decisions are more an outcome of household incomes rather than only whether they have jobs or not or whether they stay in a job for a long time or not. You can have a system that allows flexibility yet preserves individual incomes – this is a way that some of the Scandinavian countries have adopted. If you think that households have no reasons to fear that their income is at risk, there would not necessarily be any impact on consumption.”

There has been much debate here about whether the government’s decision to raise the VAT rates by one percent will hinder the growth. You suggest that consumption taxes, including VAT, don’t that big effect on growth – is that correct?

“Yes but you should bear in mind that what the data show us is that given a certain level of tax revenues, it is on average more conducive to economic growth to rely more strongly on consumption and property taxes as opposed to income taxes. That is the message the data tell us for the average OECD countries. In that respect, raising the consumption tax may still have a detrimental growth effect but it will certainly have less detrimental growth effect than if you were to raise the same kind of revenue from income taxes.”

Earlier today, Czech economist Pavel Mertlík said the Czech economy was in what he called a “liquidity trap” which means that all the standard tools of supporting economic growth have been used, albeit to little effect. How immediate do you think the effect of the structural reforms you talked about could be? And what else can the government do over the short run?

“I think that at a time of crisis, the focus is obviously to a large extent on macroeconomic policies, and quite rightly so. But at the same time, it’s also important to take a longer perspective and maybe also look a little bit at what you can do to enhance potential growth. We should not be under the illusion that the effects of that would come immediately; they do take time to materialize. However, if we don’t do them now, we’ll only do them later and will only get the effects later too. So the right time to start to think about these issues is clearly now.”

Photo: Barbora Kmentová

There has also been a lot of discussion between members of the Czech government and their critics about how important growth really is. Czech Finance Minister said time and again there were other ways of evaluating the state of the economy than just growth – do you agree?

“I think we know this is not the only objective and there are clearly other dimensions we have to look at. You could think of wellbeing which is influenced by non-economic factors; you could think about distribution because GDP per capita is just an average and does not necessarily tell you everything about the economic wellbeing of individuals. So there are other things you need to take into account.

But at the same time, GDP per capita is a measure of how large the pie is that you can then redistribute. So I think it’s an important indicator that can tell us a lot although it’s not the only thing we should look at. But it provides the basis for many other things, and it also has the advantage that it’s clearly measurable whereas if you think of the wellbeing of people for instance, you get into tremendous measurements problems, and policy should be guided by evidence.”