Introduction

The on-going economic and financial crisis in the EU has been a catalyst for deep change. Its impact can be seen in the profound restructuring of our economies which is currently taking place. This process is disruptive, politically challenging and socially difficult – but it is necessary to lay the foundations for future growth and competitiveness that will be smart, sustainable and inclusive.

In order to continue with the necessary reforms, the EU needs to be able to show that our policies are working, that they will deliver results over time and that they will be implemented fairly in terms of the impact on our societies. Correcting the problems of the past and putting the EU on a more sustainable development path for the future is a shared responsibility of the Member States and the EU Institutions. Recognising that our economies are closely intertwined, the EU is now reshaping its economic governance to ensure better policy responses to current and future challenges.

This Annual Growth Survey launches the European Semester for 2013 and sets out how this shared responsibility can be used to drive change across the EU, laying the foundations for a return to growth and job creation.

The context

The economic situation in the EU remained fragile in 2012. For the year as a whole, GDP is now expected to contract by 0.3% in the EU and 0.4% in the euro area. It will take time to move towards a sustainable recovery.[1] After several years of weak growth, the crisis is having severe social consequences. Welfare systems cushioned some of the effects at first but the impact is now being felt across the board. Unemployment has increased substantially and hardship and poverty are on the rise. These difficulties are particularly visible in the euro area, but also extend beyond it.

The duration of the crisis has not helped Member States to press ahead with meeting their Europe 2020 targets on employment, R&D, climate/energy, education and the fight against poverty, and overall Europe is lagging behind its objectives.[2] Yet, progress in all of these areas is needed to move towards a smart, sustainable and inclusive European economy.

While challenges vary significantly across countries and inside the euro area, the prospect of a slow recovery makes the situation difficult for the EU as a whole. The levels of debt accumulated by public and private actors restrict the scope for new activities and investments. Fiscal and monetary policy instruments have been heavily mobilised and room for manoeuvre is now limited. Structural reforms are an essential part of restoring Europe's competitiveness but these decisions are often difficult to take. Transparency about the objectives of current policies and attention to fairness in terms of impact on society will be very important in sustaining the momentum for reforms.

The short-term outlook is still precarious but there are also more positive trends at play. Macro-economic imbalances, which have accumulated over a long time, are now being corrected, and parts of Europe are regaining competitiveness, even if there is still a long way to go to eliminate divergences in performance.[3] Progress is being made in consolidating public finances, and important steps have been taken to reduce tensions in the financial markets. Importantly, for those countries which have engaged in deep reforms, there are initial signs that they are beginning to work, with indebtedness reducing in the public and private sector in a number of Member States and exports increasing in several countries with previously large trade deficits.

Much has already been done at the EU level in 2012 to break the vicious cycle between the weaknesses of our financial systems, tensions on the sovereign debt market and low economic growth, in order to create the conditions for a sustainable recovery:

§ The establishment of the European Stability Mechanism provides a credible backstop to assist euro area countries whose access to finance is curtailed.

§ The adoption of a Compact for Growth and Jobs by the Heads of State or Government at the June 2012 European Council should galvanise the efforts of the EU legislator and administrations at all levels to mobilise the growth levers they have at hand - from the implementation of the Single Market Acts to the more targeted use of EU Structural Funds. The Commission has also recently proposed a strategy to improve the functioning of energy markets, as well as measures for a reinforced industrial policy.

§ New rules to strengthen economic governance, notably within the euro area, are being implemented ("six pack" legislation), agreed (Treaty on Stability, Coordination and Governance) or should be agreed soon ("two pack" legislation).

§ The European Central Bank has taken important measures to safeguard financial stability in the euro area.

Other key decisions are being discussed, which will influence Europe's future:

§ We still need to find an overall agreement on the EU's multi-annual financial framework for 2014-2020. This will be essential in restoring growth and competitiveness across Europe and in achieving our Europe 2020 goals.

§ Important steps are being considered to reinforce the Economic and Monetary Union (EMU). In parallel to this Survey, the Commission is presenting a blueprint for a genuine EMU. The 2012 December European Council will also discuss these issues.

The annual country-specific recommendations adopted in July 2012[4] should be the basis for action by the Member States. Implementation is the subject of a continuous dialogue between the Member States and the Commission and progress will be assessed next spring. As shown by the report from the European Parliament on the European Semester[5], monitoring at the EU level plays an important role in coordinating and supplementing Member States' own efforts.

The priorities

The purpose of this Annual Growth Survey is to set out the economic and social priorities for the EU in 2013, by providing overall guidance to the Member States and the EU in conducting their policies. It launches the third European Semester of policy coordination, through which national performances and priorities are reviewed collectively at the EU level in the first half of each year. The European Council will issue guidance in March 2013 and Member States are due to present updated national programmes by mid-April 2013, following which the Commission will present its country-specific recommendations.

The short-term challenge is to restore confidence and stabilise the economic and financial situation, while carrying out structural reforms which will lay the foundations for a sustainable job-rich recovery and will allow the economy to transform itself in the medium-term. Such an adjustment will take time, so action is needed now.

Building on positive signs that the reforms already initiated are having an impact, the Commission considers that the priorities identified in last year's Survey remain broadly valid and that efforts at national and EU level in 2013 should again be concentrated on the following five priorities:

§ Pursuing differentiated, growth-friendly fiscal consolidation

§ Restoring normal lending to the economy

§ Promoting growth and competitiveness for today and tomorrow

§ Tackling unemployment and the social consequences of the crisis

§ Modernising public administration

1. Pursuing differentiated, growth-friendly fiscal consolidation

As a result of the crisis, the sovereign debt ratio has increased in just a few years from 60% to 90% of GDP on average in the euro area. Public finances urgently need to be overhauled to sustain welfare systems and public services, to limit the costs of re-financing for the State and other public authorities, and to avoid negative spill-overs for the rest of the economy, including possible contagion effects on other countries. Demographic developments will also continue to add pressure on age-related expenditure. Particular attention needs to be paid to fiscal policy in the euro area, where the impact of unsustainable national fiscal policies on other Member States is much stronger than elsewhere.

The overall trend of fiscal consolidation currently taking place indicates that progress is being made: government deficits in the euro area are expected to fall from an average of over 6% of GDP in 2010 to just over 3% in 2012. Public debt is expected to peak at about 94.5% next year in the euro area and in 2014 across the EU, and should then to start to decline as a percentage of GDP.

Fiscal consolidation may have a negative impact on growth in the short term. This effect is likely to be stronger during financial crises when financing conditions for other economic actors are also tight. However, this is not the only factor which matters for growth: depending on the choices made about the composition of the adjustment, the "multiplier effect" of fiscal policy will be different. For instance, experience has shown that in countries with relatively high shares of public expenditure in GDP, and relatively high tax rates, fiscal consolidation achieved through a reduction of expenditure rather than a further increase in taxation revenue is more supportive to growth in the long run. Between 2009 and 2012 fiscal consolidation was achieved by using both expenditure and revenue measures to a broadly similar extent: expenditure is forecast to have diminished by 2 percentage points of GDP and revenue to have increased by 1.3 percentage points.

Moreover, the alternative scenario of postponing fiscal adjustment would prove much more costly. Several Member States are unable to finance their needs by going to the markets or are struggling to contain rising spreads on their bonds because of doubts about the sustainability of their public finances. To restore the confidence of investors, reduce the costs of debt repayment and create fiscal room for manoeuvre, what is needed in these countries is a determined effort, at an appropriate pace, to put public finances on a sustainable path. The negative impact on growth can be largely mitigated, provided fiscal adjustment is well designed. Regaining fiscal sustainability will benefit both public and private actors in these countries and will contribute to the overall financial stability of the EU.

Each Member State is in a different fiscal and economic position and this is why the Commission advocates a differentiated fiscal consolidation effort, appropriate for each country. In line with the Stability and Growth Pact, these strategies should focus on progress achieved in structural rather than purely nominal terms, and include a composition of adjustment which supports both growth and social fairness. Such a differentiated approach also helps in readjusting current account imbalances.

The Stability and Growth Pact provides the appropriate framework for a flexible and efficient fiscal adjustment. The fiscal targets are expressed in nominal terms, and this is what often dominates the headlines. However, the Pact puts emphasis on the underlying budgetary position and the consolidation effort recommended by the Council is therefore expressed in structural terms.[6] Accordingly, if these conditions are met, a Member State may be given a longer time to correct its excessive deficit if a worse-than-expected economic situation prevents it from reaching its agreed objective. For example, during 2012, the deadlines set for Spain and Portugal to bring their government deficits back below 3% of GDP were extended by one year, giving them until 2014 to achieve this goal. Once excessive deficit situations are corrected, Member States should reach their medium-term budgetary objective, which will ensure that public finances are maintained at sustainable levels.

For those Member States which have lost market access for the refinancing of their debt, a rapid pace of fiscal adjustment is required to urgently restore investors' confidence. A concentrated effort, as agreed under the economic adjustment programmes, will also facilitate the necessary correction of macro-economic imbalances. This evidence is supported by the positive adjustment taking place in Ireland, Portugal and Romania. In Greece, however, the process has been longer and more costly due to a combination of factors, including the recurrent uncertainty regarding the implementation of the programme.

For Member States with greater fiscal room for manoeuvre, automatic stabilisers can play their role fully, in line with the Pact. The pace of consolidation can support growth, but Member States should bear in mind possible fiscal risks arising from delaying consolidation in view of the challenges of high debt levels, the prospect of an ageing population and the relatively low growth potential in some countries, as well as the negative consequences that a change in market sentiment would create.

The Commission will continue to be attentive to developments in the real economy. In particular, the forthcoming Commission winter forecasts, scheduled for early next year, will show whether Member States are respecting the agreed path for the reduction of their structural deficit and whether adjustments in the deadline for the correction of the excessive deficits would be justified, in full respect of the spirit and the letter of the Stability and Growth Pact.

Restoring sound public finances is a long process. Strong EU governance rules and national fiscal frameworks, as foreseen in EU legislation, will help to anchor these efforts over time. Such rules include the setting of numerical fiscal rules, the recourse to independent fiscal institutions and medium-term planning, with multi-lateral surveillance of progress.

On the expenditure side of government budgets, it is essential to look at the overall efficiency and effectiveness of spending. While the situation differs across countries, the Commission has recommended being selective where cuts are envisaged so as to preserve future growth potential and essential social safety nets. In particular, the Commission considers that:

§ Investments in education, research, innovation and energy should be prioritised and strengthened where possible, while ensuring the efficiency of such expenditure. Particular attention should also be paid to maintaining or reinforcing the coverage and effectiveness of employment services and active labour market policies, such as training for the unemployed and youth guarantee schemes.

§ The modernisation of social protection systems should be pursued to ensure their effectiveness, adequacy and sustainability. Reforms of pension systems should be stepped up to align retirement age with life expectancy, restrict access to early retirement schemes, and enable longer working lives. Also in the context of the demographic challenges and the pressure on age-related expenditure, reforms of healthcare systems should be undertaken to ensure cost-effectiveness and sustainability, assessing the performance of these systems against the twin aim of a more efficient use of public resources and access to high quality healthcare.

On the revenue side of government budgets, recent trends show that many Member States have increased personal income taxes and/or VAT rates.[7] There is, however, still scope to shift the overall tax burden towards tax bases that are less detrimental to growth and job creation, and to make tax systems more efficient, competitive and fairer. Such a shift requires a package approach which ensures equitable redistribution and is adapted to the circumstances of individual Member States. This is why the Commission recommends that:

§ The tax burden on labour should be substantially reduced in countries where it is comparatively high and hampers job creation. To ensure that reforms are revenue-neutral, taxes such as consumption tax, recurrent property tax and environmental taxes could be increased.

§ Additional revenue should be raised preferably by broadening tax bases rather than by increasing tax rates or creating new taxes. Tax exemptions, reduced VAT rates or exemptions on excise duties should be reduced or eliminated. Environmentally harmful subsidies should be phased out.[8] Tax compliance should be improved through systematic action to reduce the shadow economy, combat tax evasion[9] and ensure greater efficiency of tax administration.

§ The corporate tax bias towards debt-financing should be reduced.

§ Real estate and housing taxation should be reformed to prevent the recurrence of financial risks in the housing sector. In particular, aspects of tax schemes which increase the debt bias of households, typically through tax relief for mortgages, should be reviewed.

On most of these measures, detailed country-specific recommendations have been issued and peer review activities are organised at the EU level to review progress and best practice. Implementation is now the major challenge.

2. Restoring lending to the economy

The crisis has had a lasting impact on the financial situation of many public and private actors, affecting the confidence of investors and lenders and the effectiveness of the financial sector. The tensions in sovereign debt markets and within the banking sector have fed each other, creating severe funding problems for many borrowers. These developments have also led to the fragmentation of the financial system along national borders, with a retrenchment of financial activities to national domestic markets. The resulting limited or costly access to funding for many businesses and households wishing to invest has been a major obstacle to recovery across Europe to date. At the same time, high levels of indebtedness mean that many economic actors need to reduce their financial exposure or increase their savings. Such "deleveraging" can also hamper recovery in the short term. The problems are particularly acute in the vulnerable euro area Member States.

Action is under way at the EU level to address risks to the financial sector and correct the former weaknesses of our regulation and supervision systems:

§ A coordinated effort has been made to assess the risks of the banking sector and to recapitalise the banks. Recognition of losses and the cleaning-up of banks' balance sheets are crucial to improving confidence in the markets and must be completed without delay.

§ New EU supervisory authorities have been in place since January 2011 and are working to develop a single rulebook for strengthening the legal framework applicable to financial institutions. A swift agreement on the Commission's proposals on bank capital and liquidity, deposit guarantee schemes and bank resolution is needed to provide a more coherent framework for the prevention and management of financial crises.

§ Closer monitoring of the levels of private debt and associated financial risks, such as real estate bubbles, is now taking place through the European Systemic Risk Board (ESRB) and the new EU procedure to tackle macro-economic imbalances.

§ As one of the building blocks to strengthen Economic and Monetary Union, the Commission has proposed a banking union, including a Single Supervisory Mechanism, under the authority of the European Central Bank, to further integrate arrangements for the supervision of banks at EU level. The establishment of such a mechanism will also create the conditions for the European Stability Mechanism to directly recapitalise banks that fail to raise capital on the markets.

At the national level, Member States can do more to promote alternative sources of financing, increase liquidity and reduce companies' traditional dependence on bank financing, for instance by:

§ Promoting new sources of capital, including business-to-business lending, providing more possibilities to issue corporate bonds and facilitating access to venture capital.

§ Reducing late payments by public authorities, since their average duration has further deteriorated in the crisis and this creates particular burdens for SMEs in an already difficult business environment. The EU late payment directive which must be transposed by March 2013 will reduce delay to 30 days and improve compensation in case of late payment.

§ Developing the role of public banks and guarantee institutions in the financing of SMEs. This can cover some of the risks taken by private investors and can compensate for the lack of equity or for the small size of the company to be financed, including through new forms of securitisation.

§ Supporting innovative schemes such as public schemes, which allow banks to borrow at a lower rate if they increase their long-term lending to businesses or provide cheaper and more accessible loans to SMEs.

§ Ensuring a balanced approach to foreclosures in case of mortgage lending, protecting vulnerable households while avoiding banks' balance sheets from becoming overburdened. This includes measures to introduce personal insolvency regimes allowing modifications of the terms of mortgages to avoid foreclosures.

Moreover, it is important to make full use of existing or new EU financial instruments to act as a catalyst for targeted investment, in particular for key infrastructures:

§ The provision of an extra EUR 10 billion to the European Investment Bank (EIB) will enable it to provide EUR 60 billion of additional financing over the next three to four years and will unlock up to three times this amount from other providers of finance.

§ The deployment of project bonds represents an important new risk-sharing instrument to unlock private funding, for example from insurance companies and pension funds, thus complementing traditional bank lending. Several projects are now at an advanced stage of preparation by the EIB.

§ As part of the Compact for Growth and Jobs, the Commission continues to work with Member States to re-programme and accelerate the use of EU structural funds to support growth, notably for SMEs. Moreover, Member States are invited to indicate in their National Reform Programmes how they intend to use Structural Funds to promote growth enhancing priorities for the next round of programmes (2014-2020).  Full use should also be made of the Competitiveness and Innovation Programme facilities which have already mobilised EUR 2.1 billion in venture capital funds and provided EUR 11.6 billion of loans to SMEs.

3. Promoting growth and competitiveness for today and tomorrow

The crisis is accelerating shifts in the economy with some more traditional sectors particularly hard hit and newer ones finding it difficult to thrive. The rapid pace of the restructuring is challenging but also presents an opportunity to tap potential new sources of growth and jobs.[10] Such adjustments come on top of, and often serve to correct, longer-term competitiveness challenges faced by many of our economies. The Alert Mechanism Report adopted alongside this Survey shows that developments in price and non-price competiveness are contributing positively to improving external imbalances, although with some time lags.  Those Member States under intense market pressure have undertaken significant reforms but more needs to be done to improve internal and external competiveness across a wide range of Member States.

As illustrated in the country-specific recommendations, there is no "one-size-fits-all" agenda but there are common goals, a range of reforms to consider and many examples of best practice – including examples of European world leaders – to draw from. While some reforms may take time to show their effects, others can offer more immediate results.

Some framework conditions need to be in place at the national level and priorities include:

§ Driving innovation, new technologies and raising levels of public and private R&D investment. Targeted support by public authorities and greater competition for research grants will play an important role in this.

§ Raising the performance of education and training systems and overall skill levels, linking the worlds of work and education more closely together.

§ Improving the business environment, by relaxing the formalities required to start a business, simplifying authorisation, licensing and tax compliance procedures, and lowering the overall administrative burden on enterprises. Particular obstacles to activities in job-rich sectors such as construction, business services, logistics, tourism and wholesale trade should be overcome.

§ Tapping the potential of the green economy by setting a predictable regulatory framework and promoting the emergence of new markets and technologies. In particular, more ambitious energy efficiency renovation programmes – including, but not limited to, the requirements of the EU energy efficiency directive – can bring important savings and job creation, in addition to environmental benefits. Improved waste management, water management and recycling also have strong potential to create new jobs, while helping to secure the supply of scarce resources and materials.

The European single market offers many opportunities for businesses to develop and for consumers to benefit from better services and products. In the field of services, many gains can be reaped if Member States improve implementation of the services directive by:

§ Complying with their obligations to eliminate restrictions based on nationality or residence of the service provider.

§ Reviewing the necessity and proportionality of regulation of professional services, in particular fixed tariffs, and limitations on company structures and capital ownership.

§ Reviewing the application of the clause on the freedom to provide services in order to remove unjustified double regulation in sectors such as construction, business services and tourism, and ensuring transparent pricing in healthcare services

§ Strengthening competition in the retail sector by reducing operational restrictions, in particular by eliminating economic needs tests.

The performance of network industries across Europe also has a critical knock-on effect on the rest of the economy and can be significantly improved by:

§ Developing the right incentives for the rapid country-wide roll-out of high-speed internet infrastructure and the development of mobile data traffic. Frequency bands for wireless broadband need to be freed up by governments.

§ Ensuring the full transposition and implementation of the third energy package, in particular unbundling networks, securing the independence and necessary powers of national regulators and phasing out gradually regulated energy prices, while protecting vulnerable consumers.

§ Accelerating the implementation of the Single European Sky by reducing the fragmentation of air traffic management and improving the organisation of airspace.

§ Opening up domestic rail passenger services to competition, in particular through equal access to infrastructure.

§ Integrating ports better into the logistic chain, by removing entry barriers to port services.

§ Removing remaining cabotage restrictions to improve the matching of supply and demand in international transport.

§ In line with the e-commerce directive, applying harmonised rules on transparency and information requirements for businesses and consumers.

The performance of product markets would also be greatly improved if national standardisation bodies deliver the objectives set at the EU level, in particular to move from national to European-level standards. Full use should be made of the notification of technical rules for ICT products and services to facilitate their circulation in the single market.

4. Tackling unemployment and the social consequences of the crisis

Over the last twelve months, the number of unemployed people has increased by 2 million, to reach more than 25 million. The unemployment rate is up to 10.6% in the EU and 11.6% in the euro area. Long-term unemployment is increasing and nearly one in two unemployed people have been without a job for more than a year. The situation varies very significantly across Europe, with national unemployment rates ranging on average from less than 5% to more than 25%. Young people have been particularly badly hit, with youth unemployment rates reaching more than 50% in certain countries,[11] but other age groups are also affected.

Given the length of unemployment periods, the rapid restructuring of the economy and the difficulties of finding a job, there is a risk that unemployment will become increasingly structural and that a growing number of people withdraw from the labour market.[12] There are also clear indications that risks of poverty and social exclusion are increasing in many Member States.[13] Additional pressures on social protection systems also affect their capacity to perform their welfare functions.

The weak growth prospects and the time lag between economic recovery and recovery in the labour market means that there is no prospect of immediate or automatic improvement in the employment situation. This poses a major challenge for the EU as a whole, as well as for those countries most affected, and calls for more determined action by the public authorities and the social partners.

In addition to the impact of the current crisis, the structural trend towards an ageing and, before long, a shrinking working-age population in parts of Europe creates particular challenges. Encouraging the early retirement of older workers in the hope that young people will be recruited in their place is a policy that has proven largely ineffective and very costly in the past, and should not be repeated.

In spite of the high levels of unemployment, there is also evidence of skills bottlenecks and mismatches, with certain regions or sectors lacking employees who fit their needs. Raising participation in the labour market, improving skill levels and facilitating mobility remain urgent priorities.

Several ambitious reforms are being implemented across Europe. In countries under financial pressure, measures have been taken to facilitate flexible working arrangements within firms, reduce severance pay for standard contracts and simplify individual or collective dismissal procedures. Steps have also been taken to enhance flexibility in wage determination, such as easing the conditions for firms to opt out of higher-level collective bargaining agreements and the review of sectoral wage agreements.

Preparing for a job-rich recovery

Further efforts to improve the resilience of the labour market and invest in human capital are essential to help companies to recruit and adapt, and to allow more people to remain active and take up opportunities. Social partners have a key role to play alongside public authorities. This is why the Commission recommends, in particular:

§ To limit the tax burden on labour, notably for the low-paid, as part of broader efforts to shift tax burden away from labour. Temporary reductions in social security contributions or job subsidy schemes for new recruits, notably the low-skilled and long-term unemployed, could also be considered to promote job creation, provided they are well targeted.

§ To continue modernising labour markets by simplifying employment legislation and developing flexible working arrangements, including short-time working arrangements and work environments conducive to longer working lives. Reducing the gaps in employment protection between different types of work contracts should also help to reduce labour market segmentation, as well as undeclared work, in several countries. The impact of unemployment benefits should be monitored to ensure appropriate eligibility and effective jobseeking requirements.

§ To monitor the effect of wage-setting systems, in particular indexation mechanisms, and if necessary to amend them, respecting national consultation practices, in order to better reflect productivity developments and support job creation. It is important that minimum wage levels strike the right balance between employment creation and adequate income.

§ To tap the job potential of expanding sectors, such as the green economy, healthcare and ICT, through a future-oriented and reliable legal framework, the development of adequate skills and targeted public support.[14]

Improving employability levels, in particular of young people

At the same time, Member States should do more to fight unemployment, improve employability and support access to jobs or a return to the world of work, in particular for the long-term unemployed and young people. This includes measures:

§ To boost public employment services and step up active labour market measures, including skills upgrading, individualised jobseeking assistance, support for entrepreneurship and self-employment, and mobility support schemes. Despite some additional resources devoted to these activities or efforts to improve their efficiency, the support provided hardly matches the surge in the number of registered jobseekers experienced in several countries.

§ To reduce early school-leaving and facilitate the transition from school to work by developing quality traineeships, apprenticeships and dual learning models - classroom-based education combined with hands-on experience in the work place. Efforts to develop entrepreneurial skills are needed to support new business creation and improve employability levels of the young[15].

§ To develop and implement "youth guarantee" schemes whereby every young person under the age of 25 receives an offer of employment, continued education, an apprenticeship or a traineeship within four months of leaving formal education or becoming unemployed. Such schemes can be co-financed by the European Social Fund.[16]

§ To facilitate labour market participation and access to jobs for second earners through adequate tax-benefit incentives and the provision of quality affordable childcare.

§ To improve access to lifelong-learning systems throughout working life, including for older workers, by strengthening partnerships of public and private institutions involved in the provision, application and updating of specific skills.

§ To improve the connection between education and lifelong-learning systems and labour market needs. Short-cycle tertiary qualifications of two years, focused on areas where a skills shortage has been identified, as well as targeted mobility schemes, can prove particularly effective in current circumstances.

§ To encourage cross-border labour mobility by removing legal obstacles and facilitating the recognition of professional qualifications and experience. Cooperation between employment services should be reinforced, and the EURES platform can provide the basis for a more integrated European labour market.

Promoting social inclusion and tackling poverty

In addition to these measures, additional efforts are needed to ensure the effectiveness of social protection systems in countering the effects of the crisis, to promote social inclusion and to prevent poverty:

§ Active inclusion strategies should be developed, encompassing efficient and adequate income support, measures to tackle poverty, including child poverty, as well as broad access to affordable and high-quality services, such as social and health services, childcare, housing and energy supply.

§ The link between social assistance and activation measures should be strengthened through more personalised services ("one-stop shop") and efforts to improve the take-up of measures by vulnerable groups. Once the labour market recovers, it will be important to phase out crisis-related measures, while ensuring that essential safety nets are preserved.

5. Modernising public administration

The squeeze on public finances has created renewed momentum for the modernisation of public administration. In the EU, public expenditure accounts for almost 50% of GDP and the public sector represents about 17% of total employment.

Over the years, many Member States have undertaken measures to increase the efficiency of their public services as well as the transparency and quality of their public administration and judiciary. Such reforms have been particularly far-reaching in countries in financial distress. Examples include reorganising local and central government, the rationalisation of the public sector pay system and of the governance of state-owned enterprises, reform of public procurement processes, regular comprehensive expenditure reviews and the promotion of efficiency measures across the public sector, such as a greater use of shared services and information technology solutions. In several instances, Member States and the Commission have cooperated through the provision or exchange of technical assistance.

Various measures already outlined above – such as the full and correct transposition of EU law, the efficiency of the tax collection and healthcare systems, the need to reduce delays in payments and the role of public employment services – can have a significant positive impact and should be pursued. In addition, the Commission considers the following to be particular contributors to growth:

§ Employing sound financial management by making full use of public procurement opportunities in support of market competition and developing e-procurement capacities across the single market. Such actions not only contribute to greater efficiency and fairness but also help to combat corruption.

§ Simplifying the regulatory framework for businesses and reducing the administrative burden and red tape, particularly at national level.

§ Ensuring the widespread, interoperable digitalisation of public administration, aimed at fostering user-friendly procedures for service providers and recipients, as well as administrative simplification and transparency. Cross-border interoperability of online services and research centres throughout the EU is particularly important.

§ Improving the quality, independence and efficiency of judicial systems as well as ensuring that claims can be settled in a reasonable time frame and promoting the use of alternative dispute mechanisms. This should reduce costs for businesses and increase the attractiveness of the country to foreign investors.

§ Making better use of EU structural funds by stepping up administrative capacity efforts this year to ensure speedier distribution of unused funds.

Conclusion

The EU economy is slowly emerging from the deepest financial and economic crisis in decades. Member States are starting from different positions, the nature and size of the challenges they face are not the same and the pace of reforms varies. The situation remains fragile. The implementation of reforms is underway and important adjustments are still taking place, but there are signs that in the course of next year we will begin to see a recovery. In those Member States which have undertaken deep reforms, efforts are starting to bear fruit: imbalances are being reduced and competitiveness is improving.

This process is not only about a return to growth but is also about building the basis for a different quality of growth following the crisis. Structural reforms at national and EU level must strengthen the EU's ability to compete globally, generating growth at home through activities which are sustainable and which equip the EU with the policies and instruments needed to secure a prosperous, inclusive and resource efficient future. Solidarity and fairness – within countries but also across Europe – will be essential elements in ensuring that the efforts undertaken will be politically and socially acceptable and of benefit to all.

Many important decisions have already been taken in the Member States and at the EU level. Now is the time to hold the course and implement what has been agreed. To restore confidence and return to growth, it is also crucial to maintain the pace of reforms, particularly in the following areas:

· Public finances must be brought back on track to restore their sustainability. This is important not only for the confidence of investors in the short term but also to meet the needs of an ageing society and preserve the prospects of future generations. The pace and nature of fiscal consolidation may vary: while some Member States need to reduce deficits rapidly, others have more room for manoeuvre. Any negative impact on growth in the short term can be mitigated by appropriate measures on the expenditure and revenue sides of government budgets.

· Efforts to repair the financial sector must continue to restore financial stability and deliver better financing conditions for the economy, including through alternative sources of finance. Further progress at the EU level is necessary to build an integrated supervision framework and to reinforce the legal framework applicable to financial institutions.

· Structural reforms must be reinforced to promote growth and boost competitiveness.  There is still a wide range of measures to be considered at the national level, with EU legislation in place to serve as catalyst for change. A lot can be learned from best practices in Member States and third countries.

· The labour market situation and social situation call for an urgent response. Stepping up active labour market policies, reinforcing and improving public employment services, simplifying employment legislation and making sure that wage developments support job creation are essential elements of such a strategy. The situation of young people requires particular attention. Furthermore, efforts should be stepped up to promote social inclusion and prevent poverty by reinforcing essential safety nets.

· National and EU level growth strategies can only be implemented with the help of effective public administrations. More can done to modernise, for instance in the fields of public procurement, the digitalisation of public administration, improving the quality and independence of judicial systems and the effective and efficient deployment of EU structural funds.

The guidance provided in this Annual Growth Survey will be discussed at the EU level to prepare for the spring European Council next March and to help in the preparation of the updated sets of national programmes and country-specific recommendations. The Commission will work closely with national authorities, including national parliaments, EU Institutions and other stakeholders to create a shared sense of ownership and steer progress as part of wider EU efforts to exit from the crisis and to lay the foundations for smart, sustainable and inclusive growth across the EU.

[1]               More information on the economic and employment situation can be found in the Commission autumn economic forecasts published on 7 November 2012 and in the documents accompanying this Survey.

[2]               For an overview of progress towards the Europe 2020 targets, see: "Europe 2020 Strategy – towards a smarter, greener and more inclusive EU economy?", Eurostat, Statistics in focus, 39/2012.

[3]               The second annual Alert Mechanism Report (COM(2012)751) to identify macro-economic imbalances is adopted by the Commission alongside this Survey.

[4]               The country-specific recommendations can be found at: http://ec.europa.eu/europe2020/making-it-happen/country-specific-recommendations/index_en.htm

[5]               European Parliament, "Report on the European Semester for economic policy coordination: implementation of 2012 priorities [2012/2150(INI)], October 2012.

[6]               Fiscal balance is expressed in structural terms when it is corrected for the impact of the economic cycle and one-off and temporary measures.

[7]               European Commission, "Tax reforms in EU Member States 2012", European Economy, 6/2012.

[8]               In 2013 Member States will also start receiving new revenues from the emission allowances auctions under the third phase of the EU Emissions Trading Scheme.

[9]               The Commission will shortly present an action plan to strengthen the fight against tax fraud and tax evasion, together with guidance to ensure good governance in the tax area.

[10]             The first edition of the Single Market Integration Report (COM(2012)752) accompanying this Survey presents cases of untapped sources of growth. More information can also be found in the forthcoming Commission's study on "The cost of non-Europe: the untapped potential of the Single Market".

[11]             Over the last year, the Commission has set up action teams to assist countries with the highest rates of youth unemployment in the re-programming of EU funds to support training and job opportunities for young people. See first results at: http://ec.europa.eu/commission_2010-2014/president/pdf/council_ dinner/youth_action_team_en.pdf

[12]             The Draft Joint Employment Report annexed to this Survey provides more detailed information.

[13]             The number of people at risk of poverty and social exclusion has increased since 2008 in 13 out of the 23 Member States for which data are available in 2011.

[14]             The Commission spelled out ways to tap this potential in its Communication "Towards a job-rich recovery" (COM(2012)173) of 18 April 2012.

[15]             The Commission adopted on 20 November 2012 a "rethinking education" communication (COM (2012) 669)

[16]             The Commission will shortly present a "youth employment package".

INTRODUCTION

The draft Joint Employment Report, mandated by Article 148 TFEU, is part of the Annual growth Survey (AGS) package to launch the 2013 European Semester. As key input to strengthened economic guidance, the JER underpins the key employment messages contained in the AGS. The analysis it contains is based on the employment and social situation in Europe, on the implementation of the Employment Guidelines[1], on the examination of the National Reform Programmes that led to the country-specific recommendations adopted by the Council in July 2012 and on the assessment of their implementation so far.

The report is being issued at a time when:

The employment recovery has come to a halt. Employment is decreasing and the prospects are bleak for 2013. Job creation has remained subdued and has worsened despite unexploited potential in some job-rich sectors and throughout the single market. Labour market segmentation has continued to rise with an increase in temporary contracts and part-time work. Taxation on labour remains high and has further increased in a number of Member States.

Unemployment is rising again and has reached unprecedented levels in the euro area, with long term unemployment reaching alarming highs, especially in Member States under strong fiscal consolidation. More than one in five young people in the labour market are unemployed and there is a risk of a lost generation.

The disparity in unemployment rates between Member States has dramatically grown and reflects the effects of asymmetric shocks and the different resilience of labour markets to crises. Wages and labour costs have started to adjust but the effects of reforms are not fully visible yet. Signs of deterioration in the job matching process on the European labour markets are confirmed and there is a risk that increasing structural unemployment will become entrenched.

Average household incomes are declining in many Member States and recent data points to a trend of higher levels and deeper forms of poverty and social exclusion with in-work poverty and social polarisation on the rise in many Member States.

The effects of social protection as an automatic stabiliser have been weakened since 2010 and resulted in higher poverty rates. There are significant differences among Member States in the efficiency of their spending when it comes to poverty reduction.

The employment and labour market situation in Europe, and in particular in some Member States, calls for more determined action by the public authorities and the social partners. Ambitious reforms are being implemented but further efforts are needed to modernise our labour markets and invest in human capital to create the conditions for a job-rich recovery

1. Recent labour market and social developments trends

The economic and employment outlook is negative and has worsened in recent months. If 2012 will be a negative year from the perspective of employment and the small increases in GDP forecasted for 2013 will be insufficient to create employment and reduce unemployment. A more positive outlook for the labour markets is expected in 2014. The EU is currently the only major region in the world where unemployment is still rising.

The employment recovery has come to a halt and employment is decreasing. The number of people aged 20-64 in employment in the EU has decreased by 0.2 % from Q2 2011 to Q2 2012. In the 2008 – 2011 period employment shrank by 1,7 %, showing more resilience than the US during the same period (-5,8). However the decline has been more pronounced in the euro area, especially in those countries which undertook more substantial fiscal consolidation. Since the start of the economic and financial crisis in 2008, the number of jobs lost now totals 5 million, of which 4 million were lost in the euro area. The fluctuations in overall employment since the outset of the crisis have been mainly driven by part-time work and temporary contracts, but permanent contract jobs have also been affected.

Figure 1: Employment and unemployment in the EU 27, 2005-2012

Source: Eurostat, National Accounts and EU LFS

A positive feature is that the employment rate of older workers increased by 1.8 p.p. between 2008 and 2011 compared to a 1.5 p.p. decline in the general employment rate. Women have also weathered the economic crisis relatively better than men with employment rates virtually at the same level as in 2008 while the employment rate of men has declined by 2.6p.p. during the same period. At the same time, the youth employment rate declined by 3.8 p.p.

Unemployment is rising again and has reached unprecedented levels in the euro area. The overall unemployment rate of the EU is currently at 10.6%, while in the euro area it reaches 11.6 %, the highest level since the birth of the EMU. In May 2012 the number of unemployed in the EU exceeded 25 million people for the first time ever and has increased by an additional 0.75 million in the quarter since then, which represents a total increase of almost 9million since 2008. The trend in unemployment is upward in the majority of the Member States, with only six countries showing a decrease in unemployment during the last 12 months to August 2012.

Long term unemployment has reached alarming highs. In the second quarter of 2012 11.1 million unemployed Europeans had been unemployed for more than 12 months, accounting for 4.6 % of the active population[2]. This represents an increase of 4.8 million in comparison to 2008. In 2011, 70% of all long-term unemployed in the EU-27 were concentrated in the 6 largest Member States, with Spain accounting for more than 21% of the total number of long term unemployed in the EU and contributing  1.6 million to the 3.7 million increase in the number of long-term unemployed over 2008-2011.

The probability for unemployed people to find a job has decreased in most Member States since the outbreak of the crisis, both for short and long term unemployed. This decrease has been particularly pronounced for Member States subject to significant fiscal consolidation measures. In Spain the probability decreased from 50% to 30% and in Greece it dropped from 25% to 15% while it remained stable in the Netherlands and improved in the Czech Republic and Estonia.

Figure 2: Long-term unemployment rate in % of active population, 2008 and 2011

Source: Eurostat, EU-LFS

Long term unemployment has increased for all groups but mostly for young people and those with lower education levels. However the risk of becoming long-term unemployed for older workers in 2011 was more than 55% while it was only about 30% for young people. In 2011 long term unemployment among low skilled workers was four times as high as it was for high skilled workers. Also third-country nationals recorded twice as high long term unemployment as the average EU worker in 2011. Some Member States have been able to limit the extent of long term unemployment either because the recession has been shorter or due to effectiveness of labour market institutions.

More than one in five young people in the labour market are unemployed. The situation of youth in the labour market represents both an economic and a social emergency with 5.52 million young people unemployed. Over the last 12 months, the unemployment rate for young people increased in the large majority of Member States and in two Member States has remained in levels above 50% and above 30 % in six. In 2011 the employment rate of young people aged between 20 and 34 and graduating from at least upper-secondary education decreased by 4.2 percentage points to 77.2% compared to 2008, pointing to the growing difficulties in the transition from education to employment.

Early school-leavers face bleak employment prospects. Early school leavers are arguably the most vulnerable subgroup of Europe's young workforce. Across the EU, more than half of young people dropping out of school are unemployed. The share of early school leavers dropped from 14.1% in 2010 to 13.5% in 2011. Wide disparities in ESL rates continue to exist between Member States but those who introduced effective and comprehensive policies to combat early school leaving have also experienced significant improvements. Early school leaving remains more frequent among young people from disadvantaged backgrounds, among migrants and ethnic minorities such as Roma and among boys.

The proportion of young people who are neither in employment, education, nor in training (NEET) continues to increase. More worryingly, increases were higher in those Member States which already had higher levels. In spite of the larger increase registered by young men, youth NEET rates remain higher for young women in almost all European countries.

Figure 3: Share of NEETs among the 15-24 year old (%)

Source: Eurostat, LFS

The dispersion of unemployment rates between Member States has markedly increased in recent years, particularly in the euro area. The diversity is also marked at regional and local levels with pockets of very high youth and long term unemployment at subnational level. In August 2012 unemployment was lowest in AT at only 4.5% while it has reached 25.1% in ES. A large share of unemployment is concentrated in relatively few countries. In effect, the number of unemployed in IT, ES and those countries with financial support programmes (EL, IE, PT, RO) represent almost half of all unemployment in the EU and this share has increased significantly during the crisis.

Figure 4: Change in unemployment rate (% points) over the last 12 months and the last three months to August 2012 and evolution of distribution of unemployment rates between Aug. 2009 and Aug. 2012

Source: Eurostat

Notes: Eurostat. 2nd Graph: Missing data for 08'2012 for 5 MS. Data used: June for EE and LV, July for EL, HU and UK 

The gap between Member States in employment and social indicators is widening. This is particularly visible between the Southern and peripheral European countries. The Member States which have shown better resilience so far are mostly the Northern and central European countries. The shocks appear to be asymmetric but very often countries with relatively un-segmented labour markets, strong welfare systems and an ability to temporarily adjust working hours and working time (internal flexibility) have fared better.

Recent data show that wages and labour costs have started to support external re-balancing. In 2011, European labour markets showed clear signs of improved wage dynamics, with nominal unit labour costs rising moderately following real declines in 2010. Real compensation per employee declined in about half of the Member States in 2011 and expanded at a rate below that of productivity, confirming the trend initiated in 2010 of a declining wage share. Nominal unit labour costs developments differ somewhat across Member States. In general, unit labour cost developments are increasingly following patterns supportive of external re-balancing with an increasingly clear differentiation between countries with stronger needs to reduce unemployment and rebalance external positions and countries with a more sustained recovery and current account surpluses.

Figure 5: Annual growth rate of the nominal unit labour cost (2011Q2/2012Q2) and trend across eight selected Member States (those that received a Country Specific Recommendation on the issue of wages), 2008Q2-2012Q2

Note: Quarterly data seasonally adjusted

Source: Eurostat. 1st Graph: For the case of CY the comparison is with 2011q1 and 2012q1 (there is no data on 2012q2)

Source: Eurostat

The pre-crisis pattern of stronger real wage dynamics in countries with poor unemployment outcomes has been reversed since 2010. These developments have contributed to the gradual improvement of the competitiveness of export-oriented sectors. Labour demand and wages appear to be more sustained in the tradable sector in countries having clearly started or nearly completed a process of correction of current account deficits. Moreover, evidence shows that until 2009 real wage dynamics were stronger, but that this pattern has been reversed since 2010.

Average household incomes are declining in many Member States. Between 2009 and 2011 gross household disposable income fell in two out of three Member States and the situation between countries diverged further. In most Member States, the protracted economic and labour market crisis combined with the need to pursue fiscal consolidation (involving cuts in benefits and increases in taxes) weakened the protective effect of national automatic stabilizers over time as beneficiaries reached the end of benefit entitlement or faced declines in benefit levels. As a result, household incomes declined especially in those Member States where the recession was prolonged. Fiscal consolidation measures implemented since 2010 seem to have contributed to reduce significantly household disposable incomes.

Figure 6: Change in gross household disposable income during the crisis

Source: Eurostat, National accounts

The share of the EU population reporting that their households are experiencing financial distress remains historically high, having generally edged up further over recent months. The 2012 year-on-year increase in the financial stress indicator among the lowest quintile was especially strong in Spain and Italy (up 10 pp) while decreases were reported in 6 Member States.

Recent data point to higher levels and deeper forms of poverty and social exclusion. The proportion of people at risk of poverty or social exclusion has risen in a number of Member States since 2008, outnumbering those in which it decreased. Some groups have been particularly hit (including children, single parent households, the active age population and more specifically youth). The evolution of the depth of poverty confirms that those at risk of poverty are getting poorer in many countries, especially those where the overall risk of poverty rates is high. In 2010 in the EU, the median income of people at risk of poverty was 22% lower than the poverty threshold, evidencing a deepening of the poverty gap in most Member States since 2008.

Figure 7: Development in the number of people at risk of poverty or social exclusion (AROPE) across EU Member States between 2008 and 2011

Source: EU-SILC; * data: SILC 2011(2010)

In-work poverty and social polarisation is on the rise in many Member States. Working poor represented one third of the working age adults at risk of poverty in 2011. In 2010, 8.4% of the people in employment were living under the poverty threshold and the risk was significantly higher for families with dependent children (10.7%). The incidence of in-work poverty rose among women, but remains higher for men. In-work poverty significantly increased in one out of three Member States between 2006 and 2010, including some of the wealthiest Member States with more resilient economies and labour markets. Factors such as wage adjustments, reduction of working hours, short-time working arrangements and increased part-time and temporary contracts may have contributed to this.

2. Major labour market challenges

The recent labour market trends are partly the result of cyclical movements, and notably of the deep economic crisis, but they are also due to structural and institutional labour market challenges affecting economic activity and the performance of labour markets.

Net job creation (employment growth) has consistently decreased both at EU level and across Member States, with the exception of 2010. Since the mid-2011 Europe as a whole has gone back to negative employment growth rate values. This is the net result of the declining trend of job findings (unemployed getting into jobs) and increasing trends in job separations, calling for policies to stimulate labour demand and a more jobs-rich growth pattern.[3] At the same time however, job creation programmes supported by the Structural Funds and the Cohesion Funds report significant positive progress both in terms of gross jobs creation and start-ups supported.   

Figure 8: Unemployment rate and job finding rate in the EU-27, 2007Q1-2011Q4

Source: Commission Services calculations based on Eurostat data

The potential of job creation in some key sectors could be further exploited if skills shortages were addressed. The eco-industry is estimated to create about 8 million jobs by 2020, with up to 2.8 million of these jobs originating from resource efficiency measures, 2 million from the implementation of energy efficiency policies, and a further 3 million from the development of the renewable energy sector[4]. In 2012, the number of people projected to work in eco-industries specifically across the EU is expected to be 3.4 million, an increase from 2.7 million in 2008, demonstrating that even in the current economic climate there is job growth potential in the green sector. Between 2005 and 2009 the renewables sector contributed to the creation of more than 300,000 new jobs. During the 2008-2011 period, the 'health and social work' sector created about 1 866 000 new jobs. Moreover, the demand for new positions in this sector is expected to increase with a projected 8 million of total job openings between 2010 and 2020. As for the ICT sector, by 2015, it is expected that up to 700 000 unfilled vacancies will be available for ICT practitioners. Both sectors face similar challenges to replace an ageing workforce with younger workers. Significant skill shortages are generally reported within the sectors of the green economy, the ICT sector and the healthcare especially for occupations with a high degree of technical specificity.

Taxation on labour remains high and has even increased in a number of Member States, but changes in the composition are reducing the cost of labour. A high tax wedge is a disincentive to work for secondary earners and for low-income and low-skilled workers and may have a negative impact on their employment rates at aggregate level. In 2011 the average tax-wedge for the EU 27 was 39.6 % compared to 21 % in Switzerland, 29.5 % in the US and 30.8 % in Japan and Canada. On average, the tax-wedge in Europe increased by 0.3 percentage points between 2010 and 2011, affecting also low-wage earners. The increases have generally been highest in the Member States already concerned by high tax wedges. However, this has been mainly due to changes in the personal income taxes and in a number of cases accompanied by reductions in the social security costs of employers thereby reducing the labour costs.

Figure 9: Total tax wedge for low earners (using 67 % of the average wage as a proxy for this group) in 2011 and annual change 2010-2011

Short description: *Data for non-OECD-EU countries (BG, LV, LT, MT and RO) are only available for 2010; **CY data for 2007. For these countries, changes in tax wedge refer to period 2009-2010 (for CY to period 2006-2007). Source: OECD

Labour market segmentation has continued to rise with temporary contracts and part-time work expanding. Between 2007 and 2011 the share of employees working in involuntary fixed-term or part-time jobs increased in 21 out of 27 Member States. There are large divergences across Member States but Mediterranean countries and Poland are characterised by the strongest segmentation. The asymmetric employment protection legislation between permanent jobs and fixed term/temporary ones is the main cause of labour market segmentation. In 2011, 60.4 % in the 15-64 year-olds working on temporary contracts did so involuntarily. The likelihood of being employed on a permanent contract is lower in Member States with stricter employment protection legislation.

Figure 10: Share of employees working in involuntary fixed-term or part-time contracts (in 2007 and 2011) and transitions from temporary to permanent employment (2010data)

Short description: *Data for SI refers to 2011; **IE data are only available for 2007.

Source: Eurostat, LFS and SILC

Young people are strongly over-represented in temporary work on the EU labour markets and their situation has been worsening through time. In 2011, some 42.5 % of young employees in the EU were working on temporary contracts, compared to 14.0 % of the average working-age population. Evidence shows that among young people, temporary jobs may to some extent serve as a stepping stone for permanent employment, but this is not the case in a number of other Member States, where the transition rates from temporary to permanent contracts are particularly low.

Figure 11: Employees in permanent and temporary work, self-employment and total employees (15-64), 2007Q1-2012Q1

Source: Eurostat

Part-time employment has accounted for a significant share of the job growth experienced during the crisis. While total employment contracted between 2008 and 2010 and the number of full-time workers shrank by 6.2 million, the number of part-timers increased by 1.1 million in that same period. The expansion of part-time work has been steady in recent years and reached 18,8% in 2011. About one third of women in employment are part-timers compared to only 8,1% of men, reflecting the fact that childcare services only cover 28% of children under the age of 3 and 84% of children over 3.

There are recent signs of deterioration in the job matching process on European labour markets. For most Member States the Beveridge curve, linking unemployment and vacancies rates, has shifted further outward to the right. However, three Member States have moved along the Beveridge curve (BE, AT and FI) since the beginning of 2008 and for one Member State the curve has shift inwards (DE), showing the improvement of the labour markets and the matching process. The deterioration might be the consequence of mismatches between skills and educational qualifications required for a certain job, rising long term unemployment, inadequate response to demographical changes and inefficiencies in the services offered by employment services, It may also however, be the consequence of frictions and barriers to geographical and occupational mobility and asymmetric information between employers and employees. European citizens still face legal, administrative and practical obstacles when moving across borders. Further reforms are foreseen to transform Eures[5] into a demand-driven tool for intra-EU recruitment, placement and job matching, allowing Member States to develop their EURES services according to their specific economic needs, for example through supporting under-serviced occupations and specific groups of workers, including young people.

Figure 12: Beveridge curve, EU-27, 2008 (Q1) — 2012 (Q3)

Source: Eurostat, the data used are: (i) the unemployment rate (UR, %), and (ii) the labour shortage indicator (LSI, %), derived from EU business survey results

Persistent structural unemployment risks becoming entrenched. The registered outward shift of the Beveridge curve might be temporary, as the labour market seeks to react and adapt to changing economic activity for example through changes in wage dynamics, retraining or intensified active labour market policies. However, the shift may also point to more long-lasting structural problems threatening to increase permanently the structural unemployment level. Data show that the level of structural unemployment measured by the non-accelerating wage rate of unemployment (NAWRU) has risen in most EU countries since the outset of the crisis and that this increase has co-evolved with the deterioration of the Beveridge curve.

Figure 13: Non-accelerating wage rate (%) of unemployment (NAWRU) per Member State

Source: AMECO

Recently there has been a decline in the expenditure on active labour market policies per unemployed person. Evidence shows that active labour market policies have a positive effect on employment rates, particularly for women and low-skilled population. Those Member States with the lowest level of long term unemployment are also amongst those where the level of participation in active labour market policies is the highest, although other factors may have contributed to this good performance. However, the decline in actual ALMP resources per unemployed has declined by more than 20% between 2007 and 2010.[6]

Figure 14: Participation in ALMP 2010 and long term unemployment rate 2011

Source: Eurostat

The cushion effect of social protection system on households income as an automatic stabiliser has started weakening after 2009. In the first phase of the crisis, social benefits played an important role in sustaining household incomes. In the Eurozone, net social benefits and reduced taxes contributed positively to the change in gross household disposable income during 2009 and in the first two quarters of 2010. However, in the second phase of the economic crisis this effect started weakening. At the end of 2010, the contribution of social benefits to the change in gross household income has started becoming negative.In some countries more and more people are not covered by any scheme at all. The weakening is related to the reduction of the benefit entitlements over time, the phasing out of initial discretionary income support measures, and, in some countries, to the cutbacks in social spending that were part of fiscal consolidation programmes.

There are significant differences among Member States in the efficiency of their spending, namely in the outcomes and poverty reduction effect they achieve per unit of spending when the patterns of spending and structures in social protection provisions are similar. Tax and benefit systems, are among the most important instruments to prevent and address income poverty. In 2010, expenditure on social protection benefits (excluding pensions) reduced the poverty rate in the EU from 26% to 16%, i.e. by 37%. Yet, Member States spending similar amounts on social protection obtain rather different results, and vice versa. Some countries manage to reduce poverty rates among children and the old or absence due to sickness with less spending than others. Some countries can have better benefits levels for people because they manage to reduce the time they spend on benefits by bringing them quickly back to work. Striking a balance between universal and means tested benefits and between benefits in cash and kind could contribute to activating people to work. Measuring social protection expenditure against the poverty reduction suggests that some systems are more efficient than others. BG, LV, PL and RO are clustered in the area of low spending with low impact; ES, IT, PT, CY (and EL) show similar results but for higher spending. They also perform below the EU average in terms of reducing child poverty.

Major challenges remain in the full implementation of active inclusion strategies, focusing concomitantly on adequate income support, inclusive labour markets, and access to quality services. A move towards active welfare policies and tackling financial disincentives to work is now visible in many Member States. Still, persisting differences exist in the level of coverage of social assistance and minimum income schemes across Member States and challenges remain to reach out to groups experiencing the deepest forms of poverty (such as the homeless and Roma). Ensuring adequate income support is an effective tool for smoothing the transition into work, promoting social inclusion and spurring aggregate demand. Quality and affordable childcare supports parents' participation in the labour market and give children the best chances in life, but evidence shows that the most vulnerable families have generally lower rates of participation due to factors such as availability and access, affordability, eligibility, and parental choice.

3. Implementing structural labour market reforms

The European Council of 1-2 March 2012, based on the Commission 2012 AGS, set out the policy guidance for Member States to submit their national reform programmes containing their plans for labour market reforms to achieve the EU headline targets set in the employment guidelines. Based on proposals of the Commission, the Council adopted country-specific recommendations underlining areas in which Member States should undertake policy reforms within the overall framework of the guidelines for Employment Policies.

The following section reflects the policy measures taken by Member States in view of their NRP and the priorities set out in the AGS 2012.

3.1. Mobilising labour for growth

Several Member States (BE, CZ, EE, HU, IE and PT) are taking steps to reinforce active labour market policies (ALMPs) and public employment services (PES). In BE, wage subsidies for employees considered as ‘knowledge employees’ (i.e. researchers in the private or public sectors) have been increased. In CZ, community service is used as an activation measure, coordinated by the Labour Office. In EE the new Employment Programme for 2012-2013 offers a broader selection of ALMPs and expands the target group entitled to different measures. In HU the ALMPs have been reinforced by focusing on training of PES employees, development of client-oriented service models, service package to micro- and SMEs, expansion of the functions of the PES portal and e-services and transformation of public work schemes. In IE conditionality is being reinforced to ensure that part time workers are encouraged to take up full time employment. Finally, in PT measures are taken to increase the effectiveness of PES and wage subsidy schemes have been introduced for the unemployed.

In 2011 and 2012, the tax burden on labour remains high with an overall increase in labour cost even if some progress has been made for some categories of vulnerable workers such as low-skilled / low-income jobholders. Many Member States (BE, DK, CY, FI, EL, ES, IE, IT, FR, LU, NL, PT, SL, UK) recently increased personal income tax, often through increased statutory rates. This was often done on a temporary basis in the form of general surcharges or solidarity contributions for high-income earners (GR, IT, CY, LU, PT, SP). AT and CZ also plan to shortly introduce similar measures. Social security contributions were also increased in many countries (AT, BG, CY, FR, EL, HU, LV, PL, and PT, UK).

Measures to reduce the tax on labour were mainly targeted to increase work incentives for specific groups and generally involved changes in the tax base. In BE for example, a whole set of social security reductions is targeted at young people, low wage and older employees, and new hiring in SMEs or self-employed.  Tax relief measures were also granted to low and medium income earners by increasing tax credits and basic allowances in FI and HU. SE raised basic income allowances for labour income of people older than 65 aiming to increase life spent at work.

A variety of measures are being taken to promote business creation and self-employment (AT, BE, BG, EE, ES, IE, MT, HU, PL, PT, UK). In AT, a pilot project provides additional support to apprentices and companies offering apprenticeship places including legal advice services and mediation. In BE, measures are taken to improve the access to credit for companies, promote administrative simplification, or reduce social security contributions in the Horeca sector. In BG, self-employment is promoted through guidance, training and assistance to start up own businesses or through granting equipment and repairs of newly established small enterprises. In ES business creation is being simplified through reducing administrative burdens on smaller businesses and allowing extended opening hours in tourist areas. In IE, a range of aids are provided involving capital grants, loan funds and guarantees, incentives for business start-ups etc. In MT, measures are being taken to reduce bureaucracy for the self-employed and a new “Micro Guarantee Scheme” has been announced to help self-employed people and small businesses obtaining guarantees for bank loans. In PL, entrepreneurship, self-employment and business activity is promoted through the ESF. In PT access to credit is provided to entrepreneurs and self-employed, and a technical support is provided to unemployed who wants to create their own business.  In the UK, the National Loan Guarantee Scheme was bolstered to encourage banks to lend more freely to SMEs.

Some Member States have taken measures adapting unemployment benefits to facilitate the return to work (BE, ES, IE, IT, SE). In BE, the adopted reform of the unemployment benefit system implies that allowances are decreasing earlier and faster than previously. In ES, the unemployment benefit has been reduced for several groups. In PT a new law reduces the maximum duration and amounts of unemployment benefits with the view to reduce the risk of benefit dependency and long-term unemployment. In SE, more strict eligibility rules, lower income replacement rates and maximum durations for unemployment benefits have been introduced.

More efforts to reinforce mutual responsibility are being made in ES, by linking conditionality to participation in ALMP. In IE, a clearer focus on conditionality for jobseekers with particular focus on long-term unemployed has been introduced. In IT, the new system of social insurance for employment will gradually substitute the current unemployment benefit system.

A number of Member States have taken measures to address wage setting to ensure that wages develop in line with productivity (EL, ES, PT). In ES, the recent labour market reform gives priority to company-level decisions on working hours and wages and makes it easier for companies to opt out of sectoral agreements. In PT wage developments consistent with firm-level conditions are ensured by exempting collective agreements where the employer’s associations cover less than a 50 % of the total work force.

In DE, the sector-based minimum wage system is encompassing more and more sectors. In HU, the new Labour Code took effect as of 1 July 2012, implying a rise in the minimum wage of 19%. Wage-setting measures are introduced in EL with the decision to reduce minimum wages and introduce differentiated minimum wage for youth.

Measures to enhance labour mobility have been taken by a number of Member States (AT, BG, DE, ES, LV, HU). In AT, the introduction of the Red-White-Red Card, a criteria-based score system for labour market access of third-country nationals, was completed by opening it also to skilled workers in shortage professions. In BG, the adoption of a National Qualification Framework will ensure transparency of vocational training of students and workers and employer requirements concerning the education and training systems. In DE, a law was approved which lowers the income threshold for university-educated immigrants from outside of the EU. In LV, a scheme has been proposed for a re-settlement benefit to compensate workers for moving from where they live to work in another locality/municipality. In HU the Government supports mobility by giving financial support for covering rental fees to registered unemployed people who move 100 km from their place of origin.

Member States are taking measures to reduce early exit from the labour market (AT, BE, ES, DK, IE, NL, HU, UK). In AT, reforms have been introduced to reduce the number of invalidity pensions. In BE, the age limit for older employees to access the time-credit system has been increased and the system of part-time early-retirement has been discontinued. In DK, disability pension reform plans require that activation possibilities are depleted before early retirement can be considered. In ES, the schedule for increasing the statutory retirement age will be accelerated, the early retirement age will increase from 61 to 63 with increased penalties for early retirement, and a suspension of access to partial retirement for two years. In IE new initiatives will allow people receiving an Illness or Invalidity payment to both work and receive income support and the legal retirement age will increase to 68 by 2028. In NL, steps are being taken to gradually raise the pension age to 67 by 2023 and hereafter it may be linked to life expectancy. In HU early retirement has been abandoned as a general rule. The UK government has recently announced plans to link pension age with life expectancy.

Measures also focus on the promotion of longer working lives (AT, BE, BG, DE, EE, FI, LU, PL, UK). In AT, active labour market measures, professional reintegration measures and re-training, part-time allowances and employment subsidies are made available for older workers with health impairments. In BE, by collective dismissals, companies with more than 20 employees are forced to apply the same age structure in their dismissals to the age structure of the firm and they will be obliged to develop an annual plan for employees aged 45 and more. In CZ, the pensionable age will be raised by 2 months every year with no upper limit following the pension reform adopted at the end of 2011. In EE, the focus is on older workers, participation in lifelong learning and ensuring their health. In FI, efforts are being made to improve the quality of working life and wellbeing at work as a mean of extending working lives. In LU companies with more than 150 employees are being forced to provide more support to older workers in companies. In PL, efforts are being made to increase learning opportunities for older people and improve the quality of education for older persons. In the UK, the default retirement age was abolished in October 2011.

Some Member States have taken measures not supportive of the extension of working lives. In CZ, there will be an increase in the taxation of labour provided by pensioners, which is likely to lower the participation of older people in the labour market. In FR the possibility to retire at 60 years for those who have begun to work at 18 years old, if they have adequately contributed to the welfare system has been re-opened. In HU the retirement age of all public employees, excluding those working in the medical sector, was made mandatory.

3.2. Supporting employment especially of young

A number of measures have been taken to support the employment of young people especially those who are not in employment, education or training. FI is launching a comprehensive Youth Guarantee to offer young people work, a traineeship, or a study, workshop or labour market rehabilitation place within 3 months of unemployment.

A group of countries (BE, BG, ES, CY, IE, PL, PT, SE and SI) are promoting initiatives aiming at enhancing the quality apprenticeship and traineeship contracts. In BE a large scheme of in-companies traineeship has been introduced for unemployed people under 25 who didn't find a job after the six months of occupational integration. In BG traineeships are promoted in the central and regional offices of the public administration giving priority to young people with disabilities. In IE, initiatives are taken to activate and up-skill young people through 5,000 internships of 6 to 9 months duration. In ES, steps have been taken to develop a contract for education and apprenticeship, and establish a dual vocational training system. In PL a pilot project target unemployed less than 30 years of age by individual tutor support, internship and training vouchers. In PT occupational traineeships and job placements are supported. In SI young unemployed under 30 years of age are offered employment for a period of 15 months and the government is promoting voluntary apprenticeship within the Tax Administration and the Prevention of Corruption institutions. In SE, the government grants companies up to EUR 2,750, per pupil and year, to stimulate the provision of apprenticeship positions in work places, and the state grant is proposed to further increase in 2014-16

Other concrete actions to support young people not in employment, education or training include programmes focused on the vocational training dimension (DE, LV, FI), on-the-job training (LT) and on financial support (HU). In DE young people from migrant backgrounds now have improved opportunities to enter a vocational training programme. In LT the project "Increasing Youth Employment", targeted at people aged less than 29 subsidises wages and expenses for organising acquisition of skills within the workplace. In LV, 15-24 year old unemployed are offered the opportunity during a nine week period to try their hand at three different vocations in a vocational training institution. In HU the "first job guarantee" has been introduced, providing full wage compensation to the employers including gross wage and social security contribution.

In a number of Member States partnerships have been established with the social partners to promote quality apprenticeship or traineeship contracts (BG, CZ, FR, IE, IT, LU, RO and SK). In BG measures aim at providing or at supporting investment costs and labour costs for the creation of jobs for young people. In CZ, an ESF-funded project, supports the costs of internships to companies notably graduates and people who lack work experience and need to complete their skills profiles. In IE new measures provide additional training places for unemployed by means of collaboration and engagement between employers and enterprise and education and training providers. In RO, enterprises hiring young workers below the age of 25 will receive for each worker hired a one-year exemption from the payment of social insurances contributions In SK, jobs in the private sector will be subsidised up to the level of the minimum wage for one year  while employers should contribute for at least six months..

Measures to reform the employment protection legislation have only been taken in few countries (HU, SK and IT). In HU changes include regulations of holding multiple jobs, regulation of flexible working-time arrangements and simplification of firing rules. PT has reduced severance payments to 20 days per year of work for both open-ended and fixed-term contracts and eased the definition of individual dismissals for economic reasons. In IT the legislation regulating wrongful individual dismissals in firms with more than 15 employees, has been revised to increase the flexibility on exit from the labour market and measures have been introduced to limit the abuses of atypical labour contracts. In SK measures are taken to restrict the maximum duration and number of successive fixed-term contracts and remove exceptions for temporary work agencies.

Only few Member States are making progress concerning adapting education and training systems to reflect labour market needs (BE, IE, LT, MT and SK). In IE measures aim at helping unemployed and previously self-employed people to remain as close as possible to the labour market by accessing part-time higher education and training opportunities to up-skill or re-skill in areas where sustainable employment opportunities are likely to arise In LT, qualifications will be mapped in several stages in order to provide better information to people on the structure of skills demand and to identifyn the specialities that are most demanded. In MT, students are encouraged to further their education through qualifications required by industry and through a tax credit covering up to 80% of the course fees incurred. In SK the recently adopted Act on vocational education and training aims at reinforcing links between VET and labour market requirements. Also in BE all communities have taken measures to reform vocational training in view of reinforcing its quality, flexibility and links with labour market requirements

A number of measures have been taken to review the quality and funding of the universities (IT, LV and MT). IT has taken steps to decrease the generosity as tuition fees set to increase by between 25% and 100%. As regards scholarships, only MT has announced the continuation of the two scholarship schemes. LV has undertaken a large scale assessment of more than 800 higher education study programmes and a number of reforms are in the pipeline, including reform of the accreditation process, development of a new financing model of the universities and reform of the management of the universities.

Despite the European Semester's call to prioritise growth-friendly public expenditure, there is evidence that cuts are being made at the detriment of investment in education. A significant number of Member States decreased education spending in consecutive years in 2011 and 2012 (EE, IT, LV, LT, UK) or in either 2011 or 2012 (BE, BG, IE, FR, CY, HU, PL, RO, SK, FI). Discussions on budget consolidation focus on education issues also in ES. In contrast, budgets remained stable or increased in CZ, DK, LU, MT, AT.

3.3. Protecting the vulnerable

A number of Member States have taken steps to address the effectiveness of social protection systems (EE, LV and ES). In EE, the availability of unemployment insurance benefits will be significantly increased as from 2013 onwards accompanying and counterbalancing the employment legislation reform of 2009. In IE, despite general cuts of social benefits, vulnerable people still receive income support, albeit at a lower level. In LV unemployment benefits will no longer depend on seniority insurance scheme but will be based on decreasing coverage of up to 9 months. In ES the activation of the minimum income scheme will be linked to the length of the working career of a claimant.

Some Member States have made progress regarding the implementation of active inclusion strategies focusing on adequate income support, inclusive labour markets, and access to quality services (AT, DK, FI, FR, MT, PL and SE). In AT an action plan for disability has been adopted covering measures in the fields of anti-discrimination, accessibility, care, education, employment, self-determined life. In DK, a major reform of disability pensions was agreed in June 2012 restricting access to those above 40 and envisaging rehabilitation teams to support health, employment, education and social services. In MT, voluntary organisations are encouraged to employ disadvantaged persons through the allocation of financial help. In SE the Government intends to further strengthen the position of vulnerable groups in the labour market by increasing active labour market measures for long-term unemployed and people with a weak foothold in the labour market. In PT a rental social market was created aiming at ensuring access to affordable and quality housing for the most vulnerable.

Only few measures are being taken concerning access to services supporting integration in the labour market and in society (CZ, IE and PL). In CZ a pilot small-scale program offering better housing and retraining to those socially excluded families (especially the Roma) who ensure full attendance of their children in elementary schools is being launched at local level. In IE, the ESF supports programmes aiming at making immigrants financially independent and more socially integrated through employment or further education and training. In PL the income criteria has been increased to support working poor and the amount of cash benefits from social assistance has been increased including for foreigners and refugees taking part in language training.

[1]               Official Journal L308/46, 24.11.2010, “Council Decision of 21 October 2010 on guidelines for the employment policies of the Member States (2010/707/EU)”

[2]               Long-term unemployed represents currently more than 44% of the people unemployed.

[3]               See European Commission's "Employment Package" of April 2012

[4]               SWD (2012) "Exploiting the Employment Potential of Green Growth", 92final, 18.4.2012

[5]               The network of 31 European Employment Services which supports the mobility of workers between Member States, EEA countries and Switzerland.

[6]               OECD estimates based on the OECD Labour Market Programmes and OECD Main Economic Indicators Databases.

Introduction

The EU economy continues to struggle with the post-financial crisis correction. Financial tensions have continued in the euro area before the summer, while the global economy has decelerated reducing the potential contribution of exports to recovery. Therefore, the short-term outlook for the EU economy remains weak, but a gradual return to growth is projected for 2013 and a further strengthening in 2014. This outlook creates additional challenges for the necessary adjustment in many EU Member States. In particular, low growth prospects hold back investment, job creation and accelerate labour shedding, as the margins to use flexibility in work patterns are now reduced.

The challenges facing the EU economy continue to be daunting. In particular, several Member States' economies continue to face large deleveraging of the private and public sectors. This deleveraging reflects the unwinding of accumulated financial imbalances linked to previous unsustainable expenditure levels financed by credit, in some cases promoted by asset price bubbles in the private sector and in others by the lack of fiscal rigour in the public sector. This is now weighing on growth, as spending is reduced and income directed to debt repayment.

On the positive side, there are signs that the adjustment in the EU economies is progressing. Financial market situation has improved after the summer on the back of the steady implementation of the reform agenda, including the advancements in the EMU architecture, and by the important policy decisions in the euro area, including by the ECB. The significant reform efforts in the vulnerable Member States are also bearing fruit: leveraging has decreased in the private and public sectors and competitiveness is improving in countries with large competitiveness gaps creating conditions for further adjustment going forward. Exports are contributing increasingly to improvements in large current account deficits, which bodes well for the lasting nature of the correction. The large growth differences among the EU countries are also a reflection of the ongoing adjustment: temporarily lower or negative growth is often a feature of deep adjustments, but they open the way for more sustainable growth and convergence, which should be visible already in 2014.

The deleveraging and adjustment process is inevitable and the main task of policy makers is to manage it and alleviate the associated economic and social consequences.

Fiscal adjustment has to continue along the path of a differentiated growth-friendly consolidation strategy in view of the high debt levels and long-term challenges to public finances. However, as fiscal consolidation can have negative growth effects in the short term, it should be conducted in a growth-friendly manner, that is:

– the speed of consolidation has to be differentiated across countries according to their fiscal space, to strike the right balance between potential negative growth effects and the risks to debt sustainability. The Stability and Growth Pact and the central role of structural budget balances therein offer the appropriate framework to guide the differentiated speed of adjustment;

– while focusing the consolidation on the expenditure side, there is a need to devise an overall growth-friendly mix of revenue and expenditure, with targeted measures within available fiscal space to protect key growth drivers while ensuring efficiency of expenditure.

Additionally, credibility of consolidation and its positive effects are enhanced if it is anchored in a credible medium-term fiscal framework and accompanied by reforms addressing the long-term sustainability issues stemming from an ageing population.

Orderly deleveraging in the private sector requires a robust and efficient financial sector. Therefore, financial repair and restructuring has to continue in particular in the banking sector in view of its important role in the EU economy, but also new sources of funding have to be promoted. A coherent and effective micro- and macro-prudential policy framework is crucial to restore confidence in the stability of the banking sector, foster a sustainable flow of capital into productive activities and to ensure stable financing of the economy.

Structural reforms are necessary to facilitate adjustment and improve the framework conditions for growth. Structural reforms, which improve competitiveness, wage responsiveness and price flexibility are key to improving adjustment capabilities and to stimulating the transfer of resources from declining to growing sectors. Reforms promoting job creation, investment in innovation, skills and inclusive growth are necessary to tackle the risk of hysteresis and alleviate the negative impact of the crisis on social conditions. A fair distribution of the adjustment burden across society is important for sustained growth. Ultimately, however, a coherent policy mix encompassing both macro-financial and structural policies is indispensable for growth to resume. Hence a determined policy action on all these fronts is necessary to counter the negative dynamics and improve the economic situation in a sustainable manner.

The countries of the euro area are in a specific situation due to their stronger financial and economic interlinkages and the resulting spillovers.

Private capital flows within the euro area have turned around abruptly, flowing away from vulnerable countries. The external financing gap that emerged as a result was bridged through the provision of liquidity by the official sector, which prevented a disorderly adjustment. However, as a result of an increasing home bias, financing conditions for both the public and private sectors have been diverging increasingly within the euro area. This has led to a very tight policy mix in the vulnerable euro-area Member States, as tight financing conditions add to the necessary fiscal consolidation. This is hampering adjustment, contributing further to divergent economic outcomes between euro-area countries and undermining the stability of the whole currency area.

The main priority for the euro area is to continue on the path of structural reform and to reverse financial fragmentation, improve financing conditions in the vulnerable countries and to encourage the inflow and efficient allocation of capital to support adjustment. This is indispensable for growth and adjustment. Also, the need to reduce macroeconomic imbalances highlights the need for a differentiated pace of public deleveraging between the surplus and the deficit countries. Finally, in view of the single monetary policy, structural reforms to increase wage and price flexibility and facilitate adjustment play an even greater role in the euro area.

Continuous perseverance in reforms is of the utmost importance to meeting the challenges. The European Stability Mechanism has become operational on 8 October 2012 and the ECB has decided to introduce the Outright Monetary Transactions in September 2012. These are important contributions to tackling the most immediate challenge of stabilising the financial situation and restoring confidence. Restructuring and rebalancing of the economies will be materialising over the medium term, as the structural reforms usually take time to have full effect. Finally, the vision of genuine EMU is being developed as a long-term goal, for which tangible steps are already being taken to support reform momentum. As a result, financial market tensions have eased somewhat recently, but markets remain fragile and have become dependent on the continuation of supportive policies. Therefore, any stalling in reform efforts could immediately lead to a re-emergence of tensions and undo the recent improvements.

1.           growth-friendly fiscal consolidation

Sound and sustainable public finances are an essential prerequisite for macroeconomic stability and hence for growth. This is particularly the case in the euro area, where the single monetary policy cannot react to country-specific circumstances, and national budgets need to regain their ability to assume a stabilisation function in the event of country-specific shocks. At the same time, euro-area Member States share much stronger spillovers from unsustainable fiscal policies, chiefly through the financial channel, as clearly demonstrated by the current crisis. This calls for greater responsibility in terms of budgetary developments at national level. This is at the root of the rules-based fiscal governance provided for in the Treaty and the Stability and Growth Pact (SGP). The respect of these rules is essential for a smooth functioning of EMU.

Fiscal consolidation has negative effects on growth in the short term as fiscal retrenchment reduces aggregate spending, but benefits accrue in the medium-term. During financial crises, the impact of fiscal policy on growth can be larger than usual, as the so-called fiscal multipliers are thought to be larger than in normal economic conditions[1]. In the short-term, this could also entail adverse effects on debt-to-GDP ratios from consolidation if initial debt ratios, and hence consolidation needs, are high.

Nevertheless, in some Member States there is no viable alternative to consolidation, as its absence could lead to even more negative consequences. In the presence of high and rising debt levels, it is necessary to look at debt sustainability, which is a medium-term concept. The Commission’s analysis[2] shows that only under rather implausible assumptions (very high degree of myopia in the markets, very unusual reactions of risk premia) would consolidation lead to adverse debt effects in the medium term. Moreover, creating conditions for, and expectations of, a permanent consolidation is an important part of avoiding adverse debt effects, as expectations of a reversal in consolidation can cancel out its potential positive effects on risk premia. At the same time, for Member States with reduced market access, the assessment of the costs of consolidation, also in the short term, depends on the alternative scenario considered. When fiscal sustainability is at risk, the lack of consolidation can result in higher risk premia or the loss of any market access, which could prompt a much more dramatic adjustment, with consequences for growth that are far worse than in the case of consolidation and improved fiscal sustainability.

While some EU countries enjoy more room for manoeuvre, the risks stemming from slowing fiscal consolidation should be carefully assessed. Some EU Member States currently enjoy record-low interest rates on their public debt and hence could seemingly increase their borrowing without running into risks of unsustainable dynamics. However, also in those countries debt is at peacetime highs. Moreover, in almost all of them, public expenditure is projected to increase due to ageing, and in some cases, low growth prospects. Therefore, it cannot be excluded that a loosening of the commitment to sustainable fiscal policies would lead to a switch in market sentiment. This would have serious repercussions not only for the countries concerned but also for the crisis-management capacity of the euro area as a whole, which relies on the creditworthiness of these countries.

Graph 1. Government debt and deficit in EU Member States (forecast for 2012, % of GDP)

Source: Commission Services, European Economic Forecast, Autumn 2012

EU public finances face great challenges, and fiscal stability must be restored in a permanent manner (Graph 1). The challenges stem from the need to reduce high debt levels in an environment of low growth prospects, long-term spending pressures and an already relatively high tax burden. Thus, the overarching principle of growth-friendly fiscal consolidation remains valid. The strategy advocated by the Commission in the previous Annual Growth Survey, has proved successful, even if short-term negative consequences could not be avoided, as argued above, and the full benefits can become visible only in the medium term.

The effect of consolidation on growth can be influenced by its composition. Additionally, to guarantee the permanent nature of consolidation and improve expectations of fiscal sustainability, consolidation should be accompanied by reforms strengthening the long-term sustainability of public finances and supported by a robust institutional framework.

The pace of consolidation

The pace of consolidation should continue to be differentiated across countries according to fiscal space. In particular, in view of the persistent market pressure on the high-debt countries, countries which have lost access to financial markets or are under severe market pressure must continue to implement the agreed fiscal commitments. Other Member States should continue to respect their commitments under the SGP, which allows automatic stabilisers to work around the agreed path of structural fiscal adjustment while ensuring the long-term sustainability of public finances.

The Stability and Growth Pact offers a flexible and efficient framework to guide the differentiated pace of consolidation. The rules of the SGP allow for the pace of consolidation to vary according to the particular characteristics of the Member States. Within the SGP countries are assigned nominal targets, for the benefit of transparency and anchoring budgetary policies. However, the Council recommendations also specify the necessary structural effort, which should capture the underlying budgetary positions without taking into account cyclical effects and one-off measures. If a country had delivered the agreed structural effort, but fails to achieve its targets only as a result of worse-than-expected growth, the deadline for correction of the excessive deficit can be extended. This option has been taken up on several occasions in the past, most recently for Spain and Portugal.

The composition of consolidation

While expenditure-led consolidations should be favoured, the focus should be on an overall efficient and growth-friendly mix of expenditure and revenue measures. Analysis of past episodes of consolidation suggests that expenditure-based consolidations are more likely to succeed. Also, given the relatively high tax burden in the EU, further tax increases could impact negatively on future growth and should therefore be introduced with caution. Overall, in order to limit the short-term negative effects on growth, the composition of consolidations should find the right mix of growth-friendly measures on the expenditure side and the revenue side.

The efficiency of spending and the quality of public finance in general is becoming increasingly important in view of the long-term challenges to public finance. In the light of historically high debt levels and the long-term impact of ageing populations, pressure on public expenditure is likely to remain beyond the current fiscal adjustment. Therefore reviewing expenditure efficiency becomes increasingly important in reconciling the need for sustainable public finances and the provision of public services at a satisfactory level. International best practices show that in many EU countries there is significant room for savings of public resources for unchanged levels of services.

The pursuit of government sector reforms and the introduction of best practices in performance-oriented budgeting could be instrumental in increasing the efficiency of public spending. There is significant cross-fertilisation between public administration reforms spurred by spending reviews and performance-based budgeting, in terms of objectives and timeframes. While performance-oriented budgeting favours a holistic approach and requires long-term vision for both introduction and delivery of results, public administration reforms can generate fast and significant results in terms of efficiency of public spending and savings, provided that they are prepared by rigorous spending reviews and included in longer-term strategies. Public administration reforms could usefully focus on extracting savings where indicators, including cross-country and within-country comparisons, suggest the largest scope for saving (see also Section 3). Other measures relevant for spending efficiency may reflect the variety of socio-economic goals of different spending items, including distributional concerns, such as improved design and targeting of social transfers and state aid or other subsidies, identification of most productive public investment projects or improved efficiency in the provision of public goods and services. However, whatever the instrument chosen to strengthen public spending efficiency, it has to be accompanied by performance management at all levels of public administration.

Expenditure savings should avoid items, which have a positive impact on growth and growth potential. Where cuts are envisaged, they should be minimised in areas related to the development of human capital and technological advances. For public investments in fixed assets the situation is less clear-cut. Such investment contributes to potential growth only as far as the new infrastructures are inputs to private investment, which applies mainly to investment in transport, communication and certain public utilities. Secondly, public investment in fixed assets is beneficial only up to a certain level, and for Member States with an already satisfactory level of infrastructure, the focus should rather be on maintenance and possibly upgrading.

On the revenue side of the budgets, despite recent reforms, many Member States still face substantial tax policy challenges. Some EU Member States could benefit, albeit to varying degrees, from revenue-side measures to consolidate their public finances and ensure sustainability. Such measures must, however, aim at improving the efficiency of tax systems while ensuring a fair distribution of the consolidation burden across all parts of society. Additional revenue would preferably be raised by broadening tax bases rather than increasing rates or creating new taxes. This may involve a need actively to review tax expenditure and other loopholes in personal and corporate income taxation, while cutting the scope for VAT reduced rates or exemptions or raising reduced rates to a level closer to the standard rate. Excise duty exemptions could also be reviewed with a view both to raising revenue and contributing effectively to other public policies (e.g. health and environment policy).

Improved tax governance could also usefully complement revenue-raising measures. Some measures to address tax evasion, such as lifting the banking secrecy, seems to have brought significant additional tax revenue already in the short term. However, the gain in revenue from better tax governance is often difficult to estimate ex-ante and should therefore not be overestimated in the context of prudent fiscal policy, especially in the short term. Enhancing tax compliance could take various forms, such as reducing the shadow economy, combating potential VAT fraud and evasion, or promoting the efficiency of the tax administration. Improving the tax administration is a challenge many Member States face to raise additional revenue, reduce the high cost per net revenue collected and lighten the heavy administrative burden for small and medium-size companies.

With respect to increasing the growth and jobs potential of European economies, revenue-neutral reforms could be considered. This is the case especially for Member States that have both the margin and the need for a shift from labour taxes to less distortionary taxes (consumption taxes, recurrent property taxes, environmental taxes). A tax composition with a high share of direct taxes and social security contributions alongside a low share of indirect taxes might indicate scope for such a tax shift. Revenue-neutral reform could also involve reducing high corporate income tax rates.

The designing of the consolidation and tax reforms strategy should take account of other issues relating to the design of specific taxes. First, corporate taxation is often biased toward debt financing instead of equity funding. Secondly, housing taxation is based too much on transaction taxes rather than less harmful recurrent taxes on immovable property, while tax- deductibility of mortgage interest generates a debt bias and a risk of overinvestment in housing. Finally, environmental taxes could play an important role in meeting agreed environmental objectives and should over time provide appropriate incentives to reduce harmful emissions, in particular of greenhouse gasses. Tax reforms will have to reflect both economic efficiency and social equity, according to collective preferences. Distributional effects will have to be taken into account when designing tax reforms.

Addressing long-term sustainability

The need for consolidation is heightened by the challenges posed to public finances by an ageing population. The Fiscal Sustainability Report 2012[3] shows debt in the EU remaining stable until 2020, thanks to recent fiscal consolidation efforts and reform progress that nearly stabilize age-related spending. However, from 2021 onwards, the ageing costs take hold more firmly and debt in the EU starts to rise again, coming close to 90% of GDP by 2030. This dynamic can be reversed only through sustained efforts by Member States. If the improvement of the structural balance by 0.5% of GDP per year until the medium-term objective were to be achieved and maintained over the long-term, in line with the SGP,  the debt level would be brought close to 60% of GDP by 2030.

While some countries are already addressing age-related pressure on spending, more remains to be done, in addition to delivering on current plans. Substantial efforts to reform pension systems have already been made in many Member States in the last decade, with visible positive budgetary impact. In the long run, however, a further increase in public pension expenditures in the long run is still to be expected at aggregate EU level[4] (+1.5 p.p. of GDP by 2060). This calls for enhanced efforts to reform pension systems, especially in countries where increases in pension expenditure are projected to be far above the EU average and where the reform process has not yet started in earnest. In 2012, a majority of Member States were given recommendations to adapt pension policy in 2012. While good progress has been made in a number of countries, including through restricting access to early retirement and harmonising the retirement age between men and women, in other Member States the reform agenda needs to be either intensified or activated.

Linking the retirement age to life expectancy would help stabilise the balance between working years and years in retirement. To avoid recurrent difficult negotiations, the link should preferably follow automatic rules. This measure is an effective way of reducing longevity risk, addressing sustainability and adequacy concerns at the same time, by giving incentives to work longer and thus to accrue higher pension entitlements. To contribute successfully to higher effective retirement ages, reforms in pension systems need to be underpinned by policies that develop employment opportunities for older workers and support active and healthy ageing, complemented by tax and benefit policies giving incentives to stay longer at work and giving access to life-long learning.

Graph 2. Budgetary developments – euro area

Source: Commission Services

Member States have shown determination in pursuing fiscal consolidation and have reduced deficits significantly. According to the 2012 Commission Autumn Forecast, average general government deficit in the EU is expected to decline by 0.8 p.p. in 2012 and reach 3.6% of GDP. For the euro area, the picture is broadly similar with the deficit falling to 3.3% of GDP. With continuing fiscal consolidation in 2013, general government deficit in the euro area is expected to fall below 3% of GDP for the first time since 2008 (Graph 2). In a majority of Member States, the composition of consolidation can be assessed as overall growth friendly and broadly balanced between revenue and expenditure. Between 2007 and 2012 the main expenditure savings have been recorded in investment spending, intermediate consumption and the public wage bill. At the same time the share of social transfers has generally increased, particularly so in countries more strongly hit by the economic crisis.

Fiscal consolidation appears to have been even stronger in structural than in nominal terms. The structural adjustments for 2012 are forecast to exceed 1 p.p. both in the EU and in the euro area. To reach such an outcome, Member States have on average stuck to their nominal targets, undertaking corrective measures in the course of the year in the context of a deteriorating macroeconomic background. The consolidation path is expected to remain steady in 2013, since Member States either have to implement the fiscal effort required under their Excessive Deficit Procedure (EDP) or have still to converge towards their medium-term objectives. This is expected to bring structural deficit down by more than 0.5 p.p. in the EU in 2013.

Fiscal governance and budgetary institutions

Solid national budgetary frameworks are central for sound fiscal decision-making. Under the Treaties, final budgetary decisions remain with national authorities. It is thus key that Member States take action at national level to enhance predictability and the credibility of their commitments to prudent fiscal policy. The Directive on national budgetary frameworks and the Treaty on Stability, Convergence and Governance (TSCG) improve national fiscal frameworks considerably. Proper transposition of the Directive by the end of 2013 should ensure robust budgetary frameworks across EU Member States, including timely and comprehensive statistics, medium-term planning, reliance on realistic forecasts and definition of national fiscal rules promoting compliance with budgetary obligations under the Treaty. In addition, through the TSCG, 25 Member States have committed themselves to enshrining in binding national law the objective of a budget in balanced or in surplus, thus anchoring a founding principle of the SGP at the heart of national frameworks. Compliance should be further enhanced by national automatic correction mechanisms, to be designed in line with common principles and activated in well-defined circumstances, should enhance compliance.

Fiscal governance at European level has been strengthened and the Commission has submitted more improvements to the co-legislators. The Six-Pack[5] has reinforced the preventive arm of EU fiscal surveillance and the ability to spot and correct fiscal imbalances at an early stage. It has introduced new tools such as an expenditure benchmark and a numerical debt rule. As the fiscal policies of the Member States sharing the same currency share increased budgetary spillovers, the financial sanctions for non-compliant euro-area Member States have been strengthened, but are now also applied more gradually and at an earlier stage. The Commission has proposed further improvements in fiscal surveillance for euro-area Member States in the two Regulations that form the Two-Pack. The Regulation on enhanced surveillance streamlines and reinforces the fiscal surveillance applicable to Member States threatened with or experiencing financial difficulties, while the Regulation on enhanced monitoring of budgetary policies creates a closer monitoring of Member States in EDP to ensure a timely correction of excessive deficits. It also reinforces preventive action at EU level by laying cornerstones for genuine budgetary policy coordination in the EMU, e.g. a common budgetary timeline, a coordinated submission of annual national budgetary plans to the Commission ahead of their parliamentary adoption.

2.           restoring financial stability

Over the past year, financial tensions in the EU financial markets have continued, but there are signs of an improvement recently. The negative feedback loops between euro-area sovereigns, banks and growth continued to fuel financial stress and weighed on confidence. Strong policy actions by EU and national policy makers have recently led to improvements, but the sovereign spreads in vulnerable countries remain high and volatile. At the same time, some other EU countries have enjoyed large inflows of private capital and witnessed record-low, including negative, interest rates on their sovereign bonds. The tight interlinkages between sovereign markets and the EU banking sector continue to pose major risks to financial stability in the EU and the euro area in particular.

Liquidity and structural funding problems have persisted in the EU banking sector. Particularly in the vulnerable Member States, access to market funding for a number of banks has remained hampered. Downgrades of sovereign ratings have reduced collateral available for banks' operations with the Eurosystem and triggered downgrades of banks' own credit rating, leading to an increase in banks’ funding costs. In the first half of 2012, funding pressures in the vulnerable euro-area Member States have been compounded by deposit outflows, while higher-rated Member States have witnessed deposit inflows. Also, banks’ internal funding has come under pressure due to reduced growth prospects and thus lesser earnings potential. The response of banks to funding pressure was to turn from unsecured to secured lending and to the issuing of covered bonds. This has resulted in a significant increase in the amount of encumbered assets in banks’ balance sheets, which represents an additional source of concern.

Graph 3. Bank lending to households and non-financial corporations – euro area

Source: Commission Services

The scarcity of market-based funding and rising credit risks due to stagnant growth hamper the capacity of banks to lend to the real economy. Financing constraints are particularly high for small and medium-sized enterprises, which are the backbone of the EU economy and provide the bulk of employment. The lending difficulties are greatest in the vulnerable countries where distressed banks have been reducing lending, although weak growth prospects and the need to reduce corporate and household debt also reduce the demand for credit (Graph 3). At the same time, while banks have continued the necessary adjustments of their balance sheets, there have been no signs of a disorderly or excessive deleveraging. The capital flows from public sources, which have mitigated the outflow of private capital, as well as the coordinated recapitalisation exercise led by the European Banking Authority have played a key role in this regard. Still, the need of deleveraging has varied across countries, with banks in vulnerable Member States adjusting their balance sheets faster than elsewhere. In view of these factors, it is a positive sign that in the euro area as a whole bank lending to the private sector has stabilised in 2012 and the latest ECB Lending Survey has shown some easing in funding concerns.

The re-emergence of sovereign risks has reversed the process of financial integration in the euro area. The introduction of the euro, but also the global pricing of credit risk before the crisis, have spurred financial market integration in the euro area and facilitated credit flows between euro-area countries. With the bursting of the asset bubbles in some countries and the eruption of the sovereign debt crisis, cross-border flows diminished dramatically and capital retrenched behind national borders. In particular, private capital flowing over the previous decade from the Northern to the Southern euro-area Member States has been falling dramatically, as banks have been reduced their cross-border exposure vis-à-vis both governments and the private sector in vulnerable countries. The external financing gap that emerged as a result was bridged through liquidity drawn from the Eurosystem and in the later stages through EU/IMF loans under financial assistance programmes. Also, the home bias in sovereign debt holdings increased, strengthening the negative feedback loop between weak sovereigns and weak banks.

Financing conditions across the euro-area countries have diverged. Higher risk premia in cross-border lending have led to growing financial fragmentation and thereby to widening gaps in interest rates on loans to enterprises and households across euro-area countries. The private sector now faces significantly higher interest rates in vulnerable countries than in other Member States, in particular in those, which have been perceived as "safe haven" markets (Graphs 4 and 5).

Graph 4. Interest rates on loans to enterprises || Graph 5. Loans to enterprises

||

Note: New businesses, maturity up to 1 year Source: Commission Services || Note: Index of national stocks y-o-y growth rate Source: Commission Services

The dysfunctionality of credit markets across the euro area poses significant challenges for the functioning of monetary union. The ongoing adjustment and restructuring in the vulnerable euro-area Member States weighs heavily on growth. Their adjustment process depends on the restoration of normal lending conditions by the banking system, which presently does not play its proper intermediation role in the single market. Micro- and macro-prudential supervision with a cross-border dimension, should contribute to the integrated banking system to restore its function as financial intermediary.

Restoring the conditions for a normal lending to the economy requires addressing the underlying root of banks’ distress. Bold policy responses have been adopted at the EU level to break the vicious cycle between weak banks and their sovereigns, address the funding difficulties, financial fragmentation and broken monetary transmission mechanisms in the euro area.

As part of a road towards genuine EMU, the EU Heads of State agreed in June 2012 to move towards a Banking Union, with the Single Supervisory Mechanism (SSM) as a first tangible step. Following the agreement, the Commission presented proposals to establish the SSM and grant the European Central Bank supervisory powers. At the same time, the European Banking Authority would be aligned to the new framework for banking supervision in order to ensure consistency at EU level. The SSM aims at removing the differences in supervisory practices, which contributed to the trend towards fragmentation of the European financial market and put the banking sector at risk. The SSM will ensure that all participating Member States have full confidence in the quality and impartiality of banking supervision. This is important to guarantee that capital flows will support rebalancing in the short term and will not lead to new imbalances in the future (See also Section 3).

With the establishment of the European Stability Mechanism (ESM), the euro area has been equipped with a strong permanent firewall. The large funding capacity (EUR 500 bn) and a set of flexible instruments make the ESM well equipped for breaking the negative feedback loop between banks and sovereigns and helping to restore confidence. In addition to disbursing loans and credit lines for liquidity-constrained euro-area Member States, the ESM has an extensive set of instruments and can, if certain pre-conditions are met, intervene on primary and secondary bond markets, under conditionality that do not necessarily imply the request for a fully-fledged macroeconomic adjustment programme.

The possibility of using the ESM to recapitalise banks directly will be a powerful tool for ultimately breaking the vicious circle between banks and sovereigns in the euro area. The ESM can also provide loans specifically targeted at bank recapitalisation. Until now, however, these loans could be granted to Member States only, which would in turn use them for recapitalisations of their distressed banks. Although bringing some relief to liquidity-constrained governments, this approach has been a second-best solution to the problem of interconnection between banks and sovereigns. In particular, such loans would be recorded in Member States’ fiscal accounts and increase their public debt. To overcome this problem, the Euro Area Summit decided in June 2012 to allow the ESM to recapitalise banks directly, once the SSM has been effectively established. This will go a long way towards de-linking the risks of banks and sovereigns in the euro area and will be a major step towards successful resolution of the euro area-crisis.

The European Central Bank has taken effective measures to alleviate banks’ funding constraints and repair the monetary transmission mechanism. The two 3-year Long-Term Refinancing Operations carried out by the ECB in December 2011 and February 2012 filled acute refinancing gaps for euro-area banks by guaranteeing banks’ access to low cost medium-term funding. However, as funding pressure persisted and in some euro area Member States signs of severe disruptions in the monetary transmission mechanism became apparent, the ECB has introduced a new tool - Outright Monetary Transactions (OMTs) - to safeguard the proper transmission of monetary policy in the euro area. OMTs are outright transactions in secondary sovereign bond markets subject to strict and effective conditionality in connection with an ESM-financed adjustment programme. While the tool has not yet been used, its announcement has already led to improvements in the euro-area sovereign bond markets and, together with the plans to implement the Banking Union, it has great potential to mitigate financial tensions in the euro area and restore conditions for healthy lending to the economy.

While strong policy actions have eased market tensions, markets remain very dependent on the continuation of supportive policies and the implementation of commitments. Underlying vulnerabilities are still present in the EU and particularly the euro-area financial system. At the same time, the duration of the crisis in the euro area has led to high dependence of market developments on policy measures. Therefore, certainty on policy actions and forceful implementation of the agreed measures and national reform policies is crucial to containing market volatility. The commitment to build genuine EMU, and a full Banking Union in particular, will restore financial stability on a permanent basis.

3.           structural reforms to support growth and correct imbalances

Improving confidence and reviving growth in the short run while creating conditions for sustainable growth in the future is the main challenge at the current juncture. In a context of constrained macroeconomic policies, structural reforms are a crucial element of the growth and rebalancing strategy, aimed at tapping the potential of EU economies. Significant reform efforts have been made in the vulnerable countries as the crisis progressed. Although the need for action in these Member States is more pressing, growth in both the short and medium-to-long term is an EU-wide problem which requires a collective response. Despite significant differences in the economic situation across Member States, a co-ordinated approach to reforms across the Member States and at the EU level would trigger political momentum, relax political economy constraints and so facilitate the reform process.

Graph 6. Current-account balances – euro area and Member States || Graph 7. Unit labour costs and nominal compensation per employee – euro-area

||

Source: Commission Services || Source: Commission Services

Growth in the EU economy is currently constrained by persisting macroeconomic imbalances and the need to adjust past excesses in borrowing and consumption. Temporarily lower growth is an inherent feature of deep adjustment, as economies undergo restructuring, resources are transferred from non-tradable to tradable sectors and balance sheets in all sectors of the economy have to adjust. The required adjustment has continued over the last year, in spite of the difficult economic context, and is bearing fruit. Headline figures for current account balances, trade data and domestic demand show that adjustment is on-going in the EU, including among the euro-area countries, but further progress is needed (Graph 6). Adjustment is also currently underway in programme and other vulnerable countries, including those where progress appeared limited until recently. Not only are current-account imbalances narrowing, but also unit labour cost developments are supportive of more rebalancing in the future (Graph 7). In some deficit countries, nominal wages are adjusting in both the public and private sectors.

Graph 8. Current-account and net international investment position (NIIP) surplus and deficit countries

Source: Commission Services

The ongoing adjustment in external positions appears to be largely structural. Deficit countries have experienced a large compression in imports and some expansion in exports. While the import compression has been dominant so far, the gains in competitiveness prepare the ground for future export expansion and – according to the Commission Autumn Economic Forecast – export contribution to rebalancing is expected to rise over the forecast horizon. Provided that the competitiveness gains are sustained, the increase in exports should lead to development of the export-oriented industries and to the permanent nature of the adjustment. Nonetheless, the external rebalancing in current account flows is not yet sufficient to change unsustainable trends in stocks (net international investment position and external debt) (Graph 8). In most deficit countries, the external debt-to-GDP ratios keep on increasing; if they are declining, this is mainly due to large revaluation of liabilities. Sizeable adjustment will be needed, the cost of which – particularly in employment terms – will depend on the Member State’s adjustment capacity. The progress in reducing bilateral current-account imbalances between surplus and deficit countries has been much more visible. For the surplus countries, there are also signs of rebalancing towards domestic demand, though the adjustment of current-account surpluses also reflects that the current account of the whole euro area has moved into surplus.

While the full effect of structural reforms on growth and rebalancing is likely to materialise in the medium-to-long run, gains can also emerge in the short term. Reform processes are usually associated with adjustment and transition costs in the short term, partly because of their generally uneven distribution across firms and individuals. However, structural reforms might also have immediate expansionary effects, insofar as they improve confidence and expectations across economic actors. Priority should be given to reforms entailing the lowest impact on budgetary costs (such as competitiveness and competition-enhancing reforms in product markets or reduction in regulatory and administrative burden for enterprises), while emphasis should also be placed on achieving the best framework conditions (e.g. enhanced social dialogue) to support action in policy areas which are traditionally more difficult to reform, such as the labour market. Furthermore, synergies across different reform areas need to be considered. For instance, labour market reforms aimed at moderating unit labour costs might be more effective in driving competitiveness if coupled with product-market reforms aimed at increasing competition and squeezing margins. In general, interactions among different reform areas and the appropriate timing should be studied carefully, taking into account specific conditions in each Member State.

Financial regulation and supervision have an important role to play in ensuring orderly rebalancing and preventing damaging boom-and-busts cycles. The necessary deleveraging process taking place in the private sector in some EU countries, also linked with the tight financial conditions described in Section 2, might negatively affect growth in the short run. However, it is a pre-condition for the correction of excessive internal and external imbalances. In parallel, excessive credit growth and leverage in the financial sector, as witnessed before the crisis, leads to a build-up of vulnerabilities in the sector that bear a high risk of a disorderly correction, with massive negative consequences for economic growth. In this context, the development of effective macro and micro prudential tools is crucial to guarantee that, once financing conditions across the EU normalise, rebalancing will continue on the basis of sustainable capital flows towards the most productive activities and long-term investment needs of the EU economy, and that that excessive imbalances will not build up again.

Productivity-enhancing structural reforms remain a priority to foster medium-term growth prospects and ensure a lasting rebalancing of the EU economy. Empirical evidence shows that reforms aimed at increasing efficiency in product, service and labour markets can spur productivity, innovation and increase output and employment levels. Structural reforms oriented specifically at supporting innovation, investment in, and the use of, ICT and further increasing trade liberalisation also can have a direct impact on productivity. Such reforms also favour the reallocation of labour and capital, allowing for shifts towards sectors with high growth potential (including green growth sectors and digital economy). Moreover, this type of structural reform can play a key role in reducing internal and external imbalances, e.g. through improving competitiveness and export performance. Structural reforms are particularly relevant in the euro area, where relative prices cannot be influenced by nominal exchange-rate movements.

Fostering the opportunities for green growth could translate into better performance at both macro-economic and micro-economic levels. A shift to low-carbon and resource-efficient production patterns will alleviate the pressure of commodity price shocks on cost levels and inflationary expectations. It will reduce resource and energy dependence and thus also the energy trade deficit and enhance the competitiveness of the EU economy over the long term. The EU has developed policies to improve efficiency in the use of resources, including ambitious targets which will have implications for all Member States. The full rewards of these policies will be reaped only if they are accompanied by a stable and predictable regulatory framework to steer investment, tax shifts away from labour towards environmental and consumption taxes, a phasing-out of environmentally-harmful subsidies, measures to promote the emergence of new green markets and technologies, and the greening of existing production and consumption patterns.

The momentum of product and service market liberalisation should be maintained. Further action is needed to remove unjustified restrictions and improve competition in product and service markets, including in the areas of retail trade, regulated professions, construction, tourism and business services as well as network industries. This also requires action at EU level, where a well-functioning Single Market can both improve growth potential and contribute to the unwinding of imbalances. In order to realise its full potential, the development of the Single Market requires ambitious improvements, both by strengthening enforcement and by increasing reform efforts at country level, as laid down in Single Market Acts I and II. In this context, Member States are called upon in particular, to take ambitious measures to implement the Services Directive, given its growth and adjustment capacity potential.[6]

Graph 9. Government Effectiveness Index, EU Member States, 2011

Note: The World Bank’s Government Effectiveness Index shows the population’s perception of the quality of public and civil services and their degree of independence from political pressures, the quality of policy formulation and implementation, and the credibility of the government’s commitment to such policies. The index attains values in the range -2.5 to 2.5. Source: World Bank

Improving the business environment, inter alia by seeking ways to increase public sector efficiency, is a key priority. An open and effective business environment is a catalyst for growth, as it promotes business activity and reduces unnecessary costs for enterprises. Evidence shows that administrative complexity or ‘red tape’ has a significant negative impact on the level of entrepreneurship, innovation and competitiveness, and the inward FDI flows which could play a significant role in addressing imbalances. Moreover, an excessive regulatory burden tends to stimulate the shadow economy. An efficient public administration should deliver services to the whole economy without imposing disproportionate bureaucratic burdens on economic operators (Graph 9). Addressing problems in the public administration would contribute both to fiscal consolidation and to competitiveness and growth prospects. In particular, reforms of the judicial system would reduce the risks and uncertainty of starting and doing business, leading to investment and contributing to reduce transaction costs and strengthen competition. To this end, several Member States have already adopted measures to shape a more streamlined and effective public service. Key reform areas include judicial systems and enhanced use of e-government and e-procurement.

Unemployment has become a very serious issue in a number of EU countries, with increasing economic, social and political implications (Graph 10). Rising unemployment is accompanied by a major increase in the degree of divergence across EU labour markets. While unemployment has increased in most countries, reaching record-high levels in some cases, in some Member States it has been falling. Longer periods out of work and worse matching between labour demand and supply in many EU countries, also due to sectoral shifts in some countries, imply that unemployment may become increasingly structural with a negative effect on long-term growth potential.

Graph 10. Employment growth and unemployment rate – EU

Source: Commission Services

Structural reforms play a key role in tackling unemployment while improving growth and promoting adjustment. If unemployment rates are to be reduced significantly, the conditions must be created for renewed confidence and stable labour demand. At the same time, reducing joblessness will be key to strengthening confidence and ensuring the social and political sustainability of current reforms. Nonetheless, the immediate challenge is to manage high and persistent jobless rates under subdued growth conditions and, in some countries, against the background of ongoing deleveraging and external rebalancing. In the light of the different labour market conditions across the EU, the policy response needs to be coordinated but adapted to the specific circumstances of each country.

Since the start of the crisis, several EU countries have taken an active approach to labour reform. In some cases, ambitious reform plans have been adopted, with the aim of creating more favourable conditions for employment (Graph 11). Recent reform activity appears to be largely in line with the priorities set at European level, notably with measures that help to make labour markets more dynamic, reducing precariousness and improving competitiveness. Some countries with high unemployment and large external imbalances have taken up the challenge of improving the responsiveness of wages and their labour market adjustment capacity, notably by reforming employment protection legislation (EPL) and the wage-setting system. Income protection, activation and job search assistance policies have been adapted to the growing labour market challenges. However, not all countries have so far taken the necessary steps to rise to the policy challenges they are facing.

Graph 11. Number of labour market measures by domain, total EU

Note: ALMPs exclude training. Source: Commission services, DG ECFIN LABREF database.

Tackling unemployment and support for job creation should be high on the policy agenda. The momentum in labour market reform should be maintained, particularly in countries characterised by major labour market challenges. The extent to which potential growth can sustainably resume to a large extent depends on how successfully labour market bottlenecks are addressed and the risk of unemployment hysteresis is tackled. Appropriate policy responses are urgently needed in order to address structural and institutional labour market challenges (labour market segmentation, deterioration in the job matching process and persistent structural unemployment). Efforts aimed at ambitious structural reform favouring adjustment (EPL, wage setting) and the proper implementation of enacted measures need to be maintained in countries with major labour-market challenges. Specific measures can also be considered to boost labour demand by reducing taxation on labour – notably on low-paid groups – when fiscal conditions allow, and supporting entrepreneurship and the social economy. In addition, there is a need for targeted measures to promote the hiring of specific groups of workers at risk of dropping out from the labour force (such as the long-term unemployed or young workers with no previous experience), including by means of cost-effective active labour market policies and by exploiting the potential of job-rich sectors.

Annex. Selected macro-economic indicators

[1]               Although, there is no evidence supporting some recent propositions about very large size of the multipliers, see e.g. Box I.5 "Forecast errors and multiplier uncertainty" in European Economic Forecast, Autumn 2012, European Economy 7/2012

[2]               See European Commission (2012) Report on Public finances in EMU 2012, European Economy 4/2012 DG Economic and Financial Affairs.

[3]               See European Commission (2012) "Fiscal Sustainability Report 2012", European Economy 8/2012.

[4]               See European Commission and Economic Policy Committee (2012) "2012 Ageing Report: Economic and budgetary projections for the 27 EU Member States (2010-2060)", European Commission, European Economy, No 2.

[5]               A legislative package of five regulations and a directive, which entered into force on 13th December 2011. The legislation reinforced the Stability and Growth Pact and introduced a new set of rules for the surveillance of macroeconomic imbalances. See also: http://ec.europa.eu/economy_finance/articles/governance/2012-03-14_six_pack_en.htm

[6]               Commission services estimate that gains associated with the current implementation of the Services Directive in Member States are of the order of 0.8% of EU GDP, while a slightly more ambitious implementation, with each country achieving EU-average level of barriers to the cross-border provision and establishment of service activities, would bring additional gains worth 0.4 percentage points of GDP. Under an extremely ambitious scenario, where each Member State would reach the average of the five best-performing countries, an additional 1.8% growth of GDP could be achieved at EU level.