Diego Zuluaga // 13.11.2015

In a new publication, my colleague Philip Booth at the Institute of Economic Affairs makes a resolute case for Britain to become a federal country. He outlines the faults and imbalances of the UK’s current constitutional settlement, where powers are devolved to some of the nations – notably Scotland – while they remain centralised at the Westminster Parliament for others. He goes on to explain the benefits of fiscal decentralisation as suggested in numerous empirical studies, and he describes in detail how a federal arrangement could and would work in the United Kingdom.

While this is very much a UK-specific proposal designed to address the particular problems of Britain’s current structure of political decision-making, it raises a point which in my mind is highly relevant to the European Union. This is no other than the problem of centralisation of powers by the highest level of government in any federal arrangement.

Indeed, since the passage of the Single European Act of 1986, which set the stage for the common market to become a single market, wave after wave of legislative and regulatory measures at European level has been justified as necessary to promote free trade and preserve a “level playing field” throughout the Union. We see this in the financial sector, where a single rulebook is believed to be needed in order to facilitate trade in financial services and to address potential systemic problems. But the same reasoning has also been applied to labour market regulation, external trade pacts and – increasingly – the digital economy and energy policy.

Europe is not alone in exhibiting this trend. For years, the U.S. Interstate Commerce Commission used its mandate to bring down regulations which hampered trade between American states to concentrate an unprecedented amount of power at the federal level. And the Tenth Amendment to the U.S. Constitution – which aims to protect states’ rights – just like the principle of subsidiarity in the EU, has failed in stemming the flow of legislative and regulatory powers upwards from lower to higher levels of government.

This is a concerning trend. One of the reasons federal systems are almost universally more successful and growth-friendly than centralised ones is that they allow for experimentation and competition between their constituent units. Be it in the area of tax, labour regulation, healthcare or education, states’ and regional autonomy to design policies independently fosters a process of trial-and-error, followed by the adoption of best practice.

But it is not just that federal arrangements facilitate the process of arriving at the optimal solution to economic and social problems; they are also better able to adapt to the particular preferences of local people. There is no reason to believe everyone likes the same amount of property and income taxes in exchange for a uniform amount of public services. Some people are prepared to tolerate higher taxes in exchange for a given increase in the goods and services guaranteed by the state, whilst others are not. Fiscal federalism allows people to vote with their feet according to their preferences. It increases the variety of policy environments for individuals, families and businesses to choose from. And it is also a highly effective tool to discipline governments when they engage in bad policy or are perceived not to offer value for money, relative to other jurisdictions.

As an example, take taxation, over which Member States retain full autonomy outside of VAT. France’s high income taxes have driven large numbers of well-paid individuals out of France and across the Channel to London. Ireland’s low and relatively transparent corporate income tax has attracted multinationals from around the world, while many Member States with high headline rates have tended to dilute these with loopholes and exemptions, or with “comfort letters” issued to investors, in order to retain valuable corporate capital.

At the same time, different Member States operate different levels and forms of welfare provision, according to different traditions and preferences. But through experimentation at the national – and sometimes regional – level, some key guides for best practice have been established: 1) that supply-side redistribution via such things as high minimum wages, labour protections and rent controls is inefficient and counterproductive; 2) that complicated welfare schemes with many different benefits and high withdrawal rates as one’s income rises are wasteful, create disincentives and thus tend to harm rather than help the poor; 3) that the best welfare programme is a job, with income top-ups where deemed necessary.

In other words, decentralisation and the associated local experimentation and competition have both led to ‘foot voting’ by dissatisfied citizens, and ushered in guidelines for best practice even where significant divergences remain between countries. They have raised the welfare of the people involved, and arguably improved the accountability of public authorities and fostered better government.

Yet, despite their proven benefits and the fact that federal systems prevail in many Member States including Germany, Belgium and – to a large extent – Spain, decentralisation is increasingly being undermined at European level. The Eurozone crisis, and the widespread belief (which I do not share) that it exposed the need for greater centralisation and regulation at European level rather than (as I believe was the case) the devastating consequences of breaching the Stability and Growth Pact criteria and the no-bailout clause, has only hastened the process.

There are now increasing calls to centralise corporation taxes, certain forms of welfare policy, an ever greater amount of financial rules, product market regulations, and others. Sometimes such centralisation is aimed at liberalising markets, such as the expected new internal market guidelines which will open the door to the expansion of sharing economy businesses such as Uber and Airbnb across Europe. But even then, the problems of centralisation – inefficiency, distance from those affected and a concentration of risk – remain, and it is not clear that the resulting situation is an improvement over the status quo.

To my mind, the issue of whether the European Union – and, in particular, the Eurozone – can be a vehicle for increasing economic and political integration without leading to vast power transfers to the federal level is the most fundamental question facing the EU project. Making these two goals compatible will be essential to ensure that our economies become competitive, dynamic and prosperous.