Is Britain Europe's New Sick Man?

Its economy looks good, but scratch the surface and it doesn't look so robust

The news just keeps getting worse. Productivity and investment growth are slowing. Taxes are rising, and business is choking on reams of red tape. Meanwhile, the government's finances are deteriorating, and public services are a mess. Each day it seems yet another militant union threatens to take to the picket lines. Welcome to France? Not quite. This is Britain, the country long held up as a model of economic success in Europe.

Those who praised Britain are turning into its biggest critics. A growing chorus of executives believe the nation's hard-won economic competitiveness is being eroded by the policies of the Labour government. Rising taxes and a slew of new rules on everything from employment to product labeling are putting a damper on local and foreign investment, they claim. Executives also grouse that the government's decision not to adopt the euro is making their exports more expensive than those of European rivals. Toss in mounting worker unrest--firefighters and teachers are among those who have recently gone on strike--and it's easy to see why Britain Inc. is concerned.

Two-thirds of CEOs of British enterprises say the country has become less business-friendly than it was when Prime Minister Tony Blair came to power five years ago, according to a recent survey by London-based polling agency MORI and the Confederation of British Industry (CBI). "The combined burden of higher taxes, onerous regulations, and the government's failure to recognize the high cost of staying outside the euro is seriously hurting my business," says Andrew Cook, chairman of William Cook Cast Products. The Sheffield-based steel company has just closed one of six plants in England and plans to outsource more production to China.

It's quite a reversal of fortune for a country that was once viewed as the economic dynamo of Europe and a source of inspiration for the Continent. Although it has preserved its generous welfare state, Britain's flexible labor laws and competitive tax rates are in stark contrast to the high taxes, bureaucracy, and inefficiency that crimp growth across the Channel.

The fear now is that the Blair government is squandering the so-called Thatcher dividend, derived from the free-market reforms instituted during the last two decades. "Labour inherited a reasonably strong economy whose tax and regulatory systems were somewhere between the relatively free American model and the more interventionist Continental framework," says David B. Smith, chief economist at Williams de Broë, a London brokerage. "But through a policy of stealth taxation and regulation, Britain is moving closer toward Europe, and the result is British economic growth will head in the same direction as Germany's--down."

Such pronouncements may sound excessively dire, considering that the British economy is holding up better than most. Fueled by strong consumer demand, growth is set to come in at 1.6% this year, nearly double that on the Continent. Inflation is low, and unemployment, at around 5.1%, is well below the European average of 8.3%.

But scratch the surface, and it's clear that the economy isn't as robust as it looks. While it's true that the base tax rate for individuals and companies has fallen under Blair, the overall burden is rising. In 1996, public spending as a share of gross domestic product was 35%; by 2006, it'll reach 42%, says the CBI. "This government is taxing, spending, and failing," says Michael Howard, Conservative member of Parliament and shadow Chancellor of the Exchequer.

Blame it on Blair's ambitious and costly plans to shore up Britain's corroding public services, primarily the national health-care and education systems--something most British voters favor. To help plug the financing holes, the government has introduced a host of levies and hiked others. National insurance contributions, the local equivalent of the Social Security tax in the U.S., are set to rise by one percentage point in April for both employers and workers. Tax exemptions on dividend payments from pension funds have been scrapped. Coupled with a falling stock market, the tax changes threaten to trigger a pension crisis at many companies. The CBI estimates that increased taxes will cost businesses a total of $74 billion between 1997 and 2005. "Tax competitiveness is a jewel in our crown, but it's starting to lose its luster," says CBI Director General Digby Jones.

The tax hikes are taking a toll on British corporate profitability: It has been falling for 13 quarters straight and shows no sign of picking up anytime soon, according to a survey by consulting firm Experian Business Strategies. Productivity growth has taken a hit, too: The annual rate has been halved, to 1.25%, since 1997. Unlike most economists, however, Chancellor Gordon Brown is betting on a strong recovery in economic growth--and corporate revenues. He expects growth to quicken to 3.4% in 2004, which is above the 2.7% independent analysts are forecasting.

Business leaders have another ax to grind. As Britain accepted the European Union's Social Chapter two years ago, companies will now have to comply with all of the employment and social regulations coming out of Brussels. These include restrictions on hours worked as well as proposed measures that would force companies to give temp workers the same benefits and rights as permanent staff. Another unpopular EU rule being debated: mandatory trade-union representation on corporate boards. The British Chambers of Commerce estimates the cost of complying with new regulations emanating from both London and Brussels at $24 billion a year. "Britain will lose its flexibility and competitiveness as it moves closer toward Europe's restrictive work practices," warns Hugh Mathew-Jones, a partner at London accounting firm PKF.

Meanwhile, some businesses in Britain complain that if they are to shoulder the costs of EU membership, they should also be entitled to the benefits. Despite the economy's mounting woes, the pound has stayed stronger than the euro, hammering British exports. Carmakers are saying that if Britain does not adopt the euro soon, they may be forced to reconsider their British investments. Indeed, while Britain remains the No. 2 destination for foreign direct investment worldwide, the country's share of global flows has dropped to 22%, from 39% in the 1990s. Tony Blair wants to make Britain more like the rest of Europe. If he's not careful, he may get just what he wants.

By Kerry Capell in London

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