Europe’s Productivity Divide: Tax Competitiveness as a Structural Determinant of Economic Performance

Labor productivity has become the defining constraint on Europe’s long-term growth potential. Across the continent, governments have increased public investment commitments, firms are accelerating digitalization, and labor markets continue to restructure after successive shocks. Yet behind these visible efforts lies a structural divergence that cannot be ignored: European economies differ sharply in their ability to combine productive capacity with a tax framework conducive to investment, innovation, and economic dynamism.

To examine this interaction, productivity levels in 2023 (EU=100 benchmark) are paired with the 2025 Tax Competitiveness Index (TCI), creating a comparative map that situates each country within a four-quadrant structure. The result is a synthetic yet powerful diagnostic of Europe’s economic architecture, revealing not only where countries stand but also the nature of the reforms required to shift their trajectories.

Figure 1. Tax Competitiveness and Labour Productivity in Europe (Quadrant Analysis)

Source: Author’s calculations based on 2023 productivity data (Eurostat) and the 2025 Tax Competitiveness Index (Tax Foundation).

A broader interpretation of these divergences aligns with the recent analysis by Letta (2024), who argues that Europe’s productivity slowdown is increasingly linked to structural fragmentation across the Single Market. Regulatory heterogeneity, barriers to cross-border service provision, and insufficient scale for innovative firms all interact with national tax systems, shaping investment and capital mobility incentives. Countries positioned in the lower-left quadrant, combining weak productivity with low tax competitiveness, are precisely those that struggle to attract the high-growth firms and cross-border investors whose presence Letta identifies as essential for revitalizing Europe’s productive potential.

A Dual-Axis View of European Competitiveness

The quadrant structure yields four distinct groupings, each with specific structural characteristics.

First, a set of countries, including Luxembourg, Sweden, Austria, and the Netherlands, combine high productivity with high tax competitiveness. These economies are positioned closest to what could be described as Europe’s “frontier model”: productive labor, high capital intensity, and tax systems that minimize distortions. Their challenge is not catching up but preserving institutional clarity and fiscal stability in an increasingly competitive global environment.

A second group, including Belgium, Denmark, and Italy, displays strong productivity levels but comparatively weaker tax competitiveness. Their tax systems impose higher marginal burdens on labor or capital relative to similarly productive economies. Without explicit reform, the gradual erosion of competitiveness can limit investment growth, even in countries with relatively robust industrial structures.

A third cluster (Spain, Portugal, Greece, and Poland) occupies the quadrant of low productivity and low tax competitiveness, the position most associated with structural stagnation. Here, labor productivity growth is constrained by under-investment, regulatory frictions, and institutional limitations, while tax systems add layers of complexity and reduce the relative attractiveness of productive capital formation. In these cases, neither supply-side nor tax-policy levels are sufficient in isolation; both must evolve in parallel.

Finally, the fourth group, including Estonia, Latvia, Lithuania, Czechia, Slovakia, and Slovenia, combines modest productivity levels with comparatively high tax competitiveness. These economies have implemented neutral or investment-friendly tax structures, often achieving high scores in cross-border rules or corporate taxation. Yet productivity convergence remains incomplete, suggesting that tax design alone cannot substitute for deeper institutional and technological reforms.

Why Does Tax Competitiveness Influence Productivity Dynamics?

Modern empirical evidence increasingly finds that the structure of taxation (its neutrality, marginal burdens, and treatment of investment) shapes productivity outcomes. Sorbe et al. (2019) show that corporate and personal income tax design has measurable long-term effects on innovation adoption, digital transformation, and capital deepening across OECD economies. Their findings underscore that productivity is not merely a technological process but is conditioned by the incentives embedded in national tax frameworks.

Similarly, Calligaris et al. (2018) show significant and persistent productivity gaps between frontier firms and laggards in Europe, attributing much of the dispersion to regulatory and fiscal environments that influence incentives to scale, invest, and export. These insights are particularly relevant for southern and eastern Europe, where capital accumulation remains below pre-crisis trends.

Evidence from the newer EU Member States also supports this interpretation. Podviezko (2019) finds a robust association between investment-friendly tax systems and improved macroeconomic performance, though he notes that tax competitiveness must be paired with reforms in governance and infrastructure to translate into sustained productivity gains.

Taken together, the literature suggests a consistent pattern: tax systems that distort less tend to yield economies that produce more, not as a matter of ideology but because of how firms allocate capital and labor when facing different marginal incentives.

A subtle but significant policy implication

The quadrant analysis reveals that many European economies do not suffer from isolated weaknesses but rather from structural configurations that are misaligned with long-term productivity goals. For countries in the lower-left quadrant, incremental reforms will be insufficient. Productivity cannot rise on its own without a fiscal system that reduces barriers to work, investment, and entrepreneurship. Likewise, fiscal reform without improvements in skills, digitalization, or regulatory efficiency will fail to shift the underlying trajectory.

The implication is not the pursuit of lower taxes per se, but of tax systems that are stable, predictable, and neutral features, repeatedly linked to better investment behavior and faster productivity convergence. This perspective, widespread in empirical research, aligns with the broader principle that economic institutions should enable, rather than constrain, the accumulation of productive capital.

The interaction between productivity and tax competitiveness provides a revealing window into Europe’s economic future. Countries that succeed in aligning efficient tax design with productivity-enhancing reforms will be better positioned to compete globally and to sustain rising living standards. Those that remain in the quadrants characterized by low productivity or weak fiscal competitiveness risk prolonged stagnation and diminished strategic autonomy.

As the quadrant map illustrates, the policy challenge is not only technical but structural: Europe must refine the incentives shaping its economies while ensuring that institutional frameworks support firms and workers in the transition toward a more innovative, capital-intensive growth model.

Taken together, the insights from Letta (2024) and Draghi (2024) suggest that productivity and tax competitiveness must be treated as mutually reinforcing components of Europe’s long-term growth strategy. Reforms that expand market scale, reduce administrative frictions, and restore tax neutrality can shift countries out of the structural traps identified in the quadrant analysis. While the specific policy mix may differ across member states, the broader principle is clear: institutions that empower firms to invest, scale, and innovate are indispensable for Europe’s economic renewal.

References

• Calligaris, S., Criscuolo, C., & Marcolin, L. (2018). Mark-ups in the digital era. OECD Science, Technology and Industry Working Papers, 2018(10), 0_1-26.

• Draghi, M. (2024). The Future of European Competitiveness. Report for the European Commission.

• Letta, E. (2024). Much More Than a Market: Speed, Security, Solidarity. Report on the Future of the Single Market, European Commission.

• Podviezko, A., Parfenova, L., & Pugachev, A. (2019). Tax competitiveness of the new EU member states. Journal of Risk and Financial Management, 12(1), 34.

• Sorbe, S., Gal, P., Nicoletti, G., & Timiliotis, C. (2019). Digital dividend: Policies to harness the productivity potential of digital technologies. OECD Economic Policy Papers, (26), 1-30.