A recent OECD study reminds us, once again, that per capita income levels are roughly 30% lower in the euro area, as well as in the three largest Continental countries – France, Germany, and Italy – that dominate its performance, than in the United States. That gap is likely to widen as Europe’s demographic profile darkens, and if productivity continues to grow more slowly than elsewhere in the industrial economies.

Why have the large European economies failed to catch up with US income levels? The bulk of the shortfall is due to less intensive use of labor: employment rates for women and for the oldest and youngest age groups are lower in the euro area than in the US, working hours are far fewer, and, least significantly, unemployment rates are higher.

Some take consolation from this, viewing it as positive that Europeans prefer leisure to work. But low levels of labor utilization are largely due to heavier income taxes and social security contributions, as well as high social benefit levels introduced at a time when the labor force was growing rapidly and the need to replace involuntary with voluntary unemployment seemed more urgent than today. These measures will need to be revisited both to increase the supply of labor and to make public finances more sustainable.

This process is already underway, particularly in Italy and France, through cuts in social security contributions for lower-paid workers, tighter conditions for drawing unemployment benefits, and tax credits for “the working poor.” Since the mid-1990’s, the relative decline in employment in these countries has, indeed, been slightly reversed.

But factors beyond taxes and benefits also contribute to low employment rates in all the three major euro-zone economies: high minimum wages and some features of employment protection legislation slow down the flow of workers through the job market. Although a long agenda of reforms is beginning to be tackled, first in Germany and, more recently and cautiously, in France, the results are slow in coming and public understanding of the need for change remains limited.

Much can be learned from each country’s experience and from that of smaller EU member states, but labor market reforms inevitably have a strong national flavor. Employment objectives have been formulated for all EU member states since 1997 in the so-called European Employment Strategy (EES), now part of the “Lisbon Agenda,” the set of goals established to boost EU productivity. But, with the policy instruments for achieving these goals largely national and the arguments for applying them simultaneously in several member states weak, the EES has created unrealistic public expectations and triggered only limited action by governments.

Nor is the employment gap with the US the only problem for Europe. Beginning in the mid-1990’s, the rate of growth in output per hour worked – a key factor behind the rise in per capita income – slowed in most European countries while it rose in the US, reversing a decades-long pattern. Between 2000 and 2004, hourly labor productivity rose more than twice as fast in the US than in the large euro zone economies – 2.8% per year versus little more than 1%.

So why have the Europeans been unable to sustain improvements in both foundations of growth – employment and productivity – at the same time? This proved possible not only in the US, but also in other advanced economies outside Europe – Australia, Canada, and New Zealand – and, unsurprisingly, in the new EU member states.

The explanation is not capital spending, which is normally linked to productivity growth. There have been no major differences between the US and the large euro zone economies here. This leaves the “explanation” to what economists call Total Factor Productivity (TFP), a mix of several important elements, including innovation activity, a well-functioning financial system ready and willing to take risks, and organizational flexibility that facilitates rapid diffusion of new technologies.

The main lapse in TFP growth in Europe over the past decade has been in services (excluding information and communications technologies). So deregulation and integration of services will be essential if the Euro area’s TFP is to improve, as more than two-thirds of total income in most EU economies is generated in this sector.

While product markets have held center stage in the creation of the single European market, services continue to be fragmented by national regulatory, anti-competitive practices. Much of the explanation lies in the very heterogeneity of services and the greater difficulties that mutual recognition, or the “country-of-origin principle” – essential in the integration of product markets – implies for services.

Unfortunately, reform was derailed in 2005. During the referendum campaign in France preceding the vote on the draft EU Constitutional Treaty, the proposed directive was vilified as undermining the rights of labor, symbolized by that dreaded bogeyman, the “Polish plumber.” These attacks overlooked the fact that the directive makes employment conditions of workers from other EU-member states subject in most respects to host-country rules.

A revised version of the directive that reduces its sectoral scope and makes a number of compromises with the country-of-origin principle is now before the European Parliament. Even this limited version would constitute progress; most of the gains arise from removing the red tape that complicates cross-border establishment of small and medium-size service enterprises and limits competition in broad sectors of the economy.

It is a sad reflection on the state of the EU that it seems unable to agree on the one clear productivity-advancing piece of legislation when improving productivity is held out as a shared goal. The failure to mobilize consumer interests in favor of European integration is particularly disappointing for the new member states, which had expected to reap some of the benefits.