Tax competition in Europe or the taming of leviathan, A Steichen

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Content: TAX COMPETITION IN EUROPE OR THE TAMING OF LEVIATHAN by Alain STEICHEN Professor at the Centre Universitaire - Luxembourg "The best test of truth is the power of the thought to get itself accepted in the competition of the market" Justice OLIVER WENDELL HOLMES, dissenting, Abrams et al. v. United States, 250 U.S. 630 (1919) [1.] Harmonisation has always been accepted to be necessary in the fields of indirect taxes, as such taxes may create an immediate obstacle to the free movement of goods and the free supply of services within the EU. Therefore, a significant degree of harmonisation of indirect taxes already has taken place. Income tax harmonisation within the EU, however, traditionally usually is seen as an "impossible task" because of the various Member States wishing to retain what is often perceived as their last element of national sovereignty. Hence, the designing of the direct tax system has until now by and large been left to the individual Member States. Lately however, the agenda of harmonisation of direct taxes (or at least certain parts of it), seems to have been pursued gradually by the EU Commission, in a series of small steps, each steadily enlarging the involvement of the EU in tax matters. The politicians of certain Member States, such as Lionel Jospin, have further stimulated the discussions: " Combating `tax dumping' is one immediate priority; it is not acceptable for certain Member States to practice unfair tax competition in order to attract international investment and offshore headquarters of European Groups. Ultimately, the corporation tax system as a whole will have to
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be harmonised" (Lionel Jospin 28 May 2001). Such plans have recently been published by the EU Commission (see comm/taxation) and reiterated forcefully by the Commissioner Fritz Bolkestein.
[2.] Before the launch of the euro the tax harmonisation was only of peripheral interest. With the launch of the single European currency, however, the debate has sharpened. Surely, many commentators speculated, a common monetary policy across the EU would require a common fiscal policy, too? The euro however does not by itself require a harmonised tax policy. The two constraints that have been put on the EU countries that have adopted the euro (overall budget deficit limited to 3% of GDP; overall level of government debt limited to 60% of GDP) has no influence and how taxes are raised and spent. Euro participants may freely continue following "high-tax high-spend" or "low-tax, low-spend" tax policies. All that may be said is that the euro, by removing exchange-rate barriers to trade, highlights existing differences from other sources.
[3.] When only looking at the speeches recently held by the EU Commissionners and taking them at their face value, the risk of "harmonisation-euphoria" appears to be remote, the Commission apparently favouring tax co-ordination over tax harmonisation and limiting its harmonisation attempts in those fields where harmonisation really would be required. Following Theresa Villiers (2001), one may wonder however, with reference to George Orwell's masterpiece Ninteen Eighty-Four, where Big Brother and the Party said "peace" and meant "war", and where they said "freedom" and meant "slavery", in order to consolidate their grip over their subjects, by imposing a new language, whether the European Union itself has not evolved into a notably gifted practitioner of such linguistic warfare:
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are the lights we are seeing approaching us signalling the end of the harmonisation tunnel or do they merely indicate that the harmonisation train is soon to pass over us?
[4.] Do we need to go as far as Lionel Jospin has been suggesting or should the EU merely concentrate on eliminating "harmful" tax competition (if at all) is one of the many questions that immediately comes to mind when looking at the prospects of tax harmonisation. The objective of this paper is to consider the merits of the latest tax harmonisation efforts deployed in the EU, especially the need for the EU to fight "unfair tax competition": should income taxes (especially corporation tax and savings taxation) be harmonised at all? And if so, should tax harmonisation be a "one size fits all taxation" model or be limited to certain aspects only?
· Indirect ­ direct taxes · Single European currency · Harmonisation-euphoria · Tax dumping · General issues to tax harmonisation · Specific issues to corporation tax and savings taxation
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Part I. Introduction Globalisation increases competition among private economic agents, but also among governments. Whilst competition is welcomed if limited to private agents, the political class is averse to competition among governments and is dismissive of the idea that competition can be beneficial. Tax competition rather is viewed as a conspiracy against the governments and in any case detrimental to social welfare. Introduction · W hat is tax com p e tition? ­ competitive advantage ­ Fiscal externalities ­ « Predator » - actions · W hat is tax harmonisation? ­ Catch all clichй ­ Equalisation approach: full harmonisation ­ Differential approach: partial hamonisation ­ Free market forces: tax convergence
§ 1. The concept of tax competition [5.] Competitive advantage. -- The concept of tax competition, although widely used, is not obvious by itself. Especially as we will see, there is no satisfactory line between harmful tax competition and tax competition in general. The most immediate way of looking at tax competition consists in referring to tax policies operated in a country
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(usually through low taxes), which enable the country to gain a competitive advantage in the sale of its products and services. Such an understanding of tax competition does however little justice to the present concerns of the EU: the EU Treaty is based on the concept of competition of businesses operating and selling freely within the EU; if competition is welcomed as such, one does wonder why tax competition would not be.
[6.] Fiscal externalities. -- The above definition misses one element, which is crucial in the concept of tax competition, namely the impact of tax competition on foreign economies. The economists speak of "fiscal externalities". Tax competition may be defined as a process leading to a result that involves the fiscal decisions of one country affecting the economic welfare of another. Why is that? The assumption is that the political process in any given Member State is designed so that the government only maintains the interest of the population in its own jurisdiction. By disregarding the possible impact of domestic tax policy decisions on the welfare of other countries, because domestic welfare only is considered, fiscal policies of low tax country may very well negatively impact the economy of other countries (typically high tax countries). This impact is unavoidable in open economies such as the EU and is usually accepted even by harmonisation advocates. Tax competition may thus be better defined as the "process of tax policy decisions by which rational governments optimally respond to tax policy measures of foreign governments, in order to improve the economic situation in their constituency" (Genser, 2001).
[7.] "Unfair" or "harmful" tax competition. But it is possible to take this idea one step further and to hold that the governments not only set their economic policies independently from the potential
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negative economic effects on other countries but that their behaviour would be non co-operative ("non co-operative governments"). In other words, governments, considered by tax harmonisation advocates to be acting as predators, would seek to exploit tax arbitrage opportunities by attracting tax bases from neighbouring countries. This has lead to the creation of the buzzword "harmful tax competition" which comprises two different situations (Code of Conduct, 1997, article A & B):
· measures that effect in a significant way the location of business activity in the Community, which is to include;
· those measures that provide for a significantly lower effective level of taxation, such as zero taxation, than those levels, which generally apply in the Member States in question.
Whilst the second leg of the definition of "harmful" tax competition deals with special tax regimes mostly available to foreign based investors only, the first leg creates difficulties: it seems to also apply to tax regimes that, like Ireland, provide for general low tax rates applicable throughout the country. The dividing line between "harmful" and "non-harmful" tax competition hence seems to be the extent how the high tax country will be impacted by the low tax country's tax system: if the impact is high, the tax competition would be unfair; otherwise it would remain acceptable. If that understanding was to be correct, one would certainly have to admit that the dividing line between "unfair" and "fair" tax competition to be somewhat a grey area, and very subjective indeed.
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[8.] Definition. -- It is also necessary, at the outset, to provide a definition of tax harmonisation. Harmonisation consists in the adapting of each Member State's legislation to a standard which is common to all Member States and which has been set forth by the EU supranational bodies. There are many different approaches to tax harmonisation which all to often is a catch-all clichй for politicians. If the tax rules become common without the intervention of EU legislation, but as a result of competitive pressure, the result of this "soft" harmonisation process is called "tax convergence" (European Parliament, 2000). One is the equalisation approach. It seeks to achieve the highest degree of harmonisation by the adoption of standardised tax rates, tax base and tax regulations throughout a given area ("full harmonisation"). This approach seeks to achieve competition on equal terms and puts the interest of the group as a whole above that of individual member countries. VAT is a harmonised tax based on the equalisation approach, at least as regards the tax base and the fundamental principles governing the tax are concerned. Full harmonisation seeks to iron out all relevant discrepancies in the tax regimes across the EU. However, even in VAT the equalisation approach is not pure, since the VAT rates applied by the various Member States widely differ, a minimum floor rate (15%) being the only constraint for Member States. Another approach is the differentials approach. This is based on the belief that the adverse effects of one Member's State tax system on others Member States tax systems should be minimised ("partial harmonisation" also called "tax approximation"). It is furthermore based
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on the idea that each Member State should be authorised to continue managing its economy so as to maximise its own economic welfare.
It is difficult to firmly put the EU tax policy in any of the two baskets. The official word is that the EU has moved away from "complete fiscal harmonisation" towards a mere "approximation" of taxes. Tax approximation may be defined as a situation driven by EU legislation driving tax systems and tax rates closer together, without becoming identical. Harmonisation scepticists like myself may consider that this is just a word-play: approximation is just harmonisation in stages. At the best one may consider the EU to follow a mixed approach, the EU seeking greater uniformity on saving, corporation and most indirect taxes whilst still permitting greater differentiation on income taxes.
[9.] Harmonisation in theory is a limited process. -- Tax harmonisation has been on the agenda of the European Union right from the beginning, especially for indirect taxes (tariffs on imports from outside the EU; VAT). Since it only requires the respective Member States to adopt a common denominator in those aspects covered by the harmonisation process, it does not necessarily mean that tax harmonisation by itself implies the unifying or uniformisation of the material tax laws of the Member States in the respective areas. Hence, the EU Treaty correctly refers to the "approximation" of laws, which means that the concept of harmonisation by nature should be a limited process. However, practice shows that harmonisation may be more or less intensive, depending upon the domains covered. Specifically the "directive" as per art. 294 of the EU Treaty does not always leave a great choice of form and methods to the Member States: at times it is merely a disguised "regulation".
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[10.] Harmonisation in order to secure individual justice in taxation. -- The creation of a uniformed European wide tax system covering possibly all of the levies of the various Member States may sound appealing at first looks, at least for the scholars wishing to extend the circle of their potential readers. A further justification of a total rewriting of the various national tax systems could be the fact that today the Member States have not been very successful in designing a fair and just tax system of their own. Regarding this justification it may be said that, a EU-based tax system not by itself guarantee a fairer treatment of the taxpayers, nor is the achievement of justice in taxation anyway is not one of the objectives of the Treaty. Therefore, justice considerations may not justify a Community action. [11.] Uniformity is not a value to be pursued for itself. -- Uniformity of tax systems is not a good enough reason for harmonising tax either. Uniformity as such has no intrinsic merits. There is nothing to be gained from a greater "harmony". On the contrary, what is valuable is the diversity of tax regimes, since it alone allows different tax systems to show their relative strengths and weaknesses so that the better tax system may gradually emerge from the rest (so-called "institutional competition"). The examples of our host country Switzerland, as well Canada and the USA sufficiently show that differences in income tax rules do not impede the creation of a unified economical market. I suspect that some of the attention given the tax harmonisation is purely the result of its positive sounding, since "harmonisation" is close to "harmony". If we were to replace "harmonisation" by other synonyms such as "standardisation" or
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"uniformisation", the concept would immediately look much less appealing. Harmonised tax systems, as already discovered by Darwin in his Evolution by natural selection, like any homogeneous species is vulnerable; improvements come from variations some of which will turn out to be profitable. This anthropological lesson equal applies to business and taxes as has been shown by Richard Koch (2001): differentiation emerging from generality is what brings economic progress which is antithetical to harmonisation of tax laws.
[12.] The example of VAT. -- The EU itself gives a perfect example that harmonisation should be a limited process: it is considered in that area that a high degree of harmonisation is essential in the indirect tax field and that a significant degree of harmonisation has already taken place. Certainly, tax harmonisation is more advanced in VAT than in any other tax. However, even here, although the EU has set a minimum rate of VAT, currently 15%, large divergences continue to exist (table 1) between Member States, some countries applying the floor rate of 15%, whilst others do levy the VAT at much higher rates (25%).
Standard VAT rates in European Union Member States
26 %
Table 1
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Table 2 even shows that the convergence of VAT rates over the long term is negligible.
Standard VAT Rates rising, hardly converging (%)
1987 1999
1987 1999
21 Netherlands 18.5 17.5
Denma rk
25 Austria
- 20
16 Portuga l
17 17
18 Finl and
- 22
16 Sweden
- 25
18.6 20.6 UK
15 17.5
Irel and
20 Averag e
17.2 19.4
Lux embou rg
15 SD1
3.3 3.1
1 standard deviation Рa measure of the dispersion from the average
Table 2 Part II. General issues of tax harmonisation [13.] Typical justifications invoked for tax harmonisation plans. Although the emphasis may differ with each official statement, and from scholar to scholar, one typically finds four main reasons apparently justifying tax harmonisation: § the need to improve the situation of the employment in the EU; § the need to increase the revenue from tax collections for the various Member States;
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§ the desire to restore/preserve tax neutrality in an international context;
§ the desire to reduce the tax compliance costs for multinationals operating throughout the EU.
As we will see, none of these justifications are convincing. Furthermore, they do neglect certain negative aspects of tax harmonisation.
Chapter 1. Does harmonisation increase job creation?: the alleged negative impact of tax competition on labour One of the most often advanced reasons for harmonising taxes in the EU is the desire to reduce the cost of the immobile production factors, here labour, in order to render them more attractive (§ 1). This would however not solve the issue, income tax being only a small portion of the labour cost (§ 2).
§ 1. The division of the economy in mobile and immobile factors [14.] The restoring of a proper balance between taxation of capital and labour : excessive taxation of the immobile factor-labour. -- One of the most often cited justifications for tax harmonisation is the need to restore the balance between taxation of capital and labour. According to European Commissioner Mario Monti (1998, p. 12): "unbridled tax competition between Member States has caused average tax rates on mobile factors of production, notably capital, to fall from 45.5. per cent to less than 35 per cent in the last fifteen years. In the same period, the average tax rate on labour has increased from 34.9 per cent to more than 42 per cent. A growing body of evidence now points to a strong negative effect of high labour
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taxes on the level of employment and growth in Europe. Without some form of co-ordination, not only will labour continue to be penalised for being less mobile than capital, but the levels of tax revenue are liable to decrease".
Tax Rate
Labour tax rates rising, capital tax rates falling Implicit tax rate (%) 46 44 42 40 38 36 34 32 30 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 Labour =Immobile Capital = Mobile
Table 3 This statement may be questioned in many ways. [15.] Flaws of the methodology. The first question that comes to mind is whether the percentages Mario Monti has been using are reliable. Not only do they require the estimates to be based on effective tax rates, and not on statutory rates, but the allocation of the income into capital and labour needs to be done correctly as well. The existing methodology adopted by the OCDE however bears certain shortfalls (see Carey/Tchilinguirian, 2000):
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§ self-employed income should no longer be entirely allocated to capital income, but be divided into its two components: labour income and capital income;
§ employee's social security contributions should not be counted twice (as wages and as total social security contributions), as they presently are, in the numerator of the tax burden ratio of labour;
§ private employer's contributions to pension funds should be counted as labour income, although they presently are not;
§ income from pension funds should be entirely allocated to capital and not be partly allocated to labour;
§ the tax burden on capital should reflect the impact of tax preferences on dividends (as a full or partial relief from double taxation), rather than assuming that households pay the same tax rate on dividends as on any other income.
It could therefore be held that the drawing of conclusions from the statistical evidence for taking Community action is similar to the aeroplane flying without neither rudder nor compass.
[16.] How "immobile" are the "immobile factors"?. One may also question the relevance of this division of the world into "mobile" and "immobile" factors, capital and businesses being viewed as mobile and labour as immobile production factors (see already Ellis, 1999). According to the harmonisation advocates, tax competition would have lead to a reduction of taxes on mobile bases at the expense of immobile bases. The financing of public goods would hence fall on immobile bases, whilst mobile bases would behave as "free-riders": they are viewed as participating in the benefits of the public goods without paying the price for them. This classification does however forget that workers are free to move within an integrated area such as
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the EU and hence also are mobile. Furthermore, I have difficulties in seeing how the businesses may move abroad without the workers not moving, too: after all, the plants and equipment need to be operated, do they not?
Finally, the very highly qualified labour, i.e. the key decision makers in any company, are in any case very mobile indeed. Offering labour income tax incentives to those persons may be a very powerful tool for attracting new businesses, much more than corporate tax incentives. An example of this strategy would be the moving of Ericson's headquarters from Sweden to London back in 1998: when being asked what the driving factors behind this move was, the managing directors of Ericson indicated that the income tax incentives granted by UK tax law to highly qualified labour had been the most important factor in Ericson's decision.
Mobility of Different Factors of Production
Very mobile l Financial capital l Trade in goods and services
Quite mobile l Operations of large companies l Skilled labour
Immobile l Operations of small companies l Land and property l Labour
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§ 2. Why harmonisation of taxes does not help the immobile factors
[17.] Tax wedge on labour income in the case of no harmonisation: the importance of the Social security payments. -- But even if we were to accept the mobile-immobile division, the question is whether tax competition does negatively affect the job creation in the EU. We know that Europe has a dreadful job creation record: only 3,5 million of jobs have been created in Europe since the mid-1970s, most of which in the public sector, whilst some 30 million net new jobs have been created in the U.S.. We also know that Europe has a chronic unemployment problem of approximately 10,5%, most of which appears to be structural. Furthermore, the employment-topopulation ratio is approximately 70% in Europe, whilst it is approaching 80% in the U.S.. It would be a mistake however to solely impute the unemployment to the high burden labour is exposed to. Even then, one should not point to income taxes as being the main element in the tax burden. As has been extensively analysed by the OECD (OECD, 1999), the heavy taxation of wage earnings, which is typical in the EU, drives a large difference between the real labour compensation borne by the employers and the real take-home pay per worker (the "tax wedge", see figure 1).
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Supply, Demand and Government Policies
Labor Supply
Wage firms pay Wage without tax Wage workers receive
Tax wedge
Labor demand Quantity of Labor
Figure 1 As the OECD report shows, the main differences in labour tax wedges find their explanations in the social security contributions. These contributions effectively raise the labour costs of the firms employing the labour. It hence is not logical to harmonise income tax on labour factor unless the Social security systems also get harmonised. But even if one was to stick to the harmonisation idea, no significant reductions in the tax wedge on labour could be achieved, unless the governments would decide to move to "punitive" capital
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taxation. The very simple reason for this lies in the fact that the capital income tax base is much smaller (Hagemann and alii, 1987).
[18.] Incidence of taxation. Another mistake of the harmonisation advocates is that they do not take account of the shifting and incidence of tax. They erroneously assume that the absence of capital income taxation would lead to higher taxation of labour and that if capital income taxation would actually be levied, the burden on labour taxation would drop. Both of these conclusions are wrong, because they neglect the impact of the shifting mechanism that always takes place in tax matters (the EU tax harmonisation advocates seem to consider that shifting mechanism in taxes is new because they just have discovered it): if governments levy a tax on capital, the simple but subtle question is who bears the burden of the tax? The people buying the capital (the firms)? The people that are selling the capital (the owners of capital)? Or, if the firms and the owners of capital share the tax burden, what determines how the burden is divided?
The mistake of the harmonisation advocates is to believe that the governments might simply legislate the division of the tax burden, by transferring it all to the owners of capital. In reality, however, the legislative process will always be undermined by more fundamental forces in the economy, the taxpayer under any circumstance only becoming the tax bearer if he is unable to shift the burden of the tax over to someone else. The tax bearer for any tax is the person who cannot avoid the tax. This well known result from the theory of tax incidence also applies to mobile and immobile factors: if there is one perfectly mobile factor and another factor which is totally immobile, then all taxes will be paid from the income of the immobile factor.
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Economists use the concepts of elasticity of demand and supply to evidence this (Atkinson/Stiglitz, 1980; see figure 2):
Deadweight loss of taxation
Price buyers pay Tax revenue (T x Q) Price sellers receive
Size of tax (T)
Quantity sold (Q)
Quantity with <-------Quantity without
Demand Quantity
Figure 2 · Suppose a new tax is levied in a market with a very elastic supply and a relatively inelastic demand (figure 3). That is, sellers are very responsive to the (after-tax) price of the good, whereas buyers are not very responsive. Capital presumably is such a good. When a tax is imposed on a market with these elasticities, the price received by the sellers does not fall much, so sellers bear only a small burden. By contrast, the price paid by the buyers rises substantially, indicating that the buyers bear most of the burden of the tax.
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Shifting of taxes ­ Demand relatively more elastic than Supply
Price Price buyers pay Price without tax
1. When demand is more elastic than supply
3. ...than on consumers Tax
Price sellers receive
2. ...the incidence of the tax falls more heavily on producers
Figure 3 · Figure 4 shows a tax in a market with relatively inelastic supply and very elastic demand. In this case, sellers are not very responsive to the price, while buyers are very responsive. The figure shows that when a tax is imposed, the price paid by buyers does not rise much, while the price received by sellers falls substantially. Thus, sellers bear most of the burden of the tax.
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Shiftingof taxes ­Supply relative more elastic than Demand
Price Price buyers pay Tax Price without tax Price sellers receive
1. When supply is more elastic than demand... Supply
3. ... than on producers.
2... the incidence of the tax falls more heavily on consumers Demand
Figure 4 Figures 3 and 4 do show that a tax burden falls more heavily on the side of the market that is less elastic. That is so, because elasticity measures the willingness (and ability) of buyers and sellers to leave the market when conditions become unfavourable. Capital certainly has a large elasticity since capital owners have good alternatives to avoiding taxation of their savings: they may put their savings in taxfree assets (owner used homes, insurance contracts, etc.) or simply consume the capital. That means that if capital income gets taxed
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going forward, surplus tax revenue may eventually be collected by governments. But this is only a short-term effect. On the long run, labour will once again pay the taxes, as a result of the shifting mechanism:
· Investors experiencing a reduction in the after tax return of their capital, as a result of the taxes levied on the income from savings, will look for alternative placements, unless the pre-tax return of their investment gets adjusted upwards;
· Capital income taxation hence is likely to increase the required pre-tax interest rates and hence the interest financing costs payable by the companies;
· In order to maintain their profitability, the companies will look for economies of scale, which means that they will reduce the cost of labour, either through wage adjustments or through reductions in the staff employed.
Therefore, in the end of the day, the labour factor will be the real loser of increased capital taxation. This is nothing new, since in tax matters the person that is liable to tax under law always tries to shift the tax burden to someone else, the tax bearer. The tax bearer almost inevitably is the person that cannot escape the tax through adjustment of his actions, i.e. the immobile factor.
The same may be said as regards an increase of the corporation tax:
· in the short run the corporations will not be able to adjust their behaviour so that the profits will decline. The shareholders will pay the tax;
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· in the long run, however, wage earners will bear most of the burden of the corporation tax (Pechman, 1987).
But there is also a more positive side to this, when looking at the labour factor: if the tax bearer of a capital income tax is the labour factor and not capital, then the real beneficiary of tax exemption of capital income is not the owner of capital himself but labour::
· the pre-tax interest rate that is required by investors is, as a result of the tax exemption, lower than it would be in case of capital income taxation;
· the lower required interest rate increases the profitability of the corporations, as does the lower rate of corporation tax;
· this enables the corporations to invest more than what they would otherwise do, recruit more labour and/or pay better wages.
In c id e n c e o f T a x a tio n
· L a b o u r s u p p ly is re la tiv e ly in e la s tic · In c re a s e o f c o r p o r a t io n ta x a n d /o r fu n d in g c o s ts le a d s to re d u c tio n o f s a la rie s ! · R e d u c tio n o f c o rp o ra tio n ta x a n d /o r ta x e x e m p tio n o f in te re s t le a d to in c re a s e in s a la rie s !!
[19.] Could we better of through harmonisation? -- The example of the "Celtic tiger" in my opinion is a good illustration of what tax competition is all about and what tax harmonisation will not be able to deliver: full employment. Some fifteen years ago, the unemployment
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rate in Ireland was 17,5 %, a high figure even within Euroland (it was substantially higher than the EU average). As of today it has fallen to 4,2% (and now is very substantially lower than the EU average). What is the reason behind this great improvement over time? Most probably the low rates of corporation tax Ireland has established at the time and preserved ever since then. Would Ireland have achieved a success anywhere near to what has been achieved? Probably not. It could very well be that potential future tigers, perhaps the new EU entrants from Eastern Europe, will be stopped at first base, because of the requirement that they pay an entrance fee for membership in adjusting their currently advantageous tax regimes upwards.
Did Ireland, with its low taxes, steal jobs and economic activity from elsewhere in Europe? I think that it did not. It merely provided a location for firms which otherwise would not have set up their operations in Europe at all. The present situation of a great variety in tax regimes gives possible investors a choice: some countries have taxes, but also have skilled workforces; some offer low taxes as a means of establishing themselves economically. This process would be stopped as a result of the tax harmonisation without improving the job creation record in Europe. All that might happen is that job creations due to non EU-based investors setting up activities in a EUlow tax country would never occur.
[20.] The "new economic geography theory". -- The present harmonisation efforts aim amongst others at ensuring that economic activity is distributed in an efficient manner from a geographical point of view. This proposition however is difficult to sustain in view of the latest knowledge in economic geography (see Baldwin/Krugman, 2000). Economists nowadays believe that the location of economic activities very much is influenced by so called "agglomeration forces"
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leading to an uneven distribution of economic activity: just like success breeds success, an already sustained economic activity in a specific region leads investors not yet present there to set up their operations, too, at least for certain core products and services. Those activities that are not subject to agglomeration forces may however be attracted by periphery nations, amongst others through the use of low tax regimes.
Harmonisation of taxes somewhere between high tax and low tax countries would not help anyone and even reduce global welfare: high tax countries would see their tax revenues shrink, although the core industries were never at risk of moving out, because of the agglomeration forces. As Baldwin and Krugman put it very sensibly: "rich nations are an attractive location for production since they are rich". The low tax periphery countries would also lose out, since the incentive for economic activities that are not subject to agglomeration forces to set up in the low tax countries would disappear. In the end, every one turns out to be the loser of tax harmonisation.
Chapter 2. Does harmonisation improve the revenue of the Member States? The idea of tax competition leading to bankruptcy of governments is widely spread though inaccurate (§ 1). In view of the tax burden presently suffered in the EU, a "fat-cutting" exercise in fact is rather appealing (§ 2).
§ 1. The "race to the bottom" theory [21.] Erosion of the tax revenue of the Member States. -- One of the obvious justifications of tax harmonisation, especially on company tax harmonisation, is its favourable impact on the tax revenue of the
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various Member States: although fears of an imminent collapse in government revenues may be overstating the concerns of some advocates of tax harmonisation, the competitive reduction of corporate tax rates in certain countries, together with increasingly efficient tax planning, may have lead to a shifting of profits from hightax to low tax countries. This has lead government revenues from lowtaxed countries to increase at the detriment of those of high-taxed countries, the aggregate amount of taxes collected in all EU countries being lower than if the shifting of profits would not have existed. Hightax countries, afraid of losing firms and trade to other countries, get involved in a "tax war", lowering tax rates to a point where the revenue earned by the governments is insufficient to cover its spending commitments (the famous "race to the bottom").
[22.] The race to the bottom will never happen. -- Investment decisions including location decisions may be influenced by taxes to some degree, but this is certainly not the only factor influencing the decisions to be taken. More variables influence the final outcome. The problem with most harmonisation advocates is that they forget that taxes are not levied for the sake of it: taxes raised by the government on one hand will be spent by it on the other hand. To concentrate on taxes and taxes only therefore is seriously misleading. Limiting the discussion to the question of the harmonisation of the income taxation is in our opinion a logical mistake. Investors certainly do take taxes into consideration, as they do for wages, public infrastructure and so forth. Thus the diversity of income taxes may very well be the counterpart of the diversity in the services given by various governments to taxpayers. It has long been demonstrated that competing with public goods and their financing costs does not as such create any problem. Each country chooses its optimal supply of
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public goods and the corresponding method of financing. When taxation becomes excessive, capital goes and/or the firms go elsewhere, and taxation is corrected. Therefore, if taxes influence the attractiveness of a country, they nevertheless are not the whole story.
The Swedish economist Knud Wicksell already demonstrated this assumption in 1896 (the famous "Wicksell equilibrium", Wicksell, 1896). Wicksell used the example of two local communities geographically close one to the other, with different tax rates and still very little movement over the community borders. Wicksell reasonable assumption was that an individual does not wish to pay more taxes than what he demands (and receives) in the form of public services (or "public goods"). The bundle of public services he receives over his life cycle has to broadly match the taxes he has to pay. If an individual demands a high level of public services he is willing to pay a high tax for that advantage. A high-tax country that provides all that will attract such individuals more than the low taxing countries. The individual that does not wish to benefit from a high level of public services will look for alternatives and eventually move to a low-taxes country ("voting by the feet"). Whether he will do or not only depends upon the taxes he has to pay, but also on the public services he expects to receive (and those he does not want to receive).
The U.S. economy with its differences in tax regimes provides a good demonstration of this. In the U.S. as well there exists tax competition between the States, but it has not created a "race to the bottom". Low-tax Nevada has made it possible for individuals and companies to move just a few miles from California to have lower taxes and a different bundle of public services. Such moves have been observed, but not on an explosive scale. Most people are willing to stay on in California and pay the higher taxes. The example of
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California shows that a race to the bottom is not a good prediction of eventual results of tax competition under governments. Tax competition should rather be seen as a welcomed race to the most efficient use of tax receipts.
[23.] Tax revenue aspects are incompatible with the elimination of "unfair" tax competition only. -- Despite what has been said above, let us nevertheless accept for a moment the idea of tax harmonisation being justified in order to secure appropriate levels of revenue to the respective EU Member States. Those who advocate the tax harmonisation on these grounds usually limit their request to the elimination of that part of the tax competition that is perceived as being "unfair". For the remainder, i.e. the "fair" tax competition, no action at the Community level would be required. One may question however the logic of this opinion, if the tax revenue for the governments is the concern: the unfair tax competition, which by essence is ring-fenced and limited to certain activities and business sectors, certainly is a much slower road to the bottom than a nationwide reduction of the tax rates. As has been shown by Diaw and Gorter (2001), the limitation of the tax harmonisation to unfair tax measures does not alleviate under-taxation: although governments will have to scrap harmful tax practices, they will start competing with the general tax rate by setting low statutory tax rates across the board. Such a tax competition is much more dangerous for the EU governments from a tax revenue point of view. Therefore, the tax revenue concern of the Member States may only justify a complete harmonisation of all aspects of income tax laws, i.e. the tax base and the tax rates.
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[24.] Harmonisation means "higher". -- Harmonisation of taxes would for various reasons take place at high levels, close to those of high tax countries: harmonisation looks like a "race to the top". First, it is unlikely that countries with high tax rates could substantially reduce expenditure on public services to meet the requirements of harmonisation, if tax rates were to be set at low rates. Second, it seems reasonable to assume that the wish of politicians to be re-elected acts as a restraint and that voters typically tend to favour tax reductions. This democratic pressure over the politicians only exists for as long as the tax decisions remain with the Member States. Once the taxing-power has been transferred to a supranational body that is not accountable to the electorate, the risks of upward alignment of taxes become very real. As Adam Smith once put it: "there is no art which one nation more swiftly learns of another than that of draining money from the pockets of the people". Hence, it may be safely assumed that the convergence would take place at levels close to those existing in high-taxed countries. Harmonisation means "higher". On that basis, one may conclude that harmonisation would have as a consequence to push up the ratio "corporation income tax - total tax revenue" as well as the tax burden in general. The OECD statistics do show however that right now the tax pressure in the EU, on average, already is substantially higher than in the U.S. and Japan.
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% GDP 60 50 40 30 20 10 0
OECD tax burdens
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EU Av. Japan US Irel. Spain Port. UK Germ. IT NL France Belg. Finl. Swed. Den.
Except for the minority that might still be convinced that taxes should be higher in the EU, this is certainly not a good reason to harmonise.
Trends in EU, US and Japanese tax burdens
45 % 40 35 30 25 20 15 10 5 0 1965 1970 1975 1980 1985 1990 1995 1998 1999
Japan US EU Average
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[25.] Comparative statistics show that corporation income tax is already set at too high a level. -- The KPMG International Tax and Legal Centre recently has presented its annual survey of corporate tax rates for 2001. The survey covers 58 countries. including the OECD countries, as well as many countries in the Asia Pacific and Latin American regions. The survey demonstrates that the tax-cutting trend continues in all the regions and that the average tax rate differences continue to narrow in the regions surveyed.
OECD and EU Average Corporate Tax Rates 1996-2001
32 1996
OECD Member Countries EU Member Countries
Average Corporate Tax Rate
The tax convergence we are presently facing still does not mean that the EU countries now have become competitive in terms of
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corporate tax rates, the average corporation tax rate in the EU being some 2-4% above those in the other regions.
Average Corporate Tax Rate
Average Corporate Tax Rates at January 1, 2001
34 33.5 33 32.5 32 31.5 31 30.5 30 29.5 OECD Countries
EU Countries
Latin American Countries
Asia-Pacific Countries
An immediate objection to this survey is that it may be seen as too simplistic, statutory rates being eventually very different from the effective corporation tax rates. This criticism may be overcome by looking at the percentage the corporation tax represents in total tax revenue. The latest OCDE statistics (OCDE, working papers n° 303) show that the weighted average of corporation income tax as a percent of total tax revenue is 7,1% and 9,0% in the U.S.. Does this mean that the gap of 1,9% is attributable to unfair tax competition? Hardly so, because such a comparison neglects that the relative importance of the main revenue sources is quite different in the U.S. and in the
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EU: the EU countries rely more heavily on consumption taxes (28,8% vs. 23.2%) and social security contributions (32,7% vs. 23,7%) and less on income tax (31% vs. 49,5%) than the US (Joumard, 2001). The 1,9% appears to be due to differences in the design of the tax systems, rather than tax arbitraging by corporations. In fact the comparison rather indicates that the part of the corporation tax in total tax revenue is above what it should be when considering the mix of tax revenue in the EU and the U.S..
Impact of tax structures
Income Capital Consumption Social Security
Chapter 3. Does tax harmonisation improve international tax neutrality ? Tax neutrality is a good feature for any tax system to have, both domestically and internationally (§ 1). The review of the current practices by the EU governments however does not justify tax
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harmonisation on those grounds, since neutrality in an international settings may be achieved through other means (§ 2).
§ 1. Tax neutrality in an international settings [26.] Unfair tax competition would induce distortions. The fact that taxes do affect economic decisions is not new. Both the EU and the OECD do think however that this issue is particularly relevant in case of cross-border investments, unfair tax competition apparently distorting the location of capital and services and hence reducing global welfare. This view is based on a very simple though apparently convincing argument: all things being equal, if the pre-tax return in two countries is the same, but if country A levies a higher tax than country B, capital will tend to get invested in country B and not A. It could therefore be held that tax harmonisation would improve the ability of economic agents (consumers, investors or firms) to make decisions that are less affected by tax considerations and more based on the real state of the economy. The intuition may well be that if it is cheaper to produce in Milan in the absence of tax, the tax system should not lead to the production instead taking place in Spain. Looked at it from this angle, tax competition, not only the harmful one, by creating tax advantages, enables high cost producers to coexist with, or even drive out, low cost producers. But there is another way for looking at tax competition: suppose the owner of a town's only hairdresser. Suddenly he has to deal with a bunch of competitors after years of having charged high prices with poor service for his haircutting. The arrival of the competitors will lower the price of haircutting, increase the quality of the service and make the lives of the habitants of the town much better. Competition meaning that "customer is king", there is no reason for not applying
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this idea to tax policies: the taxpayer is the consumer and governments must learn not to overtax him unless they risk of driving economic activity away. Just like competition is not welcomed by firms that are competing against each other, governments do not see tax competition as a good thing. But taxpayers certainly do so.
In my opinion, if distortions exist, it is not because of the existence of tax havens and low tax countries within the EU, but as a result of high taxes being levied in certain EU countries with no equivalent high level of public service. The source of distortions being the high taxes, the only way to eliminate the distortions would be to force high tax countries to cut their high tax rates rather than trying to force low tax countries up to their level. Tax competition achieves just that.
Generally, the alleged distortions most of the time are attributable to small economies (or even smallest economies). It would however be very astonishing if small economies would be able to significantly alter the world allocation of, and thus the return to, real investments. Most of the time the alleged distortion is limited to financial capital they attract from high tax countries. But as long as the capital thus attracted is not actually invested in the low tax economy, the world allocation of real investments does not change and the alleged distortions do never become reality (Tanzi, 1995). If for example a German headquarter sets up an Irish financing subsidiary for intra-group lending purposes, the passage via Ireland does not change any of the final capital flows and hence no distortions arise; all Ireland achieves is a net tax savings for the group without impacting on the real economy.
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There is another fundamental flaw in the present tax competition discussion: if the concern is whether a country's tax regime induces economic activity to shift, than all tax competition is harmful and not only the "unfair" one. The only way to prevent taxinduced changes of investment location would be for all the countries to adopt the same tax system (income definition, tax rates).
[27.] Capital export and capital import neutrality. The search for principles in international revenue and tax-base allocation is nothing new. It deals with the apparently simple question as to who should be permitted to tax the income resident of country A generates in country B? Country A as the country of residence or country B as the source country? Traditionally, the residency principle which permits the capital-export neutrality (CEN) has been favoured: by leaving as much power to tax as possible with the State of residence and by having that State tax the world-wide income, the capitalexport neutrality does not affect the choice between investing at home or abroad: all since taxpayers investing abroad will pay the same amount of taxes whether they invest abroad or domestically. Under the residence principle, income is taxed at the rates, and revenue accrues to the country in which the recipient resides. Capital-export neutrality may only be ensured if the residence country uses the tax credit method for the taxes paid by its taxpayers abroad. Under the capital export neutrality method, a reduction of tax rates in low tax country bears no fruit for the investors in high tax country, since all of the benefits granted in low tax country will be "taxed away" in high tax country. Bracewell-Milnes therefore rightly calls the CEN "fiscal imperialism".
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It therefore comes as no surprise if scholars (e.g.: Vogel, 1994) increasingly favour the source principle that implements the capitalimport neutrality (CIN). Under this principle, resident and nonresidents doing business in the same State face the same tax bill since they are subject to the tax laws of the source country only. As a result, the residence country should exempt the foreign income, which would only be taxed abroad. Under the CIN, a reduction of tax rates in low taxed country generates permanent tax savings for investors of high taxed countries. Under the source principle, the income is taxed at the rates and the revenue accrues to the country in which the income arises.
§ 2. Practices of EU Member States These are the theoretical benchmarks used when assessing tax neutrality in an international context. Since the CEN and CIN do approach this question in a totally different manner, only a total harmonisation of tax rates and tax bases in all EU countries would allow reconciling both CEN and CIN. [28.] Consequences of the predominance of the CIN. If more realistically only the source principle was to be retained as the leading principle in international taxation the consequences of this choice as regards tax harmonisation would be easy to foresee: there would be no tax harmonisation because under the CIN there simply is no need to harmonise (and hence under the EU Treaty no authority either) the substantive income tax laws of the EU. The source principle requires the source country alone to have the taxing power over the companies' profits realised in the source country. This may only be ensured if the residence country exempts the source country income (exemption of the income attributable to the permanent establishment set up in the
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source country, exemption of the dividends paid by the subsidiary set up in the source country). Hence, under the CIN the level of taxation in the source country does not impact upon the tax revenues of the residence country. Under the source principle (or "territorial system"), economic activity is only taxed if it takes place within the Nation's borders. Simple to administer and avoiding any conflicts between Nations, the territorial system does avoid the needs for tax harmonisation.
[29.] The place of CIN in the EU Member States' tax policies. It is therefore interesting to look at the tax policies followed by the various EU governments as regards the tax neutrality. It would be logical to expect all of those that advocate a harmonisation of income taxes to adhere to the CEN.
Comparative tax law do show that most EU countries follow the CEN method as regards income from savings, since they tax their residents on their worldwide income on such income, also under the applicable international tax treaties. Hence the EU governments that are favouring a harmonisation of savings taxation whilst having retained the CEN technique do remain consistent.
The situation is different however as regards corporation tax, since most countries of Continental Europe (Ireland and England, in line with the prevailing Anglo-Saxon imputation tax system adhere to the CEN) have adopted the exemption method for foreign branches, either unilaterally (e.g.: France), or under the applicable tax treaties (e.g.: Germany, Italy). Continental countries by and large adhere to the CIN as regards corporation tax and hence act inconsistently if they request tax harmonisation for corporation tax on the grounds of neutrality whilst having retained the CIN system in this area.
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Everyone knows the importance given by the European Court of Justice to the concept of "coherence": discriminatory tax treatments running afoul of EU law may eventually be acceptable under EU law if they can be justified on the grounds of the coherence of the tax system. That same argument should be applied here to deny the requests made by governments to harmonise corporation tax if they anyway do not live up to the standard of the CEN. On those grounds it seems somewhat harsh to expect from low tax countries to "bite the bullet" by sacrificing themselves for the greater good: the aim of any tax reform measures always are national welfare, also in a unified economic area such as the EU, and the least one may expect from the harmonisation advocates is to act consistently at all times, not only when it suits them.
Chapter 4. Limits of tax harmonisation Not only are the reasons for harmonising tax regularly put forward not convincing (see chapter 3 before), but harmonisation anyway bears important shortfalls: · tax competition only is able to remedy to the over-expansion of the public sector; · fiscal decentralisation as presently existing is better able than a centralised decision making process to meet the taxpayers' needs; · harmonisation will be at the expense of certain countries, typically the smaller economies; · harmonisation bears an inherent democratic deficit; · harmonisation of taxes no longer enables governments to pursue their own tax policies.
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§ 1. Tax competition as a remedial to the Leviathan syndrome
Leviathan proposition
· Over-expansion of public sector · Fat-cutting · Voting by the feet · Tax competition promotes growth
[30.] Over-expansion of the public sector. In my opinion the absence of collection of taxes on the capital income may neither be justified on the grounds of it leading to a (Pareto-) sub-optimal level of public services. Public choice scholars (Buchanan/Buchanan, 1980, to cite only 2 of the most prominent authors) rightly hold that tax harmonisation contains a built-in bias that produces inefficiency and, in particular, an over-expansion of the public sector. This has lead to a revitalisation and modernisation of David Hume's famous Leviathan proposition of systematic over-expansion of the public sector: governments tend to maximise total tax revenue net of expenditures for public goods rather than offer those services that are desired by taxpayers at the cheapest possible price. The Leviathan proposition has even been indirectly admitted by European Commission Fritz Bolkestein (keynote speech on May 29th, 2001): "tax competition (...)
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obliges the governments to offer the best possible services at the lowest possible price".
Tax competition should therefore be welcomed because it imposes a rationalisation of public expenditure and enables firms to access public services at the lowest possible price. Tax competition means "fat-cutting" which is good for society; it alone may tame Leviathan (Guimbert, 1999). Anyone who adheres to the Leviathan proposition surely favours tax competition and smaller governments, since it ensures that tax levels and hence the public spending are reduced. Tax competition is the perfect tool for making the public services leaner, more efficient, whereas tax harmonisation merely enables countries to export their high taxes across the EU and hence decrease competitive pressure.
[31.] "Voting by the feet". "Bad" tax competition all too often is seen as entailing drawbacks from a political and democratic point of view. It is often held that national jurisdictions outbidding each other surrender themselves to the market, although they are convinced that they are retaining their fiscal sovereignty. In other words, under tax competition, governments' tax policies would be dictated by taxpayers rather than by the goal to imposing a reasonable part of the cost of public expenditure on every production factor, including the mobile capital one.
There obviously is some element of truth in the above opinion, namely that taxpayers, as a result of the liberalisation process within the EU, now have a saying in the tax policies pursued by their governments. It does draw the wrongs conclusions: only the liberalisation permits the taxpayers to express their disagreement with the tax policies of their government. The existence of tax havens in
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and outside the EU is nothing but the citizens' demand for protection from high-tax regimes in EU countries. Tax competition is the only way for EU taxpayers to indicate to their governments that the public services they receive and the cost for them is not in line with the level of taxation the citizens have to face.
(Tax) Competition
· « You like the protectionism as a `working man'. How about as a consumer? » · The State acted in the past like a monopolist · Competition always is unfair to the monopolist · US fears of Mexican tomatoes
§ 2. Being close to the customer: fiscal decentralisation [32.] Virtues of fiscal federalism. -- Leaving the fiscal powers to the respective governments of the EU Member States has obvious merits similar to those justifying local taxing power at the country level: governments are better placed than the EU Commission to meet the local needs and preferences for public services. Letting local needs for services be tested by the willingness of local residents to pay is the most efficient way to determine the size and nature of the public
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services. Tax competition is in fact helping to create more prosperity by forcing the governments of the Member States to be more efficient, to become more frugal with the money they collect ("efficiency effect"). Tax competition allows both citizens and capital to move out of jurisdictions with poor governmental performance and high taxes; it alone is able to reveal what is efficient and inefficient government use of tax, what taxpayers do desire and what they do not.
[33.] Governments pursue different tax policies. Indirect taxes already having been harmonised, unification of direct taxes would mean that the main aspects of the domestic tax systems in the EU would be harmonised as well. Since taxes collected by the governments are spent by them, it may be safely assumed that harmonisation of income taxation will lead to harmonisation of the public expenditure within the EU. At the present stage of integration within the EU, governments of the various Member States do however follow different policies as regards the financing of public expenditure. Should the health care system be financed by way of taxes or social security payments, should motorways work on the basis of a toll charge or through taxes, should reliance be grater on direct taxes or indirect ones, to name only a few? For example, certain countries such as Denmark finance the bulk of their welfare systems out of indirect taxation, applying relatively high rates of VAT. Others such as France have chosen a system of high direct social security contributions. By starting the harmonisation of the income tax base one would almost inevitably start harmonising the tax structure and the public services throughout the EU. Such a movement, if ever required, should be based on (presently missing) explicit EU Treaty provisions.
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In my opinion harmonisation of national tax systems typically is looked at as a purely mathematical exercise based on the application of tax rates to a tax base. When doing so harmonisation advocates forget that the rates and the base have their roots in national tax structures. The EU governments have pursued different strategies when they built up their welfare states. Continental countries created a link between welfare expenditure and social insurance fees to finance them (the "continental tax policy"). The Anglo-Saxon and Scandinavian countries rather favoured the general income tax. Those political choices are not accidental but do reflect different philosophies as to how a tax system in a welfare state should be organised. A centralised tax harmonisation approach will not solve these fundamental differences in tax philosophy between EU countries for the EU.
[34.] EU seems to consider taxes only as a revenue provider. -- It is well known that taxes are not only used for providing the country with the necessary means for its spending commitments, but that it is also used in order to influence the behaviour of the taxpayers. Taxes may be used as a tool to stimulate the economy or to cool it down in case of risks of overheating (stabilisation policy). Tax policy is also designed to promote growth and high employment. Hence countries with high levels of unemployment and low output may wish to stimulate economic activity by cutting tax rates, whilst countries whose economies are overheating may wish to raise tax rates.
Also, countries may wish to operate different "sin" tax rates if they have different views on the extent of harmful effects of smoking and drinking for instance.
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It will be difficult for the individual Member States to continue following these objectives if the tax harmonisation realises a greater convergence of the tax systems of the various countries.
[35.] Subsidiarity principle. Bearing this in mind and considering the subsidiarity principle as enshrined in the EU Treaty, the case for any form of partial income harmonisation appears to be rather weak. As we all know, subsidiarity proceeds from a presumption in favour of decentralisation: Member States should be permitted as much tax sovereignty as is commensurate with the goals of free trade and free competition in the single market (Cnossen, 1996). Although this principle is very general, and at times is seen as merely being a "political slogan" (Barents, 1996), it nevertheless clearly limits the mandate for any supra-national action to those situations where certain objectives may not, or only with great difficulties, be achieved at the level of the individual Member States. Applying the subsidiarity principle to corporation tax and taxation of savings leads in my opinion to following conclusions.
As has been said before (see [27.]), achieving CIN in corporation tax may easily be achieved at the level of the individual Member States and does not require any Community action. Therefore, the subsidiarity principle forbids any Community action in that area.
Hence, only savings taxation needs to be looked at. Since taxation of the latter is residence based, the case for Community action appears at first sight to be rather strong here, in order to ensure "external neutrality". "External" neutrality of tax systems is considered to exist if the tax systems have no influence on the cross-- country pattern of private sector economic activity. It seems plausible that existing bank secrecy laws and absence of withholding taxes in
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certain countries do make "external" neutrality" impossible to be achieved through individual Members' state actions.
It would be logical however to request the Member States that demand the harmonisation to at least respect the "internal" neutrality of taxes. In reality however, tax systems are not neutral, and never were, not even domestically. Tax harmonisation requests on a crosscountry basis are hardly acceptable, when looked at from the point of view of a low tax country, if the demanding countries do not live themselves up to the standards domestically. Models for achieving domestic neutrality as regards the cost of capital of companies do however exist. Neutrality could be achieved through the deduction of dividends from the companies tax base, just like is the case for interest. An even better method consists in the non-deductibility of interest at the level of the payer (Cnossen, Bovenberg, 1992). Under the latter system, the corporation tax rate being set at a level close to the top marginal individual income tax rate, taxes would no longer affect the company's financing (Modigliani/Miller, 1958, 1963), since they would be treated equally, none reducing the corporation's tax base. Under this model, neither the dividends nor the interest would be subject to tax in the hands of the investors. Reforming corporation tax along those lines, by disallowing the deductibility of interest payments, is fully in the hands of each EU Member State. Therefore, under the subsidiarity principle, the legal basis for harmonising savings taxation does not exist.
[36.] International competition is on tax and expenditure. -- In a global environment, governments compete by means of tax and expenditure policies, or the European Parliament put it: "it is not tax systems in isolation that are in competition, but fiscal systems as a whole - that is, the pattern of both revenue and expenditure" (2000, p.
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74). This means that an exclusive focus on taxes is misleading. The presumption must be that the demand for public spending, especially for income transfer programmes, increases with globalisation, in order to cope with the consequences of the economic risks triggered by it ("compensation effect"). The degree and extent of this insurance policy varies with each country, and may explain why "high tax-high spend" countries may perfectly coexist along side "low tax ­ low spend" countries.
§ 3. Tax competition promotes growth [37.] Tiebout Hypothesis. It is universally accepted that high tax rates inhibit economic growth (Tanzi/Zee, 1997). Tax competition, by encouraging lower tax rates, therefore is beneficial to the economy. This general concept is known as the Tiebout Hypothesis, after the author of a seminal 1956 article on the issue (Tiebout, 1956). The EU (and the OECD) mistakenly assumes that tax harmonisation, especially on savings, simply shift where investments take place. But as has been noted before: the world's supply of capital is not fixed but depends on the net rate of return. If tax harmonisation takes place at high levels, world accumulation of capital will be slowed down as will be economic growth. This must be the case because the after tax return of the capital will be lower than before. A reduction of the rate of return of the capital will impact on the amounts used by the taxpayers for consumption and savings. Hence tax harmonisation not only impacts on where investments take place, but more importantly also on whether they will occur. [38.] Harmonisation is not Pareto-optimal. -- The EU has a wellarticulated policy towards intervention in private industry. It is based on the promotion of efficient allocation of resources through the
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encouragement of competition, which is seen as the active progenitor of economic efficiency and welfare. The gains from free competition may go to the producers or the consumers, or both. From an economic efficiency point of view, however, it is irrelevant whether surplus accrues to consumers or to producers. Economic science is more concerned with the "baking of the biggest cake" than the redistribution of income.
Every day life however gives plenty of evidence that the best deals are those where all the parties win (the "win-win" situation). This idea has been formalised many years ago already by the great economist Pareto under the name of the "theory of the general optimum" (Pareto, 1927). The Pareto-optimum refers to an optimal situation because it may only be improved at the expense of other persons. Extending Pareto's theory to the tax harmonisation process within the EU means that tax harmonisation is only justified if it increases global welfare, i.e. if the welfare of one or several Member States improves without any of the other Member States' welfare deteriorating.
[39.] Harmonisation does not increase the welfare of all Member States. Economic research has applied the Pareto theory to capital income taxes in a two-country model, though its conclusions may be extended to corporation tax and the whole EU as well (Homburg, 1999). As has been demonstrated, harmonisation of taxes within the EU never leads to gains for all Member States (Sшrensen, 2001). With residence taxation, harmonisation of savings taxation may only redistribute income from the low tax countries to the high tax countries. The same may be held for company taxation, the small countries with location disadvantages losing out to the benefit of larger countries with large domestic markets. Fuente and Gardner
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(1990) as well as SШrensen (2000) have shown that the welfare gains to be derived from complete harmonisation of EU tax would be distributed unevenly amongst the EU countries. Most of the gains would accrue to the larger countries (France, Germany, Italy, UK and Spain), whereas smaller countries such as Ireland and Luxembourg would suffer welfare losses. Hence, tax harmonisation is not Pareto optimal.
§ 4. No taxation without representation: the unanimity principle in direct tax matters [40.] "Creeping" harmonisation through the activity of the European Court of Justice. There is no doubt that in recent years harmonisation of the European tax systems has progressed. The reason for this may be found in the increasing number of direct tax cases put to the European Court of Justice ("ECJ"). As a result of its interpretations of domestic tax provisions in the light of the four fundamental freedoms laid down in the EU Treaty, the ECJ has been able to increasingly eliminate discriminating national tax laws. Most experts complain about this development and accuse the ECJ to introduce a silent, creeping harmonisation of tax laws into the tax systems of the various Member States, a process for which they would have no authority. The same critics consider that the power to harmonise tax law would rest solely upon the politicians. Most critics would haste to add that the unanimity rule, which still exists in direct tax, matters should be surrendered, in order not be stopped in the harmonisation process by the veto of a dissident Member State. [41.] The responsibility to make tax changes rests upon elected policy makers. -- What is the reason behind this request to stop the
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creeping harmonisation process initiated by the ECJ? Those who spell it out would say that the judges at the ECJ are technocrats, specialists selected for their competence in legal matters: they have the authority to interpret the law but not to change it. This reminds me of the old adage: "no taxation without representation". The same comment may be made as regards harmonisation of direct taxes at EU level, especially if the unanimity principle were no longer to exist. There is absolutely no guarantee whatsoever that the citizens of the EU desire the tax harmonisation. It may be most certainly be assumed that the citizens of low tax countries that will lose out under the harmonisation process and which no longer may veto the process are likely to consider that the harmonised tax system has been imposed upon them and not freely adhered to by them. "Taxation without representation is tyranny", James Otis said in 1725. The example of the US revolution over the British empire is one of the most famous statements of a universally applicable fact: that people resent paying taxes and will only agree doing so if they have a say over the government which imposes them. The EU Commission not having been elected by the EU citizens, the transferring of taxingpower to Brussels necessarily lacks democratic legitimacy, especially if the veto right was to be given up. Tax harmonisation contains an inherent democratic deficit.
[42.] -- No room for direct tax harmonisation under the competence by attribution principle. -- Under the principle of competence by attribution, which is fundamental under the EU Treaty, harmonisation of direct tax laws is only legitimate if authorised by either an express provision or by implication from the EU Treaty. In contrast to harmonisation of indirect taxes, which is particularly provided for by article 93 of the EU Treaty, harmonisation of direct
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taxes may only be based on the general rules of article 94 and 95 of the EU Treaty concerning the "approximation of laws". Article 95 of the EU Treaty explicitly excluding taxes from its scope (§ 2), only article 94 of the EU Treaty may be applicable. Article 94 of the EU Treaty has two essential features, one of which will only be looked at here (for the other see below [43.]).
Direct tax harmonisation needs to have a direct incidence on the establishment and functioning of the common market ("directly affect"). Hence the question is whether existing tax discrepancies across countries do affect the economic and social components of the fundamental freedoms guaranteed by the EU Treaty (see on this point: Pistone, 2000, p, 58)? We will see later that this is not the case (see [56.]): existing differences across EU countries do not negatively affect the movement of capital and the establishment of businesses in EU countries, but rather constitute the necessary ingredient for the freetrade itself. I see nothing wrong, under the EU Treaty, if a German headquarter provides capital to an Irish company, the monies being on-lend to a French borrower. Nor do I perceive community law problems if French savings are transferred to Luxembourg banks for portfolio management purposes. It may well be that these transactions could be more efficiently directly out of Germany or France, but does not constitute a hindering of the fundamental freedoms under the EU Treaty. The existing tax discrepancies do not negatively impact upon but rather stimulate the actual exercising of the EU freedoms. One might as well consider that high tax country, because it levies extremely high corporation taxes, negatively affects the free flow of capital, because foreign investors will for that reason avoid it and go elsewhere. In fact, the EU Treaty is not concerned with the question of how much burden a State imposes on its resident
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taxpayers and whether it makes investments in high tax countries unattractive. Likewise, it should not be bothered with the low tax burden existing in certain Member States for as long as both resident and non-resident investors equally benefit from the low taxation. I therefore think that the legal basis for harmonising direct taxes anyway does not exist.
[43.] Alternative instruments for tax harmonisation. Second, article 94 of the EU Treaty also requires unanimity. It only seems fair to give each Member State a veto right in the last domain of national sovereignty it still has. Unanimity is a safeguard against individual governments being taken by assault and having to accept decisions taken by others against their will. Unanimity in direct tax matters means democracy. The need to have unanimity however certainly also is an impediment to a quicker harmonisation in direct taxes, because of the many different and conflicting views the respective Member States have in this domain. This has lead the Commission to recently state: " given the difficulties in reaching unanimous decisions (...) the community should also consider the use of alternative instruments as a basis for initiatives in the tax field".
Alternative instruments are manifold and already in place right now: the Code of Conduct; the "enhanced co-operation" procedure. A recent example in tax matters however shows that the risk of seeing the veto right in tax matters being circumvented by the use of the single market legislation over which there is no veto (art. 95 of the EU Treaty) no longer is remote. The Commission, when passing the revised Directive 2001/44/CEE (June 15, 2002) regarding the mutual assistance in tax matters, referred to article 95 of the EU Treaty. How could this be in view of the fact that article 95 of the EU Treaty specifically excludes tax matters? The trick consisted in giving a very
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narrow reading of the "tax measures" as laid down in article 95 of the EU Treaty. According to the Commission, mutual assistance is not a tax matter, even if it deals with the collection of taxes. Although the Council did overturn this reading by the Commission, the case now being with by the ECJ, it does show that the last word in this area has not been said yet.
One may even take this idea one step further and wonder whether direct tax harmonisation could be based on article 96 of the EU Treaty: article 96 permits EU action where legal or administrative rules of a Member State distort competition within the EU. The beauty of article 96 of the EU Treaty (at least for the harmonisation advocates) is that legislation may be adopted under it via a qualified voting majority. So far, article 96 has hardly ever been used nor has it ever been referred to for imposing tax measures. However, the Commission has issued scarcely veiled threats that it might one day seek to do so.
[44.] Harmonisation means "tax cartel". The fighting of "harmful tax competition" is not only on the top of the agenda of the EU. The OECD also has urged its members to stop "harmful tax competition" (OECD, 1998). The OECD does call on its members to eliminate low tax policies that attract foreign investment. It also tries to dictate tax policy in non-member nations by pressuring 41 low-tax countries (so called "tax havens") that have harmful tax regimes to sign an agreement to remove their low-tax policies. The efforts undertaken by the OECD have been relayed by the Financial Action Task Force (FATF), an adjunct of the OECD, to list countries that allegedly contribute to money laundering. The G-7 nations have joined the fray, creating the Financial Stability Forum, to identify regimes that
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supposedly destabilize the world's financial systems by being sources of mobile capital.
All of these initiatives have in common their heavy-handed approach, since they threaten the non-complying countries with severe sanctions such as a financial embargo ("name and shame" strategy). A perfect example of this attitude is Senator Charles Schumer, in his "Testimony to House Banking Committee": financial institutions incorporating in areas with "bank secrecy laws should not be allowed to participate in the U.S. financial system or transact with U.S. financial institutions".
The harmonisation efforts presently undertaken by the EU participate in the same school of thoughts. It may well be that to EU policymakers "tax cartel" may look like a good idea. For high-tax countries such as Germany and France, this is understandable, since it would enable them to impose their views on tax policy and government spending upon the low tax countries within the EU. Nevertheless, the imposing of the views of high tax countries on low tax jurisdictions may not be seen in any different manner as an attack on the low tax jurisdiction's sovereignty. High tax nations should not be allowed to bully low tax countries into raising their tax rates and modifying their tax policies; and if they are, they should be call by their name: tax cartel.
Part III. Specific issues of company tax harmonisation Governments deploy great efforts to attract into or retain firms in their respective countries. Since taxes do impact on the firm's decisions as to where to locate, the risks of "beggar-thy-neighbour" policies may not be underestimated. The objective of the Code of conduct is to eliminate these harmful tax practices (chapter 1) by
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restoring a "level playing field" (chapter 2). Such a strategy not only bears certain limitations but it is also unnecessary in view of the lines of defence that are already existing (chapter 3).
Chapter 1. The Code of Conduct The Code of Conduct spells out various criteria that seem, at first looks, rather convincing for determining when a tax policy may be harmful (§ 1). The application of these criteria to real-life examples does show however that these criteria may also be questioned (§ 2). Especially, they make little sense in case of small economies (§ 3).
§ 1. The approach adopted by the Code of Conduct [45.] Scope limited to taxation of companies. From a practical point of view, the lowering of the tax burden by countries engaged in tax competition in favour of foreign investors may take different forms. In particular, there may be: · a reduction of the corporate tax rate applicable on income earned by foreign investors, · a tax holiday for a limited or an unlimited period in favour of foreign investors, · the creation of special tax-free zones, · the reduction of withholding tax rates on outbound income distributions, · special investment allowances, the formation of tax-free reserves, and accelerated depreciation deductions for foreign investors. All of these forms of tax subsidies are covered by the Code of Conduct, unlike however measures in the area of individual taxation,
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such as special expatriate regimes. These measures are usually meant to make it attractive for multinational groups of companies to assign their executives and specialised personnel temporarily to job positions available in the country concerned.
[46.] The approach adopted by the Code of Conduct as regards the identifying of "harmful" tax measures. The main criterion used under the Code of Conduct to identify the measures to be classified as harmful is the assessment of their relevance in affecting the firm's decisions on the location of their investments irrespective of economic factors. In order to clarify how this criterion is to be applied in practice, several markers are pointed out by the Code of Conduct as tools to be used in the assessment on whether a decision on investment location has been driven exclusively or preponderantly by tax considerations. In particular, the following tests need to be carried out for this purpose:
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When is taxation harmful? The EU code of conduct on business taxation states that, when considering whether taxation measures are harmful, account should be taken of, inter alia: · whether advantages are accorded only to non-residents or in respect of transactions carried out with non-residents, or · whether advantages are ring-fenced from the domestic market, so they do not affect the national tax base, or · whether advantages are granted without any real economic activity or substantial economic presence within the Member State offering such tax advantages, or · whether the basis of profit determination in respect of activities within a multinational group of companies departs from internationally accepted principles, notably those agreed upon within the OECD, or · whether the tax measures lack transparency, including where statutory rules are relaxed at administrative level in a non-transparent way
· Is a tax incentive available only for non-resident taxpayers or for transactions concluded with non-residents? · Does a tax incentive entail the computation of taxable income according to principles other than the internationally accepted ones (i.e. the OECD ones) in favour of multinational companies? This criterion is meant to cover all those special regimes relying on the computation of taxable profits in a way other than the standard one based on a company's financial statements, such as notional tax bases resulting from "cost-plus" calculations and the like. · Does a tax incentive lack transparency, for instance because it is based on unpublished administrative practices departing from the general statutory law? That test targets all of the "hidden"
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incentives aimed at attracting foreign investments. A favourable administrative practice is an example of what may fall under this category. These incentives are probably the most dangerous harmful tax measures, because they are difficult to be detected and rely on a high degree of discretion exercised by the tax administration. This may trigger inequalities of tax treatments between informed and uninformed taxpayers, as well as "manipulations" of the general tax system by the tax administration escaping judicial, administrative, and ultimately DEMOCRATIC CONTROL.
[47.] One particular test: the concept of "ring-fenced tax measures only available to non-residents". Most harmful tax measures (though not all of them) presently listed are those where the reduction of the tax burden has been granted by way of "special" incentives limited to a certain category of taxpayers (i.e., non-resident ones) or of transactions (those concluded with non-residents). This in turn highlights that the most important factor in the assessment of a certain measure as harmful of tax competition is its "speciality" as compared to the standard tax system applying to resident taxpayers.
In other words, harmful measures are those, which deviate from the "benchmark" tax system in effect in a certain country and are targeted exclusively towards the attraction of foreign investments. The relevance of this test is also shown by the fact that it is used by the Commission and by the European Court of Justice in the assessment of the compatibility of fiscal State aid measures with EC law (see below [61.]). The reverse side of the token is that tax measures forming part of the benchmark tax system do not constitute harmful tax competition.
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However, it has been pointed out by several scholars that tax measures implemented generally through the standard tax system may be harmful as well, such as a very low rate of corporate taxation, the absence of withholding taxes on outbound income distributions, favourable depreciation provisions and the like. For instance, the exemption from withholding tax on outbound payments is a general provision but is likely to favour (almost) exclusively foreign investors, and it would not be considered "harmful" according to the above test because it is not special. Another example of a general measure, "normal" in a country, but nonetheless harmful, is banking secrecy that has been pointed at by the OECD Report. The suggestion is thus that also general measures should be scrutinised, because they may turn out to be harmful tax competition on the same footing as the special ones.
§ 2. An example of the limitations of the Code of Conduct rules: the Luxembourg 1929 Holding Company [48.] The tax regime of holding 1929 companies. Luxembourg is well known for its long established "1929 holding company" regime. It was introduced in 1929 in order to favour the establishment in Luxembourg of companies engaged exclusively in the management of shareholdings in other companies. Eligible entities must be incorporated in Luxembourg as joint stock companies, limited liability companies, partnerships limited by shares or co-operative companies. There are only a few activities that may be carried on by 1929 holding companies: · management of shareholdings in domestic and/or foreign companies;
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· management of government or private securities;
· supply of advances and loans in favour of companies in which a "reasonable" direct participation is held;
· management of intangible rights (provided certain conditions are met).
There are explicit restrictions applicable with respect to the activities of 1929 holding companies. In particular, the latter are prohibited from:
· exercising any kind of commercial or industrial activity, or opening an office open to the public,
· holding immovable property other than that necessary to carry on their activity;
· charging fees for the services provided;
· borrowing money exceeding certain ceilings.
Several tax privileges are accorded to 1929 holding companies. They are exempt from corporate taxation in Luxembourg and are not required to withhold taxes on payments of dividends regardless of the country of residence of the receiving company. Furthermore, they are exempt from the net worth tax and from the municipal business tax on companies' income normally due by the other corporations resident in Luxembourg. Other tax benefits granted to 1929 holding companies include an exemption from tax on capital gains realised on qualifying shareholdings, an exemption from corporate tax upon their liquidation, and an exemption from tax on liquidations of qualifying subsidiaries.
The only tax 1929 holding companies are subject to is a 0.2% annual subscription tax on the value of the shareholdings owned.
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The main drawback of establishing 1929 holding companies for multinational groups is that the tax treaties concluded by Luxembourg and the Parent-Subsidiary Directive do not apply to such entities. As a consequence, holding 1929 companies are not entitled to the (reduced or) nil rates of withholding taxes on dividends received from abroad. Furthermore, as a result of the tax-exempt status of holding 1929 companies, outbound dividends distributed by such companies are not eligible to the participation exemption abroad from corporate tax in Luxembourg. Lastly, the stringent limitations concerning eligible activities and the limited possibility of granting loans make these entities not as attractive as certain entities that may be set up under other advantageous tax systems available throughout Europe.
[49.] Is the holding 1929 a harmful tax measure?. The holding 1929 has been characterised as a harmful tax measure under the Code of Conduct, which assumes that it meets the criteria outlined above. In particular, it should have a (potentially) great impact on the firms' decisions on their investment location. Furthermore, the tax regime of holding 1929 companies should deviate from the normal tax system in effect in Luxembourg and be available only to non-resident investors. All of these assumptions do not stand the test of reality.
The access to holding 1929 companies is not limited to multinational companies established and active in countries other than Luxembourg: any person (private or corporate, Luxembourg resident or non-resident) may set up such a company with no restrictions. In fact, due to its tax exempt status and as a consequence the unavailability of the Luxembourg double tax treaty network, the interposition of a holding 1929 in a group structure, either for holding or for financing purposes, is tax inefficient. Hence,
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in fact, a holding 1929 proves to be eventually a useful investment vehicles for all taxpayers but multinationals. Nor is the tax-exempt status of holding 1929 limited to those companies that only operate internationally.
The holding 1929 being a tax exempt company in its own rights, the issue as to whether its falls foul of the criterion of the calculation of the taxable base according to principles other than the OECD ones is not relevant. Nor is the special tax regime based on any favourable administrative practice laid down in resolutions adopted by Luxembourg's tax authorities; all of the relevant provisions are laid down in (special) laws passed by Luxembourg's central legislative bodies.
Nor could the holding 1929 be considered to constitute a "deviation" from the ordinary tax systems generally applicable in Luxembourg. The standard tax policy followed by Luxembourg in respect to intra-group dividends is to eliminate the double taxation in the hands of the beneficiary of the dividends, i.e. the holding company. The holding 1929 should be seen as a very simplistic (archaic?) method for achieving that goal.
§ 3. The difficulties of defining the "unfair" tax competition [50.] Limitations of this concept in the case of small economies: the case of Ireland. Tax competition generally is defined as being "unfair" if it aims at attracting foreign investments and is limited to certain parts of the country's economy (see [6.]). In large economies this understanding of "fair" and "unfair" tax competition may very well make sense. The example of Ireland however clearly shows the limitations of this "summa divisio". As
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everyone knows a temporary 10% tax rate for certain manufacturing companies was introduced in Ireland over 20 years ago, when the rate applicable to other sectors was 45%. At that time, the Commission raised no objection under the State Aid rules but later, after the scheme had been extended, the Commission become concerned. In 1998 the Commission concluded that it did now represent State Aid because it was sectoral, applying only to certain activities, and felt that it should be phased out. For the same reasons the tax regime was found to be harmful under the Code of Conduct.
We know how the Irish government reacted to this. By 2003 the general statutory rate will be 12,5% and will apply to all corporations operating in Ireland. Since the setting of the corporation tax rates is a matter for the individual Member State, as has unsurprisingly been confirmed by the Commissioner Fritz Bolkestein, the low rate of corporation taxes in Ireland does not infringe the Stat Aid rules. Nor does it justify Ireland's corporation tax system as a whole to be mentioned under the Code of Conduct.
When Ireland had to reshuffle its tax system in order to make it EU compliant it was faced with a choice: should it cut the corporation tax rate for all companies in order to become EU-conform or should it accept (some of) its attractiveness to foreign based investors to disappear? Before taking its decision, Ireland certainly made a "costbenefit" analysis in order to determine the costs of extending the reduced tax rates to its own based investors versus the benefits to be derived in respect to foreign headquartered companies operating in Ireland. The result of the cost-benefit calculation was not difficult to guess in advance. It is a perfect example of a conclusion that may be generalised for other EU countries (Wilson, 1999):
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§ a large economy with a strong domestic corporate tax base is unlikely to adopt general measures profiting to all of the businesses operating in its jurisdiction with a view to attracting certain foreign businesses;
§ a small economy may not hesitate adopting general measures if they also benefit to those foreign-based investors that are being targeted.
The tax harmonisation discussions that presently take place do by and large focus on harmful measures pursued by small economies. It would not seem difficult for the respective Member States to avoid the criticism they are facing by generalising their specific tax rules to all businesses operating in their country. Technically this would get them out of the Code of Conduct and State Aid issues, though in substance nothing would have changed.
Chapter 2. The idea of a level playing-field within the EU Main-stream economics do recommend policies seeking to maintain a level playing field in between competing countries, in order to eliminate any risks of distortions. This has lead the EU Commission to investigate various models attempting to achieve greater neutrality and transparency of the tax regimes (§ 1). The fundamental questions however remains as to whether corporation needs harmonisation at all (§ 2).
§ 1. Models considered by the Commission for achieving harmonisation of corporation tax To restore the level playing-field for business competition, which should be driven by economic factors only, four different
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models for reforming company taxation have been presented by the EU Commission:
[51.] The Home State Taxation model. The Home State Taxation Model (Lodin/Gammie, 2001) implies that EU multinationals would be allowed to calculate the consolidated group profits on their EU-wide activities according to the tax code of their home state, i.e. the tax code of the Member State where their headquarters are located. A German headquartered group would hence calculate the group's total taxable income according to the German Income Tax Code, even if operating in say France as a subsidiary and in Italy as a branch. The consolidated tax base would be divided amongst all the member countries in which the headquarter operates, each country taxing the income allotted to it at its (non-harmonised) income tax rates. The weakness of this mutual recognition model is that it does not eliminate the tax competition, since the applicable tax rules will be dependent upon the location of the headquarters. Home state taxation to some extent invites the Member States to intensify competition by offering generous tax base rules in order to attract corporate headquarters.
[52.] The Consolidated Common Tax Base model. The Consolidated Common Tax Base model takes a different approach and provides for an optional harmonised set of tax base rules for EU multinationals, the competence for setting the corporation tax rates remaining with each Member State. As a consequence, the competition on the tax rates will still take place. Also, this would create other distortions between large and small firms within the same Member State, since the small firms would remain subject to the domestic tax rules. The parallel existence of two different tax systems also creates administrative inefficiencies.
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[53.] The European Union Company Tax model. The same applies to the European Union Company tax, which is economically equivalent to the Consolidated Common Tax Base, except that it is administered at the EU level and no longer domestically.
[54.] The Compulsory Harmonised Corporation Tax model. This is the fourth model presented by the Commission. It would, unlike the Consolidated Common Tax Base and the European Union Company Tax, apply to all firms operating within the EU, not only to multinationals. Although this would eliminate some of the distortions indicated above (difference in tax treatment of small and large firms, two tax systems within the same Member State), the model still assumes that the power to set the corporation tax rates continues to rest with the respective Member States. Research undertaken by the EU Commission however seems to indicate that the bulk of the crosscountry variation of effective tax rates is caused by the current variation in statutory tax rates. A harmonised tax base with no harmonised tax rates would hence fall short of the hopes put in this model.
If the Commission and the advocates of the present harmonisation discussions of corporation tax were really serious about their desire to restore the level-playing field within the EU, the Compulsory Harmonised Tax would be the only model worth considering. It would however not be sufficient to apply the same corporate tax base throughout the EU to all corporate taxpayers, but one would need to also harmonise the corporation tax rates as well.
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[55.] The playing field of countries is by nature not level. -- Academic research has evidenced that corporation tax differential do affect corporate location decisions, even though taxes are only one of several factor determining the choice of location: quality of labour and infrastructure, transport links, availability of suppliers, market size, political risk, culture, language, geographical location, and so on, all are factors firms take into account when deciding where to set up their production sites. Hence the concern that corporate capital may flow to the countries offering the lowest effective tax rates and not to the countries where the capital may be most productively invested.
Level playing field
· Countries would be comparable but for taxes · Countries are unequal by definition · New economic geography theory · International trade is driven by the existence of differences & specialisation
Whether the corporation tax needs to be justified on the grounds of the level playing field is however questionable altogether. As Maarten Ellis (Ellis, 1999) put it very accurately when he discussed the Code of Conduct: "Looking at the EC Code of Conduct, one cannot but feel that it constitutes an effort to equalize a playing field that is
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unequal by definition. The principal assumption underlying the Code of Conduct is that but for preferential regimes the competitive tax position of all countries is equal". It would seem to me that it is important for countries to operate different tax systems in order to compensate for different degrees of location advantages. For example, a country far away from the centre of the main market may wish to offset its cost disadvantage by levying lower taxes. Proximity of a large market, qualified labour are factors influencing the tax policy decisions of the governments. External economies of scale anyway lead to the concentration of production in the larger country. Empirical analysis seems to evidence that there exists a relationship between distance and taxes: the larger the distance to the main markets, the lower the taxes in order to compensate for the location disadvantage (Bйnassy-Quйrй and alii, 2000).
The idea of maintaining tax as tools for restoring situations that are uneven is well known even at the EU level itself. It suffices to look at the various EU initiatives that aim at lessening the tax burden of small businesses in order to compensate them for certain structural disadvantages (higher relative cost of tax compliance, difficulties in accessing the financial markets for funding purposes, etc.).
[56.] Markets will disappear if a real level playing field was to be created. -- It is not only incorrect to assume that the playing field would be even within the EU but for tax reasons, but it is precisely the existence of differences between the markets that do make the intra-EU free trade attractive. It is the irregularities in the playing field that facilitate commerce, international trade only existing because of comparative advantages, where one country is better at doing one thing than another. If production costs, which include taxes, were equalised everywhere, free movement would be rendered
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pointless and there would be simply no trade anymore: a level playing field is not the condition for a free trade, but its death pronouncement.
Economists have demonstrated long ago that differences in production costs in two countries, including taxes, do create opportunities for the businesses to change the structure of production in cost savings ways, which in turn raises incomes and living standards in both countries (Ricardo, 1817). Countries gain from trade once they specialise in doing what they are relatively best at. The relevant yardstick for defining this is the concept of "comparative advantage": it will be beneficial for country A and B to trade with each other (country A would produce tomatoes and country B wheat), even if country A has an absolute advantage over country B in producing both tomatoes and wheat, i.e. if country A produces more cheaply than B both goods. A should concentrate on producing tomatoes because its comparative advantage is largest there, i.e. because its opportunity costs is lower when producing tomatoes than wheat. Country B would specialise on producing wheat, where it does relatively better. Under that scenario, country A would export some of its tomatoes to country B in exchange for wheat exported by country B. Total production in the economy of both A and B rises as does the well being of both countries. These benefits however only arise because each country has different production costs and specialises in those productions where it is relatively best. Once the productions costs have been equalised throughout the EU, the very reason for trading within the EU will disappear.
Tax harmonisation by creating a level playing field for firms as regards taxes reduces the existing comparative advantages of the various EU countries and hence potentially reduces international trade
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rather than foster it. More importantly, differences in taxes existing between two countries A and B may explain why country A (with lower taxes) may have an absolute advantage over country B (with higher taxes). That difference however has no impact on the relative prices in country A and B, the comparative advantages however remaining unchanged. Hence differences in taxes do not later the trade amongst nations and should not be viewed as impacting on the functioning of the common market within the EU. Harmonisation of taxes hence is not required within the EU. This may be shown in a simplified example. Let us assume two countries A and B that levy no taxes and that produce both tomatoes and cars. As a result a result of a comparative advantage review, country A has decided to specialise in producing tomatoes and country B in cars, A trading some of its tomatoes with B in exchange for cars. Let us further assume that the terms of the trade are such that 2 units of tomatoes are exchanged for 1 unit of cars. Let us now furthermore assume that country decides to levy a sales tax of 10% on all goods it produces which would increase the sales price of cars and tomatoes in country A by 10% as well. As a result of the difference in taxation existing in countries A and B, the absolute advantage of country B over country A may have increased, but the relative prices for the tomatoes and cars remains unchanged. There is no difference between climate reasons and specific qualifications of the workforce that lead to countries A and B to specialise in tomatoes and cars and financial, legal including tax law differences that may exists in the two countries to which the firms have to adapt and adjust: climate differences may never be harmonised, differences in the skills of workforces could eventually, though only with greats costs; tax differences could be easily eliminated through harmonisation. But since none of these
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differences limit international trade, none require harmonisation; especially, harmonisation of tax systems does not need to take place on the grounds of tax laws, contrary to climate conditions, possibly could getting harmonised.
Chapter 3. Existing tools for fighting harmful tax competition Governments and the EU policy makers are not dependent upon corporation tax harmonisation to take place for protecting their legitimate interests. Most governments, especially those that are capital exporting, dispose of powerful weapons for combating international tax avoidance. Originally based on the US Sub-Part F, the existing CFC rules however are problematic from an EU tax law point of view (§ 1). The EU Commission furthermore may take actions against governments for illegal tax subsidies on the grounds of the State Aid provisions under the EU Treaty (§ 2).
§ 1. The isolationist" approach of most EU Member States: CFC legislation [57.] CFC legislation. -- Governments, while pressing for harmonisation of tax systems in the EU, have tried in the meanwhile to tackle the challenge of globalisation in a different way: through the creation of CFC legislation aiming at rendering the use of low tax jurisdictions by resident corporations without any practical effect in the country of residence of the parent company. This is typically done either through deemed distribution rules or deemed attribution rules. The deemed distribution rules accept the existence of the foreign company; they fight the retaining of profits in the foreign low taxed country through a deemed dividend distribution rule (e.g.: Germany). As a result, the tax deferral, which normally would have existed, no
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longer, is possible. The deemed allocation rules take this process one step further by disregarding the foreign low taxed company and directly attributing all of its income to the controlling parent (e.g.: Italy). The CFC legislation usually only applies to holdings in foreign companies and hence constitutes a forbidden restriction of either the freedom of establishment or the free capital movement. The compatibility of this "isolationist" approach to global tax issues under EU law is not obvious (in detail Lang, 2002).
[58.] Abuse of law justification. -- Almost every tax system knows the abuse of law or fraus legis concept, at times under statutes and at times as a general principle of tax law. The purpose and effect of the abuse of law concept is to deny tax benefits to taxpayers they would normally be entitled to, because the transaction had solely been entered into with a view to obtain tax benefits, whilst leaving unchanged the economics of the transaction. The abuse of law may be committed domestically and would often be, but may also comprise international aspects such as the setting up of sham companies in low tax countries. The abuse of law would consist in this context in the avoiding of domestic tax though the use of a foreign company to which most of the income would be shifted to, whilst the foreign company would do very little itself to justify the income allocation. For instance, a low tax company set up in the offices of an accounting firm and run by two local attorneys can hardly be seen to be integrated in the economy of low tax country, and it may be safely assumed that most if not all of the profits of low tax company are in fact entirely attributable to its parent established in high tax country. The use of CFC legislation on the grounds of the fighting of abuse of law situations appears at first sight rather compelling.
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However, anti-avoidance concerns, if they may be legitimate and justify certain actions of the level of the Member States legislation, are however also subject to constraints, as the ECJ has shown in the Leur Bloem case (ECJ 17-7-1997, Leur-Bloem, C-28/95). The question put to its attention was whether the benefits of the merger directive could be denied to a group reorganisation on the grounds of abuse of law considerations. The language of the directive itself provided for the possibility for the Member States to deny the tax advantages provided for by the merger directive if the merger has as principal objective or as one of the principal objectives tax evasion or tax avoidance. The ECJ did however point out that if Member States may stipulate the fact that the merger was not carried out for valid commercial reasons to constitute a presumption of tax evasion or tax avoidance, the competent national authorities may however not confine themselves to applying predetermined general criteria. They rather must subject each particular case to a general examination whilst observing the principle of proportionality. Therefore, the laying down of a general rule automatically excluding certain categories of operations from the tax advantage, whether or not there is actually tax evasion or tax avoidance, has been considered by the ECJ to go further than is necessary for preventing such tax evasion or tax avoidance and would undermine the aim pursued by the Directive. This would also be the case if a rule of this kind were to be made subject to the mere possibility of the grant of a derogation, at the discretion of the administrative authority.
In essence, the ECJ considers that anti-avoidance provisions must be tailor-made and be limited to those situations that actually constitute tax avoidance. Specifically, anti-tax provisions may never be drafted in such a way so as to lead to irrefutable assumption of tax
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avoidance. This is however precisely what CFC provisions do, since they set forth the situations under which foreign companies are in any case disregarded. General anti-avoidance provisions are unlikely to stand the scrutiny of the ECJ and hence may not serve as a justification for CFC legislation.
[59.] Low taxation of foreign company as a justification for CFC legislation. -- Rather than basing CFC legislation on abuse of law considerations it could be held that it merely aims at ensuring that all of the income of the resident taxpayers, including the income derived from abroad, are subject to appropriate levels of taxation. The domestic tax burden being naturally the benchmark here, CFC legislation may be considered to aim at ensuring that low tax companies pay income tax equivalent to what would be due if they were a resident of high tax country. Put differently, the advantage for a taxpayer to benefit from low taxation abroad would be offset with the disadvantage to suffer additional taxation in high tax country. Such an offsetting of benefits and disadvantages is however unacceptable under EU law, as the ECJ already indicated in its very first direct tax case (ECJ 28.1.1986, Avoir fiscal, 270/83). It has been confirmed again in a case involving interest/rental payments made by a German company to a low taxed Irish company: there too the ECJ did not accept the low taxation of the Irish company as a valid justification for disallowing the deductibility of the payments made to it by the German company (ECJ 26.10.1999, Eurowings, 249/97). In my opinion, the ECJ would make the same point as regards CFC legislation if it aims at counteracting the low taxation in the other Member State with an additional levy in the high tax Member State.
[60.] Taxation of worldwide income as a justification for CFC legislation. -- Most countries that have CFC legislation also adhere
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to the worldwide income taxation principle. Hence it could be argued for CFC legislation to be necessary in order to secure that principle (Schцn, 2002), since taxpayers would be able, absent any CFC rules, to permanently shield the income from taxation in the home country. In that case, however, the home country would need to apply that principle in a consistent manner throughout its dealings with international tax aspects of its businesses. Logically, this implies that the home country should retain the imputation system both as regards foreign permanent establishments and foreign dividend payments, i.e. follow the CEN model (see [27.]). On the contrary, Continental European countries all follow the exemption method both for foreign permanent establishments and subsidiaries. Also, this would require those countries to apply the legislation to any foreign operations, irrespective of the nature of the income generated abroad and the level of taxation suffered abroad. However, when looking at the CFC legislation of the various Member States it is striking to notice that the CFC rules usually only quick in if the foreign income is "passive" (interest, dividends, royalties, etc.) and the foreign tax system a low tax country. It therefore seems inconsistent to justify CFC rules as they presently stand on the basis of the desire to tax worldwide income.
I am not saying here that the worldwide taxation principle would in any case not be appropriate. The residence principle of taxation is one of the two possible systems for assessing the ability to pay, the other one being the source principle. Nor is the worldwide taxation principle a necessary consequence of the ability to pay principle. All the ability to pay principle means is that the taxpayers must eventually accept all of his income, both domestic and foreign, to be subject to tax. It does not indicate however how the taxing rights
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for the income should be divided in between the residence and the source country (Mцssner, 2000).
In fact, CFC rules are antithetical to the free flow of trade and commerce those countries seem to be so concerned about, as is any type of discriminatory treatment of foreign investments.
§ 2. The global approach under the form of the State Aid rules [61.] State Aid Provisions in EC Treaty. Under article 87, paragraph 1 of the EC Treaty, Member States are prohibited from granting aid through state resources in any form to favour certain companies or sectors if the aid threatens to distort competition or trade between member states. Four conditions must be cumulatively met for a measure to constitute incompatible state aid: · the measure must confer a benefit; · the benefit must be granted by the state or through state resources; · the benefit must be selective, in that it favours certain companies or productions; and · it must distort or threaten to distort competition or trade between member states. Measures that may constitute state aid fall under a system of prior European Commission authorization, subject to review only by the European Court of Justice. Aid measures may not be put into effect until the European Commission has approved them. The European Commission may demand the recovery of any unlawful aid from the recipient companies over the past 10 years, including
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interest, unless that would be contrary to a general principle of Community law, in particular the principle of legitimate expectations.
[62.] Toughening of the Commission's policy. In the past, the European Commission has been lenient toward preferential tax regimes such as the Irish Corporation Tax (ICT) regime and the Belgian Coordination Centre regime. The Commission's accommodating attitude ended with the adoption on 1 December 1997 of the EU Code of Conduct for Business Taxation. On that occasion, the European Commission made a commitment to clarify the application of state aid rules in the field of business taxation. Moreover, it announced that it would review all tax regimes that fell within the scope of the EU Code of Conduct for Business Taxation.
On 11 November 1998, the European Commission issued the Notice on the Application of State Aid Rules in the Field of Business Taxation. The notice implied a departure from the European Commission's previous policy regarding fiscal aid. With the publication of the notice, it was clear that the European Commission had taken a stricter approach to State Aid in taxes and that certain tax regimes no longer were considered EU compliant. The notice introduced a new range of criteria that could render a tax measure selective, therefore constituting state aid, such as the fact that a tax benefit was limited to certain services carried out in a group of companies or the fact that a tax benefit was limited to non-resident companies. The list of criteria in the notice was not meant to be exhaustive. Soon after publication of the notice, the European Commission started preliminary state aid investigations into tax regimes that were on the list of the Primarolo group. As it became clear in spring 2001 that Member States were reluctant to comply
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with the timeline adopted unanimously a few months before, Monti resumed the State Aid investigations.
On 11 July 2001, Monti initiated formal state aid proceedings regarding 15 tax regimes that previously had been found harmful under the EU Code of Conduct. In the 11 July 2001 release announcing the launch of large-scale state aid investigations into harmful tax measures, Monti linked the launch of state aid investigations to the EU Code of Conduct for Business Taxation, declaring that "the current launch of investigations is the beginning of a longer-term exercise that will ensure that no tax measures in the EU are being used to support companies in a way that is incompatible with the single market." Monti, therefore, can be expected to launch new state aid investigations if member states are reluctant to roll back their harmful tax measures under the provisions of the EU Code of Conduct. All (and not only some as the European Parliament once thought, 2000, p. 10) regimes that fall within the scope of the EU Code of Conduct for Business Taxation are therefore susceptible to a state aid investigation. That includes all 66 regimes included on the Primarolo list of harmful tax measures that was issued 23 November 1999.
Furthermore, all tax regimes that fall within the guidelines for the rollback of finance branches, holding companies, and headquarter companies are susceptible to a state aid investigation. Since the EU Treaty contains self-sufficient provisions enabling the Commission to fight "harmful" tax measures, I do not see the need for any additional actions aiming at the harmonisation of corporation taxes.
[63.] Are State-Aids bad for the consumers?. The State Aid provisions, as well as the unfair-competition argument, are based on
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the common theory that free trade is desirable only if all countries play by the same rules. If firms in different countries are subject to different laws and regulations, then it is unfair (the argument goes) to expect the firms to compete in the international market place. For instance, suppose that the government of the Netherlands subsidizes its tulip industry by giving tulip producers large tax breaks. The other EU countries might argue that they should get protected from the Dutch tulip producers because the Netherlands is not competing fairly.
Would it, in fact, hurt the other EU countries to buy tulips at a subsidized price? Certainly the tulip producers would suffer, but their consumers would benefit from the low price. The Dutch subsidy to its tulip producers may be a bad policy, but it is the taxpayers of the Netherlands who bear the burden. The other EU countries can benefit from the opportunity to buy tulips at a subsidized price.
Chapter 4. The administrative burden argument [64.] 15 different tax systems increase the administrative burden for companies. In April 2002 the EU Commission held a seminar to which it also conveyed representatives from multinationals, in order to present its tax policy for the next decade. The main reason put forward by the Commission for considering harmonising corporation tax was the administrative burden and inefficiencies the filing of 15 different tax forms in 15 different countries would create. When being asked to comment this issue, the representatives of the multinationals did seem to confirm the headache of filling out tax forms. The administrative burden of filing 15 different tax forms is part of the inefficiency. This burden includes not only the time spent filling out the forms and the time spent throughout the year keeping
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records for tax purposes and the resources the governments have to use to enforce the tax laws. This deadweight loss exists in any country but certainly is enhanced if a multinational operates in the 15 Member States. There therefore seems to exist a strong case for harmonising corporation taxes on the grounds of reducing the administrative burden for companies.
[65.] This is not a good enough reason for harmonising. There is nothing new in the argument of tax compliance creating substantial administrative burden on the taxpayers: taxpayers do not only lose the amount paid as taxes but also the time and money spent documenting, computing and avoiding taxes. The obvious answer to this issue seems to be that the administrative burden of the tax system could be greatly reduced by simplifying the tax laws. Yet simplification at a domestic level is often politically very difficult. Most people are ready to simplify the tax code by eliminating loopholes that benefit to others, yet few are eager to give up the loopholes that they use. In the end, the complexity of the tax results from the political process as various taxpayers with their own special interests lobby for their causes. This situation is not unique to the U.S. where the Jimmy Carter once called the tax code "a disgrace to the human race" but exists in many countries, especially the larger ones. Comparative tax law gives sufficient evidence of the fact that the larger the country is, the more complex its tax code will be. Tax laws being complex and administratively burdensome domestically, it is hardly surprising that the same complexity and inefficiency exists internationally. As long as the individual EU countries do not simplify their tax codes domestically, there seems little reason to force an international simplification of tax laws. In order to be eventually justified, the costbenefit analysis of harmonisation of corporation taxation should
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undisputedly show that the benefits (reduction of tax compliance costs) clearly and substantially outweigh the costs (loss of fiscal sovereignty) of tax harmonisation.
Part IV. Specific issues of savings tax harmonisation [66.] Introduction. Modern tax systems were developed when countries' economies were relatively closed. At that time most of the incomes received were domestic and capital income taxation could be ensured. The increasing globalisation of economic activities has rendered capital income taxation an impossible task, capital having moved to countries where tight bank secrecy laws and no capital income taxation existed. The political agreement that was reached at Feira (chapter 1) is meant to restore capital income taxation within the EU. For such a proposal to make sense, several conditions precedent need to be respected which presently is not the case (chapter 3). More importantly, the business case for harmonising income from capital taxation appears to be rather weak (chapter 2).
Chapter 1. The Feira agreement and the subsequent draft savings directive I will first summarise the main conclusions of the "Feira agreement" (§ 1) before discussing its usefulness (§ 2).
§ 1. The contents of the Feira agreement [67.] The deadlock has been broken in the harmonization of savings taxation. The Feira European Council reached a historic agreement on the taxation of savings and maintained momentum in the tax package, initially agreed in December 1997. The Member States agreed to information exchange as the ultimate objective of the
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EU's tax policy, but provided a sunset clause until 2009 for those states that apply withholding taxation today. It implies that the concept of a "community resident" is accepted, meaning that a EU resident is to be taxed wherever he lives in the EU. The implications of this agreement will not only be limited to the taxation of savings. The discussions on the "Code of Conduct" and the interest and royalties directive will now be unblocked. The principle of information exchange will also spill over into other areas of taxation.
[68.] Co-existence model. The first draft of the savings taxation directive was based on the co-existence model, meaning that interest income would be taxed at source by the paying agent or else information about interest income would be passed on to the home country tax authorities. As such, bank secrecy could be kept intact. This proposal did however run into problems with the British government, which feared the negative impact of such a withholding tax on the Eurobond market in the City. Initially, the British government therefore opposed the draft directive, but later, they proposed as an alternative that the directive be fully based on the exchange of information between tax authorities.
[69.] An attack on bank secrecy laws. The Feira agreement was too rapidly dismissed by the press as superficial and full of loopholes, given the length of the transition period and the numerous caveats. However, this dossier has been on the Council's table for more than 10 years; an agreement has now been struck, and it is based on the exchange of information. Moreover, the compromise was agreed unanimously. Austria and Luxembourg are given sufficient time to remove their banking secrecy practices, and will be under strong pressure if they do not begin to take such measures in due course. The decision is also consistent with the policies adopted by other
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bodies, notably the OECD, which has just released a report on the progress in identifying and eliminating harmful tax practices and, through the FATF (Financial Action Task Force on money laundering), identified a number of banking secrecy havens. Plus, following the release of the OECD's Banking Secrecy report earlier this year, Austria had already agreed to modify its banking secrecy laws. Thus, pressure is increasing from several directions, making it difficult for EU member states not to follow suit.
[70.] Calendar for the harmonization. The Council agreement sets a calendar for the introduction of information exchange as a replacement for the withholding tax on savings of non-resident EU citizens:
· by the end of the year 2000, the Council and the Commission commit themselves to seeking agreement on the substantial content of the Directive, including on the rate of the withholding tax. Although some delay has been suffered in that respect, a draft directive on savings taxation has been agreed upon by June 2001;
· As soon as an agreement is reached on these matters, the Presidency and the Commission shall enter into discussions with the US and key third countries (Switzerland, Liechtenstein, Monaco, Andorra, San Marino) to promote the adoption of equivalent measures in those countries; at the same time the Member States concerned commit themselves to promote the adoption of the same measures in all relevant dependent or associated territories (the Channel Islands, Isle of Man, and the dependent or associated territories in the Caribbean). Here, too, considerable delays have been encountered since the discussions have just about started with the various territories; especially
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Switzerland seems to be adamant about keeping its bank secrecy rules, though being agreeable on the levying of a withholding tax on interest on behalf of the EU.
· the directive shall be adopted by unanimity, no later than 31 December 2002, once the Council has obtained sufficient guarantees on these measures being also implemented in dependent territories (Channel Islands, etc.) and certain third countries such as Switzerland. The chances for seeing the directive adopted by then are at the best remote, in view of the little progress that has been made with the third countries and associated territories.
[71.] Sunset clause. All member states agreed to implement the exchange of information no later than 7 years after the adoption of the directive, thus in 2009, and a large group is committed to implement it by 2007. By stating clearly that no derogation from the exchange of information shall be granted in the enlargement negotiations with the accession candidates, the Council has guaranteed that the future UE member states cannot develop as tax havens, while at the same time providing for a strong incentive for the EU countries to have the directive in place before accession starts.
§ 2. Information exchange only or return to the dual system? [72.] Reasons justifying the return to the dual system. The reasons as to why the initially suggested dual system (information exchange or withholding tax) has been abandoned under the draft savings taxation directive are not obvious to me: · The withholding tax system, whether as a final tax settlement or as an advance payment against the income tax liability of the
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beneficiary of the income, is practised in more Member States than the exchange of information system.
· When looking, under a comparative law approach, at the tax systems as applicable to capital income taxation, it is noticeable that an increasing number of countries (Nordic, Eastern Europe, but also the Netherlands) have implemented a dual income tax system aiming at taxing earned and unearned income at different rates. A EU wide withholding tax would be in line with this trend.
· The implementation of the information exchange system will create identification and localisation issues as regards the beneficiary of the income (as indicated in this group's general comments) that do not exist under a withholding tax model, which thus is much easier to administer.
· The parallel existence of the information exchange system (after the transitory period) within the EU and a withholding tax regime in certain Third Country States such as Switzerland will not achieve the level-playing field the EU Commission appears to be so concerned about. Irrespective of the semantics ("identical" measures are not necessarily "corresponding" measures") used in the Feira compromise positioning paper, it should be clear that the level playing field will only exist in respect to non-EU countries if the latter adopt the same principles as EU countries as regards taxation of savings: hence, if EU member States have to comply with the information exchange system, so should non-EU countries.
[73.] Attack on privacy under the information exchange system. A withholding tax, unlike the information exchange system, does not create any constitutional issues regarding the respecting of the
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citizen's privacy by the respective Member State. Clearly, if the contents and positioning of the right to privacy within the juridical system may vary in each Member State, it nevertheless does exist in all Member States. Historically, financial privacy has been seen as an essential safeguard of the citizen against the power of dictatorship. Even if the worry about government oppression may not be that relevant any more, privacy still remains an important value to the European culture: the financial "glasnost" that would result from the information exchange is fundamentally against the European mentality. But bank secrecy laws do not only protect (financial) privacy. Even the OECD admits that they also provide systematic benefits to the financial system as a whole: "Customers would be unlikely to entrust confidentiality of their dealings with banks if the confidentiality of their dealings with the banks could not be ensured" (OECD, ·, p. 19). Financial privacy also makes it harder for criminals to select victims.
Chapter 2. Reasons that are just not good enough The harmonisation advocates like to stress that harmonisation of capital income taxation alone may eliminate tax evasion (§ 1) and restore neutrality as regards investments decisions (§ 2). They also like to think that tax harmonisation of capital income is necessary in order to ensure the freedom of capital movements (§ 3).
§ 1. Tax evasion [74.] International tax evasion. Tax evasion consists for the taxpayer in not suffering his fair share of burden as regards the financing of the public bodies through illegal means. The tax evasion leads to a tax system where taxation is levied according to relative
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possibilities for the taxpayers to evade taxes rather than their ability to pay. Viewed by many as being the Achilles heel of any tax system one has to admit though that tax evasion is to the taxpayer what the shadow is to man: an idea he quickly gets addicted to and which accompanies him until death.
Tax evasion not only exists domestically, the integrating world rather constitutes a strong stimulus to it. The liberalisation of the financial markets since 1990 has increased the incentive for the taxpayers to take their savings out of the country, in order to place them in one of those tax-free accounts for "non residents" that seem to be so widely available, or in a tax haven country with tight bank secrecy laws and no withholding tax on income from deposits. Absent any harmonisation at a EU wide level it would seem that the only way for the Member States to prevent large capital outflows, towards tax havens, consists in lowering the effective tax rate on financial savings. This has actually been done in some countries by lowering withholding taxes, in other countries by creating tax-exempt opportunities to their taxpayers, or even by simply adopting a relatively lax enforcement. Since no Member State may apparently by itself, through the taking of appropriate actions, efficiently combat tax evasion on cross-border portfolio income, the case for action at Community level seems to be very strong.
[75.] Impact on savings. Albeit tax evasion as regards income from savings should be fought on the grounds of justice, that principle does not stand alone when deciding upon tax policies: justice considerations have to be set against efficiency aspects of the proposed legislation, in what has been once called "a big trade-off" (Okun, 1975). Research has shown that, even in an perfectly informed and well-intentioned world, the removing of the possibility of capital
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flight would enhance the ability to tax accumulated capital and so might lead to the expectation of capital levies. This fear of future "punitive" tax measures, even if any government did not intend them, would negatively affect current savings decisions (Kehoe, 1989).
[76.] Inflation. One of the primary reasons for tax evasion on income from savings, and eventually a morally acceptable justification for it, is the impact of inflation on the taxation of financial capital. In the 1970s, inflation was a major issue in the western economies; although the inflation rates are low nowadays in comparison to those times, the issue remains in place, though to a lesser degree: taxation being levied in all EU countries on the nominal interest income, the effective marginal tax rate which is obtained by dividing the tax payable by the real interest income (i.e., the nominal interest net of inflation) may easily exceed 100%. In this case the income tax becomes a capital tax. As a consequence, there will be a great incentive for the taxpayers to invest their savings abroad in tax-free accounts. This is often the only way the taxpayers may avoid spoliation. Hence, a reduction of tax rates levied on income from savings in high tax countries should not only be seen as a concession for keeping the capital domestically but also as a necessary measure for taking account of inflation and hence fully justified on the grounds of justice in taxation.
§ 2. Neutrality of tax laws as regards investment decisions [77.] Who said that (income) tax was neutral? -- One of the main reasons for harmonising savings taxation is the attempt to raise economic efficiency by securing equal tax treatment of foreign-source and domestic-source income from savings. The present system would offer incentives to the citizen's to invest their monies abroad, even if it
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would make more sense for them from an economic point of view to eventually invest domestically. This raises the question as to whether the efforts to harmonise the taxation of savings be justified on the grounds of neutrality? Harmonisation could be based on the fact that all forms of savings would suffer taxation except for the interest on savings, as a result of the investment being made in tax heavens. This would obviously require the various existing tax systems of the EU member states to be based on a comprehensive income tax conception, a la Schanz, Haigh and Simons, usually referred to as the S-H-S concept of income. Under the S-H-S concept of income, all forms of income would be taxed equally, whether earned or unearned, whether in cash or in kind, whether actually perceived or imputed (e.g. the rental income of owner-occupied houses). Obviously, that concept of income does include in the tax base dividends and interest, as well as capital gains, both realised accrued. There is no point however in implementing a harmonised tax system for income from private capital savings, if the capital income taxation remains full of unjustified distortions, as it is the case presently in most of the EU member States. Rather than taking measures to combat the evasion of a specific form of capital income, the Member States of the EU ought to concentrate their efforts on improving their respective tax systems. That would be a formidable task, since the distortions in the present tax system as relating to capital income are manifold.
· the corporation tax would need to be fully integrated with the shareholder's income tax, especially in case of cross-border shareholdings. Such an integration of corporate and individual income taxes presently does not really exist.
· foreign income should be taxed in full, with a credit for foreign tax suffered. However, presently all countries impose a limitation on
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foreign tax credits, which is usually equal to the domestic tax rate applied to the foreign-source net income, the withholding tax however being levied on the gross income.
· in all EU member states, arbitraging possibilities exist which enable the taxpayer to transform heavily taxed interest income into taxexempt capital gains (e.g. purchase of money market investment funds).
· capital gains other than short term, speculative ones, are typically outside the scope of the income tax law.
· capital income tax is levied on the nominal interest, though the tax base under the S-H-S concept of income requires adjustment for inflation.
· the interest accumulation arising in life insurance contracts as well as in private and public pension plans remain out of consideration in almost all the Member States;
· most EU countries favour house ownership through the creation of tax preferences: the imputed rental income is not taxed; capital gains are not taxed and mortgage interest often are partly at least deductible.
[78.] Neutrality should be restored domestically first. One may hence wonder whether one should not start cleaning the Augean stables before harmonising EU capital income taxation. Enforcing throughout the EU taxation of interest income only is not meaningful, if on the other side the tax systems of the various Member States are characterised by an uncoordinated existence of many direct and indirect individual levies. Harmonisation of interest income taxation only makes sense in the context of a harmonised tax structure based on the S-H-S concept of income. To put it bluntly: if a tax is not
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neutral, it remains not neutral even if it is generalised and has been harmonised. Taxes never are neutral (Bradford, 1986, p. 174): even uniform consumption taxes or wage taxes, as well as comprehensive income taxation, cause distortions, since they favour leisure over consumption. The only tax system that would be neutral is the lumpsum tax payment a la Pigou (Pigou, 1962). The disastrous experience suffered by "Iron Lady" when implementing that taxation method locally in the United Kingdom (the "domestic rates", a local lum-sum tax) is a sufficient example of the practical limitations of the neutrality principle in taxation. Hence one may rightly ask the question as to whether income from capital should be taxed at all (see on this question Gravelle, 1994)?
[79.] Funding of future retirement. -- Favourable tax treatment of pension plans, both voluntary and mandatory, is widespread in the EU. The reasons for the encouragement of long-term private savings are well known and often have something to do with the severe ageing of the EU population. Tax policies geared towards encouraging pension savings are a useful means to smooth the transition from pay-as-yougo financing to pre-funding. As we have seen in our Lisbon meeting of last year, most countries favour the EET tax system for private pensions characterised by the granting of tax allowances for private pension contributions and the exempting of the returns on fund assets, taxation only occurring, often at relatively light levels, at the end, when the benefits are paid out (EET stands for: initial saving Exempt, the return on assets Exempt and benefits Taxed). The pension plans aim at setting funds aside for future consumption, upon retirement. This is no different to the interest on savings, which equally is the compensation for the renunciation by the taxpayer to immediately consume his income. In both circumstances the taxpayer
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wants to set aside funds for future consumption. Therefore, it should make little difference to the governments as to whether the taxpayers do not legally pay tax as a result of their investments in pension funds or illegally avoid taxes through offshore bank deposits.
§ 3. Freedom of capital movements [80.] Low tax countries do not restrain the freedom of capital movements. The question of the competence of the EU to harmonise capital income tax is arguable not existing: absent the EU Treaty being driven by the principle of competence by attribution, any authority to achieve harmonisation of direct taxes and harmonisation of capital income taxation is legitimate only if based on either express or implicit provisions of the Treaty. In the absence of any explicit provision under the Treaty, the directive may only be justified on the basis of the freedom of capital movement. The question is whether the maintaining of (a) low-tax jurisdiction(s) within the EU does affect the free movement of capital. Taking the example of the German withholding tax experience, the answer appears to be a clear and simple yes: the mere announcement by the German Government, back in October 1987, of the future implementation of a 10% withholding led to immediate massive capital movements mainly benefiting to Luxembourg banks. Since the economic conditions of Luxembourg and the manner to run banks hardly had changed over night, one has to assume that the reason for the sudden attractiveness of Luxembourg was exclusively a tax one. Has therefore the freedom of capital movement been affected? I do not think so. The main purpose of the freedom of capital movement is to combat restrictions imposed by the various member
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states upon investments made by their residents in other member states. The logic of the EU Treaty, just like the General Agreement on Tariffs and Trades (GATT) has been inspired by mainstream economic liberalism: capital ought to be invested wherever it yields most. In today's sophisticated financial markets, we believe the above still is true, even in presence of intra-EU low-tax jurisdictions. Luxembourg banks collect the savings of German taxpayers whilst offering the financial instruments as would German banks. The Luxembourg banks themselves will invest the German savings wherever appropriate, possibly back in Germany. The temporary "visit" to Luxembourg does not prevent the German savings to be invested in those assets that offer the most attractive rates of return. In fact, if in the past a link existed between the savings of a given country and the investment made in that country, the EU of today is rather characterised by a situation whereby the total savings of the residents of the EU finance investment projects in the EU, without regard to their exact localisation. The case for harmonisation the capital income taxation on the grounds of the freedom of capital movement therefore appears to be rather weak.
Chapter 3. Erroneous assumptions Capital income taxation only makes sense under a S-H-S income concept. Country reviews do show however that the S-H-S tends to be abandoned in favour of expenditure taxation (§ 1). Also, the idea of creating "Fortress Europe" which capital would no be able to flee from appears not to be terribly realistic (§ 2).
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§ 1. Harmonisation only under the Schanz-Haig-Simons concept of income
Policies aiming at ensuring that income from savings of private households actually are taxed imply that a comprehensive income tax model rather a consumption based tax system has been adopted as the appropriate model of the European Union. However, the question of whether and to what extent capital income should be taxed at all is one of the most controversial issues in taxation. The theoretical solutions for the treatment of capital income depend upon the benchmark used: the comprehensive income tax or the expenditure tax. Following other scholars (Krause-Junk, 1999), case of capital income tax harmonisation solely rests upon the desire not to dissolve the comprehensive income tax system. This however requires the comprehensive income tax system to actually exist within most of the EU countries. [81.] Merits of expenditure taxation. The expenditure tax can be traced back to John Stuart Mill; Mill argued that taxation of interest income would lead to a double taxation of savings, since the interest income usually stems from income that has already been taxed. Though this argument does not appear to be convincing, since the interest income is an incremental income not taxed before, Mill's comments nevertheless bear a certain element of truth: taxing interest income makes saving for the future more expensive relative to the current consumption, hence less attractive. According to a growing member of economists (Wenger, Wagner, Rose) and even of lawyers (Joachim Lang, 1991, 1999), the taxation of interest income may lead to an intertemporal misallocation of economic resources: less capital formation, more consumption and a weakening of economic growth.
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An expenditure tax leaves the present value of tax unaffected by when the spending takes place. This is not true of a comprehensive income tax. Since returns to saving are taxed, someone who consumes early in life will pay lower tax in present value terms than someone who consumes late in life. There are no obvious reasons why this should be the case, and so this argument favours the expenditure tax.
Expenditure taxation may also be justified on the grounds of fairness, since in present value terms, the consumption of a household is equal to its lifetime earnings. The implication of this is that interest on savings is only the price at which current consumption is sacrificed for future consumption. Hence, the income tax, by taxing the interest from savings, taxes more highly future consumption than current consumption. Thus, it may be argued from a fairness point of view that capital income should not be taxed at all.
[82.] No need to harmonise capital income taxation in an expenditure tax system. Since the expenditure tax is levied on the sole consumption of the taxpayer, it does completely exempt his savings from tax. Under the expenditure tax system, there is no room for a capital savings taxation directive, since the income from capital savings anyway is not taxable. This may be achieved either though an indirect tax on consumer goods or alternatively as a direct tax on the income net of savings.
In any case the expenditure tax solves the problem of tax evasion: in such a case, it would not matter whether savings were invested in the country of residence or abroad. More importantly, there would exist a strong incentive for the taxpayer to declare the savings that are invested abroad, since the income saved reduces the tax basis of the expenditure tax.
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[83.] Expenditure tax as a solution for the ageing of the EU population. Assume for a second that one or several EU member states would follow the recommendations of Lord Nicholas Kaldor as implemented for a short while by Sri Lanka and more recently by Croatia, by switching over to an expenditure tax system. Such an attitude may be particularly justified due to the growing difficulties with which the old age social security scheme is faced in the long term in the EU as a result of demographic trends. It may seem appropriate to some EU member states to promote private saving by exempting its income and in this way facilitate private saving for old age as a supplement to the public pension offered by the state. Under that scenario one may wonder on what grounds certain countries should get forced to either levy a withholding tax on interest income or to proceed to an information exchange which is not compatible with their own tax system. The shift towards consumption taxes which has occurred in Japan is a perfect example of a policy which might serve as an example for the future EU tax policy: just like the EU, Japan needs to prepare for population ageing; and the greater reliance on consumption taxes in Japan is to be seen as the attempt to stimulate national savings for future retirement of the citizens of Japan.
[84.] First steps towards an expenditure tax: the Nordic dual income approach and the Dutch "box" approach. -- One way to gradually implement the expenditure based taxation system is the dual income approach adopted in most Nordic Countries: Denmark introduced a dual income tax system in 1987; followed by Sweden in 1991, Norway in 1992 and Finland in 1993. The essential feature of the dual income tax system is to tax capital income at relatively low flat rate, while taxing earned income (wages, salaries, transfers) under a progressive tax rate schedule (Mutйn, 1996). Other countries (e.g.
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France, Italy, Spain) are moving in the same direction by adopting a separate capital income tax. The tax rate for capital income in an ideal situation is set at the corporation tax rate and to the lower rate of the progressive income tax on wages. The aim of the dual income tax being to tax capital income, though only once, corporation tax may be used as a tax credit for personal income taxation. The dual income tax clearly achieves a high degree of tax neutrality.
The Netherlands has also introduced in 2001 a system that resembles a dual income system (the so-called "box approach"). Since 2001, income is classified in the Netherlands into one of the three boxes depending upon how it was generated: income from labour; income from substantial business interest; and imputed income from wealth. The first component is taxed according to a progressive rate schedule while the other two are taxed at a flat, though different, rate.
§ 2. Ring fencing the EU [85.] The impossible dream. Another point that can be made against a future harmonisation of the capital income taxation within the EU is the impossibility to ring fence the EU from the rest of the world. The German experience of the late 80s and early 90s has proven that taxpayers show a great reluctance to suffering taxation on their capital income: when Germany introduced its withholding tax, the capital flew abroad (Luxembourg, Switzerland). If a European-wide withholding tax would be introduced, the Luxembourg "route" would no longer be available. This does not mean however that Germany would see its revenue rise in respect to capital income taxation. The financial markets of today are sophisticated, banks operating on a truly worldwide scale. Hoping to be able to ring fence the EU from the rest of the world in a global economy able to swiftly operate capital
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movements wherever, whenever, would soon appear to be chasing the Kingdom of Nirvana. By the time the harmonisation would actually be implemented in the various EU Members States, the savings of the EU taxpayers would already have disappeared in off-shore trusts, special purpose vehicles, anonymous bank accounts, and so forth. Undoubtedly, the banks would help in that process, if only for the mere reasons of protecting their client base. At the best, an intra-EU uniform withholding tax on interest would be effective against small and unsophisticated investors. Assuming this to be true (we even doubt that), that alone should be a sufficient reason for not introducing the common withholding tax, since all it would lead to is a further distortion of the vertical equity, larger and more sophisticated investors having a greater ability-to-pay still being able to circumvent the withholding tax which would fall on the sole shoulder of the small, unsophisticated taxpayers.
Since there are no gains to be expected from tax harmonisation among competing countries that constitute just a fraction of the world economy, the idea of a common withholding tax or information exchange would need to be adhered to by the rest of the world, too, or at least by the most important financial centres and tax haven. Obviously, it would be not sufficient for these purposes if Switzerland were to join the bandwagon of the EU harmonisation process.
[86.] Efficiency considerations. The above comments should make it clear that there exists a trade-off between justice and efficiency as regards capital income taxation in the EU: justice may require the introduction of a common withholding tax or the information exchange; efficiency considerations however lead me to believe that a common tax system limited to the EU or even the OCDE member states may not yield sufficiently in the end of the day. The
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Code of Conduct itself, when drawing the difficult line of harmful and non harmful tax measures has been sensitive to this issue, by clearing certain special tax measures for mobile activities such a s shipping. In an open economy such as today's it may be perfectly sensible to tax highly mobile activities less heavily than immobile activities.
Conclusion · Harmonisation means « higher » ­ Governemntal approach ­ Taxpayer's approach · Competitive pressure on public spending · State Aid rules are sufficient in corporation tax · De facto exemption should be replaced by de jure exem ption for capital income [87.] The wrong perspective. Tax harmonisation has a fundamental flaw in its conception: it formulates the economic and social integrating of countries purely from a government's perspective: how to maximise tax revenue when economies integrate. The obvious and better alternative would be to formulate it from the citizen's perspective: as a safeguard against punitive taxation. Tax competition
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has another advantage: it informs governments on the quality of their fiscal policy, whether they are over-taxing people in their jurisdiction or not, whether they offer the right level of public services or not. Tax harmonisation is a threat to the Anglo-Saxon love of human nature, competition and spontaneous order as so admirably presented by Friedrich von Hayek to replace those values by the French taste for the "jardins а la franзaise". In my opinion, harmonisation does not eliminate chaos; at the best it harmonises it.
The difficulty of tax competition at the EU level is that it is always identified in totally negative terms: it "erodes" the tax base, it constitutes a "beggar-thy neighbour policy" or is "undermining" governments. Tax competition would be bad because it would "steal" foreign governments' tax bases. Tax competition however has many merits, the most important one being that it forces governments to respond to economic needs through competitive pressure on public spending. Tax competition should be celebrated, not persecuted. It forces politicians to be more responsible, pushing tax rates down and allowing people to enjoy more of the money they earn. In fact, if at all, one should speak of the "harmful tax harmonisation".
[88.] There is no case for tax harmonisation. There are no reasons why income tax, corporation tax or capital income tax, should be harmonised across the EU. The Member States should continue to be to set their tax policy independently from each other, and accept that taxation might be used as a means to better compete within the EU. Tax differences do foster international trade rather than impede it and should be welcomed when looking at corporation tax. There seems to be some case at first looks for harmonising capital income taxation, because it is such a mobile factor. However, legislative action is unable to fight against overriding economic forces: capital
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supply being relatively elastic, any capital tax will in the end of the day fall upon the labour factor. Furthermore, taxation of capital income anyway does not seem to be right way for tax systems to develop, tax expenditure taxation being preferable in view of the aging issue of the EU nations. Finally, the various governments could individually secure tax neutrality as regards capital income taxation by disallowing interest financing costs as a deductible business expense.
[89.] Harmonisation of environmental taxation. Is that to say that direct tax matters should not ever be on the agenda of the EU? There certainly are common sense fields of activity for the EU: the abolishment of customs duty within the free trade area is a past example of it, as were the regulations avoiding the double taxation of intra-group dividend distributions or cross-border mergers and spinoffs. Environmental taxation is another example of where Community action makes sense. Because pollution does not respect national borders, EU Member States all have a legitimate interest in each other's Environmental policies: a factory that pollutes the Danube upstream in Germany will affect water quality downstream in Austria; the Chernobyl explosion affected much of Europe; and so forth. It is these "spill over" effects that do give any international body a mandate to tackle environmental issues, including through tax harmonisation.
Alain Steichen
Luxembourg, 30.05.02
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A Absolute advantage · 71 Agglomeration forces · 26 Anglo-saxon tax policy · 46 Approximation of tax laws · 10 B Bank secrecy laws · 84
Index Cost of tax compliance as a justification of corporation tax harmonisation · 81 Customer is king · 37 D Democracy and taxation · 31, 52 Distortions (economic - induces by tax diffentials) · 36 Dutch · 99
C Capital export neutrality · 38 Capital import neutrality · 38 CFC legislation · 73 Code of Conduct · 57 Co-existence model · 84 Coherence (- of tax systems) · 41 Comparative advantage · 71 Competence by attribution · 53 Compulsory Harmonised Corporation Tax · 68 Consolidated Common Tax Base · 67 Continental tax policy · 46
E Elasticity of demand and supply · 21 Environmental taxation · 104 EU Treaty and tax harmonisation · 54 European Court of Justice creeping harmonisation · 51 European Union Company tax · 68 Expenditure taxation · 96 F Federalism (fiscal -) · 44 Feira agreement on savings taxation · 83
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Fiscal externalities · 7 Free trade and tax differences · 70 Freedom of capital movements · 94
L Level playing field · 66, 69 Leviathan syndrom · 42
G GATT · 95 H
M Monetary policy (common - and common fiscal policy) · 2
Harmonisation · 9 Holding 1929 companies · 61 Home State Taxation · 67 I Immobile factor-labour excessive taxation of - · 14 Immobile factors definition · 16 Inflation · 90 Information exchange · 84 or withholding tax for savings taxation? · 87 Institutional competition · 11 J Job creation impact of taxes on · 14
N Name and shame strategy · 56 Neutrality in taxation external · 47 internal or domestic · 48 savings · 91 New economic geography theory · 26 No taxation without representation · 51, 52 Non-cooperative governments · 8 Nordic dual income tax · 99 P Pareto optimum · 50 Pension funding · 93, 98 Public goods · 29 R
Race to the bottom · 27
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Race to the top · 31 Ring-fenced tax measures · 60 Ringfencing the EU · 100 S Schanz-Haig-Simons concept of income · 96 Small economies · 37 speficic or general tax cut rates · 64 State Aid rules · 78 Subsidiarity principle · 47
Tax convergence · 9 Tax co-ordination · 2, 43 Tax evasion · 89 Tax wedge on labour income · 18 Taxes and economic policy · 46 Tiebout Hypothesis · 49 Tulip industry · 81 U Unanimity principle in direct tax matters · 51, 54
T Tax burden flaws in methododology when calculating - · 15 Tax cartel · 55 Tax competition unfair · 7
V Voting by the feet · 29, 43 W Welfare of nations · 7, 50 Wicksell equilibrium · 29

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