TCS Daily

The Real Threat from the East

By Daniel J. Mitchell - February 27, 2004 12:00 AM

Many Western Europeans are increasingly nervous about the imminent expansion of the European Union. While politeness usually prevents it from being phrased in these terms, it sometimes seems as if the 10 accession countries are viewed as ne'er-do-well bums who will raid the refrigerator and leave dirty laundry on the floor once they get a key to the house in May.

To minimize this supposed threat, incumbent EU nations are following two strategies. First, they are putting new locks on the door by limiting the ability of Eastern Europeans to work in Western European nations. Second they are hoping that income transfers will dramatically improve living standards in the accession countries and thus convince East Europeans to stay in their own homes.

These are not very wise policies. Regardless of work restrictions, some East Europeans will be lured by higher living standards in the West. And if they cannot legally find employment, they will either gravitate to welfare or shift to the underground economy. It is even more naïve to believe that higher structural adjustment funding will yield positive results. In part, this is because many of Europe's richer nations are reluctant to approve a big increase in the EU budget, but mostly it is because there is scant evidence that previous wealth transfers in the EU have helped close the income gap between nations.

But even if these policies were successful, debates about work restrictions and structural adjustment funds are important -- at least in the long run -- only if Eastern Europe remains a backward and impoverished region. But while many of the accession countries are poor today, as one would expect after decades of communist mismanagement and difficult transitions, they are aggressively enacting pro-market economic policies -- reforms that are likely to generate rapid economic growth.

Fiscal policy is a good example. Most East European nations are implementing dramatic tax-rate reductions and fundamental tax reform. Several nations also have shifted toward private pension systems, thus lowering long-run government liabilities and greatly boosting the sustainability of pro-growth tax changes. Among the more prominent examples are:

* Slovakia has enacted a 19 percent flat tax for both individual and business income, and many forms of double-taxation -- such as the death tax -- have been repealed. The government also has created a private retirement system based on individual accounts.

* Hungary has reduced its corporate tax rate to 16 percent and has partially privatized its pension system.

* Poland has dropped its corporate tax rate to 19 percent and also implemented a flat tax of 19 percent for individual business income. Poland also has set up a partially privatized system for old-age pensions.

* The tax regimes in Malta and Cyprus are so attractive that they were blacklisted as part of the Organization for Economic Cooperation and Development's anti-tax competition crusade.

* The three Baltic nations -- Estonia, Lithuania, and Latvia -- all have flat tax systems. These nations also have pro-growth tax regimes for business income. Estonia, for instance, has eliminated the corporate income tax for reinvested profits.

These free-market tax reforms -- not the possibility of handouts and migration -- are the real reason why enlargement is a "threat" to Western Europe. Simply stated, market-oriented East European countries are going to impose enormous competitive pressure on high-tax welfare states. Beginning on May 1, walls come tumbling down and companies can shift economic activity to countries like Poland, Slovakia, and Estonia. Why pay the enormous costs of producing in France and Germany, after all, when you can move a few hundred miles, dramatically reduce the burden of government, and still be inside the EU customs union?

Indeed, the competitive pressure already is having an effect. Germany recently lowered its corporate tax rate from 40 percent to 25 percent and is in the process of dropping personal income tax rates. Italy and Finland have made some modest reductions in corporate tax rates. Austria just announced that its corporate tax rate will be cut from 34 percent to 25 percent, and Portugal and Greece have stated that corporate tax rates will be reduced as well.

To be fair, tax competition may not be the only factor leading to these lower tax rates. And even if tax competition is the driving force, a significant share of the credit belongs to Ireland. The Emerald Isle's 12.5 percent corporate tax rate has been a huge success, leading to much lower unemployment and turning Ireland into the second richest nation in the EU. Because of this example -- and the concomitant desire to keep jobs and capital from migrating to Ireland, some West European nations probably would be reducing tax rates even if nations like Slovakia and Estonia were still under Soviet rule.

But there also can be little doubt that East Europe's accession countries make it even more difficult for nations like France and Germany to prop up their costly welfare states. This is why high-tax nations in the EU favor tax harmonization. Fortunately, repeated efforts to harmonize corporate tax rates have been unsuccessful, and attempts to create a tax cartel will be even more difficult after May 1 since East Europe's low-tax countries will have a seat at the table.

EU expansion traditionally has aroused concern among advocates of economic liberalization, and there can be no doubt that over-regulation from Brussels remains a serious problem. But now it is possible to look at the glass as being half full. If the accession nations continue to make market-based reforms, all of Europe may wind up engaging in a "race to the top," competing to implement the best economic policy.

Daniel J. Mitchell is a Senior Fellow in Political Economy at the Heritage Foundation and the author of The Flat Tax: Freedom, Fairness, Jobs, and Growth.


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