TCS Daily

Tax Europa

By Veronique de Rugy - May 10, 2004 12:00 AM

The historic enlargement of the European Union with the addition of ten new countries on May 1 was a cause for celebration in many national capitals, but the accession party could be followed by a hangover. Joining the EU may be akin to boarding the Titanic halfway across the ocean. The pre-expansion EU is very uncompetitive in the world economy. With an average tax burden consuming almost 45 percent of GNP and high levels of regulation, many of the original 15 EU countries face a double-digit unemployment rate and economic stagnation. And since many of them have huge government unfunded liabilities for pensions and health care, things could get worse before they get better.

As a result of these anti-growth policies, unemployment remains very high and a large amount of capital is fleeing to places like the United States and Switzerland. The post-communist countries that just joined the EU also have been benefiting from these capital flows. After decades of communism, most Eastern European nations have reformed their tax systems and have become low-tax jurisdictions. For instance, Slovakia just adopted a 19 percent rate, as did Poland; Hungary has a 16 percent rate; Lithuania and Latvia have a 15 percent rate; and Estonia even has a zero percent rate on some items. These low rates are an indication of good tax policy on the part of former communist regimes. And it already represents competition for countries like France and Italy -- with respective rates of roughly 34 percent and 38 percent -- and even Germany, which recently cuts its rate from 40 percent to 25 percent.

The interesting question is whether these new EU nations will be allowed to keep their free-market policies. The EU is at a crossroads. The bureaucrats in Brussels who run the EU can decide to welcome the competition from these lower tax jurisdictions and urge the nations of "Old Europe" to reform their tax systems and cut tax rates. In other words, the EU could decide to respond to tax competition with tax competition. The EU's second option is to undermine tax competition by bullying the newcomers into increasing their rates. The underlying assumption is that differences in tax rates create "unfair" tax competition. To stop money, businesses and jobs from escaping Europe's high-tax economies in order to flee to Eastern European countries, they want tax rates to be harmonized.

In the 1980s, Ireland faced the same dilemma that now confronts the EU. It made the wise choice to implement supply-side tax reforms that were and are still successful. Sweeping corporate tax rate reductions from 38 percent to 12.5 percent created a decade of economic growth, and the "poor man of Europe" is now the "Celtic Tiger" with the second-highest living standards in the EU (behind tax haven Luxembourg). The Irish model shows how fiscal discipline and low tax rates help attract capital and entrepreneurs instead of scaring them to other countries.

Sadly, Germany is not inclined to follow Ireland's lead. German Chancellor Gerhard Schröder has made this very clear by telling his Eastern neighbors that their low tax policies and the competition they induce are unacceptable and should not be tolerated. According to the German leader, "tax dumping" is unfair to the German economy because of the transfer of jobs by German companies to Eastern Europe. Obviously, instead of fixing a system that makes Germany unappealing to capital and companies, the Chancellor would rather buttress an oppressive tax system by forcing low tax jurisdictions to increase their rates.

Schröder laments the existence of national vetoes on tax issues in the EU decision-making process that makes direct tax harmonization impossible for now. For months, Germany and France have tried to get rid of the national vetoes for tax matters. Their latest attempt took place in the drafting of the EU Constitution by introducing qualified majority voting -- a system of weighted votes -- on corporate tax issues to replace the unanimity rule. Under a qualified majority rule, each member state is given a certain number of votes, weighted according to its size and population. If qualified majority were ever adopted on tax issues it would mean that member states would no longer have a right of veto to prevent large countries like France and Germany from imposing their bad tax policies on the rest of the Union.

This is all very strange. For years, economists have argued that low tax rates and tax simplification are effective tools to promote growth and to prevent capital and company flights. In addition, lower tax rates often bring in more revenue than high tax rates as demonstrated by the Irish and the Eastern European experiences. So instead of trying to force other nations to adopt their bad tax policies, Schröder should try to finish what he started in 2002 when he cut the German corporate rate and impose more tax reforms on his own country.

Veronique de Rugy is a Visiting Scholar at the American Enterprise Institute. She recently wrote for TCS about the World Wide Web of Taxes.


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