TCS Daily

All For The Company

By Pavel Kohout - September 29, 2004 12:00 AM

Any reader of business newspapers (and his dog) knows that most European economies suffer from long-term structural recession, high unemployment, stiff labor markets, heavy burden of taxation and a number of other obstacles to growth. One might therefore expect that the European stock markets should reflect this gloomy balance and lag hopelessly behind their American counterparts, let alone the dynamic Asian economies.

The reality may be surprising, however. If we compare the Morgan Stanley Capital International (MSCI) Europe Index and MSCI USA Index returns from early 1970 to the end of July 2004, we obtain the average annual rate of 11.3 percent and 10.7 percent, respectively. (For comparability reasons, both returns are in terms of US dollars). By a whisker, European shares outperform the US stocks. From the point of view of mathematical statistics, the difference does not count, but it is clear that the European stock markets do not have to blush for their performance. The returns are consistent over time. Between January 1993 and July 2004, the American stocks returned an average of 10.4 percent, while the European ones did 10.2 percent per annum. Again, the difference is negligible.

How is it possible that in terms of stock returns, the companies from the "ossified" Europe are doing as well as the American ones? One possible explanation is the burden of taxation. American companies pay a federal income tax of 35 percent, to which we must add the income taxes levied by the states. According to KPMG International Tax Survey, American companies thus pay an average income tax rate of approximately 40 percent. This is more than anywhere else in the world except Japan. In addition, American companies bear substantial social welfare costs, since many Americans rely more on company pension funds than on the government welfare system.

European governments, on the contrary, literally spoil their large corporations. Countries with high corporate taxes (France with 34.33 percent, Germany with an average of 38.29 percent) treat their companies with generous options for accelerated depreciation. Regional governments and authorities compete to provide the best investment incentives. Germany gives indirect subsidies to large businesses in the form of cheap credits at the state banks (Landesbanken). A few years ago, the international financial press published advertisements promoting the "Austrian tax haven" with the effective business tax rate of 17.67 percent. The Scandinavian countries "charge" from 28 percent to 30 percent of their companies' profits, the UK 30 percent, Portugal 27.5 percent, Switzerland 24.1 percent (average of all cantons), Iceland 18 percent, and Ireland a mere 12.5 percent.

Of course, the nominal rates do not give us the whole picture, as the "generous" European tax legislation allows companies to cut substantially the actual burden. The high Italian rate (37.25 percent), for instance, may hide the fact that Italian businesses pay effectively only about 17.7 percent income taxes, according to one study.

Europe is generous towards its businesses, which thus make handsome profits. European shares are attractive for investors in the long run. All sorts of both direct and indirect subsidies, tax allowances, accelerated depreciation rules, investment incentives and other mechanisms level the advantage of better-functioning stock and bond markets of the United States. While the typical American company issues securities, the typical German company cultivates friendly relationships with its Landesbank and the government. In this system, large companies naturally thrive at the expense of small businesses. This is why all European attempts at creating a market similar to NASDAQ have been a failure.

But who is actually funding those notoriously costly European governments? Citizens, of course. Excise taxes, income taxes and the payments levied from wages are much higher in Europe than in the US. The minimum basic rate of the European VAT is 15 percent. The American sales tax rates range from 0 to 9.35 percent (varying by states and cities). America shows a more friendly face to its citizens, the taxpayers. Europe, on the other hand, follows the slogan "All for the company".


What is particularly remarkable, however, is the contrast between Europe and the US on one hand, and China on the other. The "Middle Empire" records an economic growth of about 9-10 percent every year. But what a surprise for investors keen on buying Chinese stocks, when they discover that from December 1992 to July 2004, the MSCI Index had been falling at an average rate of 12.1 percent a year! Why? The shares traded on Chinese exchanges are mostly those of state-owned enterprises, lots of which are on the brink of bankruptcy. Their role is not to make profits, but to maintain employment for the time being. Thus, the slogan "All for the government" holds in China.

The profit-makers in China are mostly the subsidiaries of Western companies. So if you look for the profits from the nearly double-digit growth of Chinese economy, you must go to the stock exchanges in London, Paris, Z├╝rich, Frankfurt or New York.

The author is an associate of the Center for Economics and Politics (CEP), Prague.


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