TCS Daily


Death and Taxes in the EU

By Meelis Kitsing - December 13, 2005 12:00 AM

"In this world nothing can be said to be certain," Benjamin Franklin famously said, "except death and taxes." But when applied to corporations today, even that isn't necessarily true. On one hand, a skillful use of complex tax systems decreases the certainty of corporate death. On the other, regulatory complexity and competing jurisdictions have increased the uncertainty of corporate taxes and, thus, the health of corporations -- particularly for firms operating internationally.

No wonder, then, that some companies have recognized this trade-off between taxes and well-being, and aim to make taxes more certain. Intense lobbying by these corporations is a part of the reason EU Tax Commissioner Laszlo Kovacs has proposed providing a common tax base within the EU, thus letting firms pay corporate tax on the basis of one methodology. This implies the implementation of EU-wide rules on what share of business profits are taxed by taking special tax breaks and exemptions into account.

The proposal aims to reduce transaction costs affiliated with operating a business in different tax jurisdictions within the EU. A recent European Commission survey "shows that cross-border activity currently leads to higher company tax and VAT compliance costs for companies. Compliance costs are significantly higher for companies with at least one subsidiary in another EU Member State compared to companies without subsidiaries abroad and the costs increase according to the number of such subsidiaries."

This EU proposal should address unfounded worries of "race to the bottom" feeders, social dumping whiners and other anti-big, bad business warriors. Instead, the multinationals' support of the proposal confirms the power of the national tax authorities. If there were a true race to the bottom, companies could avoid national taxes at their leisure, and national governments would be of no consequence. If this were the case, why would multinational companies lobby to create a common EU tax base? Faced with the complexity of tax regulations, companies want to minimize the risks that implicit or explicit actions will land them in trouble with authorities.

Policymakers are faced with a constant dilemma in deciding to what degree to allow tax competition and to what degree to unify tax systems. Tax competition has not led to convergence on the lowest common denominator because national power in tax issues still matters to a great degree. The result has been a kind of balkanization, where multinationals are faced with large transaction costs. Multinationals have realized that the outcome in this issue does not correspond to the most favorable tax systems for companies. Instead of engaging in constant regulatory arbitrage in balkanized EU tax systems, companies have realized that an EU-wide consolidated tax base offers them protection from national authorities.

The proposed legalization of the common tax base constrains the power of national governments by utilizing three components: obligation, precision and delegation. Once EU-wide rules have been made, the stipulations must be followed -- tax legislation cannot be simply changed according to the political considerations of national governments. Ambiguous tax laws can leave much room for interpretation, thereby potentially undermining obligations when the exact commitment is unclear and thus not adhered to. For example, recent decisions by the European Court of Justice concerning EU company tax issues have been understood differently by national governments and have led to different changes in national legislation.

Despite some benefits, a common EU tax base is still the second-best option for companies. It is a compromise between the current situation, in which some member states, like Estonia, have no corporate income tax on reinvested profits, while a high tax country, like France, advocates the harmonization of corporate tax rates within the EU. It goes without saying that Kovacs's threat to circumvent national vetoes by using a so-called enhanced cooperation mechanism in the EC treaty for implementation of the proposal may turn this second-best option into the second worst-option. (The worst option being harmonization of corporate tax rates by circumventing national vetoes.) Kovacs plan has already by undermined by his colleague, the EU Internal Market commissioner Charlie McCreevy, who announced last month that national vetoes will be kept and tax competition preserved.

Harmonizing the tax base may benefit large multinational companies, but it does not necessarily help small- and medium-sized firms that do relatively little business across EU jurisdictions. An EU survey conducted in September 2004 showed significant differences between transaction costs of multinationals and SMEs.

If they want to catch up with the US, EU policy-makers should not forget that small- and medium-sized companies are a tremendous force driving the growth of American economy. Nor should they forget their own rhetoric about the importance of small- and medium-sized companies. The priority should not be doing favors for large multinationals, but rather making national tax codes simpler and reducing taxes in general. This creates incentives for people to start companies. The best way to achieve these goals is to allow tax competition. If entrepreneurs cannot get started in Germany or France, they can always move to Ireland or other entrepreneurship-friendly member countries.

Tax competition, like any kind of competition, is better than top-down harmonization, however limited it might be. Such unification and harmonization of rules is good only for preserving the status quo. Institutional competition allows a superior set of rules to emerge. Instead of consolidating the tax base, different institutional settings should be left to work and determine the best outcomes.

The EU has an opportunity to simplify an EU business environment characterized by complexity and uncertainty. Corporate taxes can be made more certain by making the tax code simpler. The death of entrepreneurship can be made less certain by making taxes lower. The best way to achieve both is to abolish corporate income tax altogether. Nothing can be more certain than a simple statement that a country has no corporate taxes whatsoever.

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