Is tax competition bad?

EU enlargement was meant to be a cause for celebration. But one seemingly esoteric issue is threatening to spoil the fun: taxation. West Europeans fear that low tax rates in the new member-states will lure companies eastward, taking jobs and investment with them. To add insult to injury, the richer EU countries complain that ­ through their contributions to the EU budget ­ they will end up paying for tax cuts in the new members.

Gerhard Schröder, the German Chancellor, thundered in April that it was unacceptable "that Germany, as the EU's biggest net payer, finances unfair tax competition against itself". Germany has openly threatened to cut EU regional aid unless the new members rethink their tax policies. Germany and France have dusted off old plans to introduce a minimum rate of corporation tax in the EU. Are the two governments right to push for tax harmonisation in the enlarged EU? No, because their claims of 'tax dumping' rest on three highly questionable assumptions.

Tax myth no 1: The East Europeans have much lower corporate tax rates

The tax rate on corporate profit in France, Italy and Germany ranges from 35 to 38 per cent. In Hungary, Poland and Slovakia, rates are only 16 to 19 per cent, in Latvia and Lithuania 15 per cent, and tiny Estonia does not levy any tax on corporate profits that are reinvested. But such headline tax rates reveal little about the real tax burden. The 'tax base', the item or activity that the tax is levied on, is equally important. There are various ways in which tax authorities treat say, a company's debt or the depreciation of its machinery for taxation purposes. In addition, most EU governments grant various kinds of tax relief, for example for research and development, or investment in poor areas. As a result, the real tax burden ­ or what economists call the 'effective' tax rate ­ is usually different from the headline tax rate. For instance, in Germany's fiendishly complicated tax system the effective corporation tax rate is estimated to be only half of the 38 per cent headline rate. Some of the country's largest companies enjoy so many tax breaks that their effective tax rate is zero.

Since headline rates reveal little about a country's tax system, it makes no sense to call for harmonised minimum business tax rates ­ as France and Germany have done. The EU would have to harmonise tax bases first. The European Commission has long called for such a move, most recently in July 2004, when it won the support of half a dozen member-states (among them Germany and France, but also low-tax countries such as Estonia). Many multinational companies would also welcome such an initiative, which would make it easier for them to calculate their pan-European tax bill.

Tax myth no 2: Low East European taxes harm the old EU

The accession countries have attracted more than €140 billion in foreign direct investment since 1990. But most of this money has come in addition to, not instead of, investment in the old EU. Governments, not only in Eastern Europe, but around the world, can and do use their tax system to lure investors from abroad. Large companies have at times played off one EU country against another in an attempt to get the most favourable tax treatment. Many of the West European car producers that have built factories in Slovakia, Poland and the Czech Republic secured lengthy 'tax holidays', during which they pay little or no tax. However, taxes are only one factor in determining companies' investment plans. In the case of Eastern Europe, fast growth rates, improving business environments and low-wage, high-skilled workers are at least as important in attracting foreign businesses.

Nor is it true that the EU is financing East European tax cuts through its common budget. The EU has put aside only €40 billion for enlargement in 2004-06, while the newcomers also have to pay their dues into the EU budget, leaving them with a net balance closer to €25 billion. The EU money is earmarked for regional development and farm support, which means that it will only help to keep East European taxes low insofar as it replaces national budget spending.

Tax myth no 3: The EU must clamp down on unfair tax competition

The EU does not have the right to tell member-states how to design their tax systems ­ it only sets rules for those taxes that affect the functioning of the single market, such as value-added tax. But the EU does have the right to clamp down on industrial subsidies and other state aids that undermine competition. The Commission has tried to classify some tax incentives as a form of illegal state aid, in particular those that are available to one sector or company but not another. In 1999 an expert group listed more than 60 such 'harmful' tax measures in the EU-15. In line with a voluntary EU 'code of conduct', the member-states have phased out most of them and refrained from introducing any new ones.

In the run-up to accession, the EU asked the newcomers from Central and Eastern Europe to phase out all discriminatory tax incentives, in particular those for foreign investors. To keep their economies attractive, many of the new members have responded by cutting overall tax rates for both domestic and foreign investors. Since these cuts are not discriminatory, there is nothing the EU can ­ or should ­ do about them.

So why are some old EU members so upset about East European taxes? Perhaps some governments want to divert attention from the pressing need to clean up their own tax systems. Germany's recent tax reforms look positively timid compared with Slovakia's introduction of a 'flat' 19 per cent tax on all forms of income. Perhaps the tax debate is an opening shot in the EU's next budget battle. In their attempt to cap EU spending, Germany and France could use allegations of 'unfair'tax competition to limit transfers to Eastern Europe.

And perhaps Germany and France are using the spectre of tax harmonisation to show that they are still the motor for European integration. The British government, supported by the new members, insisted on keeping the national veto for all tax matters in the EU's new constitutional treaty. In turn, Paris and Berlin added procedures that will make it easier for a small group of EU countries to go ahead with a policy initiative on their own. They are now talking about using these 'enhanced co-operation'procedures to harmonise their corporate tax systems. But, as the Commission's July proposal makes clear, they would have to start by aligning their tax bases. A common base would make it easier for companies to compare tax systems, thus encouraging rather than discouraging tax competition. After this step, Germany and France may find it even harder to persuade low tax countries to agree on a minimum corporate tax rate.