Introduction
Tax harmonisation in the European union has been talked about for many years. However politicians from most countries often shun the idea as the prospects of surrendering tax controls to the European Union (EU), for fear of the loss of more sovereignty and for many is another step down the road to a federal European state. More importantly it is an important source of revenue and is an important regulator of the economy and so the prospects of nations losing a degree of control over them are not politically favourable. However with the Euro currency now in place tax harmonisation is for many the next logical step to avoid what some view as harmful tax competition between member nations. The original aims of the EU were to create a single market with the free movement of goods, persons, services and capital. However different taxes across the union create distortions and so create an increase in the excess burden of taxation. In this paper I shall be examining the implications of implementing a common tax on all income across the EU. Income is broken up into three tax identities, corporation tax, savings tax (taxation of interest income) and personal income tax. I shall then analyse tax competition and evaluate whether this is a better alternative to the implications caused by a common tax on income.
Corporation tax
In 1992 the Ruding report made several proposals for harmonisation of corporate taxation, including a recommendation of a minimum corporate tax rate of thirty percent. The EU has still not taken up these proposals, however in 1997 the EU did agree to a ‘Code of conduct’ which aims to eliminate tax concessions that are viewed discriminatory. The aim of a common corporate tax is to avoid distortions in the allocation of capital across the EU and the transfer of paper profits in multinational firms across borders. Currently there is concern amongst some in the EU that the different tax rates in the member nations is causing firms to relocate and invest in lower tax countries. Nations such as Germany and France are becoming particularly frustrated with nations such as Ireland and to a lesser extent the UK, which have, lower corporation tax. Ireland with significantly lower rates of corporation tax has generated massive amounts of inward investment as a consequence and now has GDP rates averaging at around 7% annually. Lower taxes abroad has also lead to firms relocating for example Ericsson a Swedish maker of mobile phones moved its headquarters to London to avoid high taxes in Sweden, many firms in Germany are also threatening their government with similar consequences if they don’t lower there business rates. If there is not a common tax on corporations it could lead to tax competition among nations in the EU as nations are forced to lower tax rates as capital and corporations are relocated to lower tax nations as many forms of capital are relatively fluid. However is tax competition really a bad thing? I shall be addressing this issue later in the paper.
Savings tax (Taxation of interest income)
Taxation of interest income is even more sensitive than that of corporation tax as savings are even more liquid therefore savings are even more sensitive to changes in tax. When there is full international capital mobility any tax rate on capital will be fully reflected in the gross interest rate of that country. Since capital is an elastic good due to its high mobility it is not productive to tax it, as investors will simply take their portfolios elsewhere. The OECD realised this in 1977 and recommended the residence principle of taxation for interest income where the investor is subject to taxation only in his resident country. However this is not an ideal model as Germany found out the hard way in 1988 as Haufler states, they imposed a withholding tax of 10% on interest income from both foreign and domestic investors and subsequently caused a massive capital flight out of the country of four times the normal rate. The German government was forced to turn back on its policy in 1989 due to this capital flight. However in 1993 the German government bought back a withholding tax of 30% but this time the tax did not apply to foreign investors, consequently the capital flight was no where near as great as in 1998. The EU and the OECD is fully aware of this and the EU in 1998 proposed that each member state be required to levy a minimum 20% withholding tax on all interest income on EU residents making it an even playing field across the EU. However investors may not be as mobile as first stated since if they were then almost all capital will be invested in countries such as Luxembourg and non EU members, such as so called tax and regulation havens as Switzerland. It is therefore argued that there is a degree of bias in an investor’s decision to his or her home nation, this would also explain Germanys experience of less capital flight in 1993. There are also other reasons against the idea of perfect capital mobility such as transaction costs, which are a particular problem to small investors. However for large investor’s transaction costs are relatively lower as they can spread the cost against their larger income and are not as sensitive to transaction costs. The risk of exchange rate fluctuations in foreign nations also is a factor in a persons investment decision as a persons wealth could diminish very quickly if the foreign currency devalued on the world markets, if they invested abroad to avoid high taxes. However if the EU did have a common interest income tax, although there are arguments for efficiency gains, it would cause a lot of redistribution particularly being at a loss to London and its Eurobond market and Luxembourg. It taxes are levied at to high a rate it could even lead to capital moving out of the EU and into other tax havens such as Switzerland. This unsettling redistribution of interest income could result in job losses and therefore decreased tax revenue, as jobs are lost as a consequence as labour does not follow the capital due to labour immobility. These concerns as well as possible resulting national income changes mean the EU will be pressured into compensation packages for those at loss which will run into measurement difficulties as well as political difficulties as it may not be very popular with voters.
