Tax competition and tax reform are tools for Europe’s salvation. In effect, they are a way to save Europe from itself – especially “old” Europe.
We should define what these terms mean so we know what we are talking about.
Tax competition is the ability of labour and capital to benefit from better tax systems by crossing national borders and the resulting pressure this puts on governments to implement better policy.
A suitable analogy is that of petrol stations. If there is only one petrol station in a town, that station can charge high prices, can offer shoddy service and can operate inconvenient hours. But if there are five petrol stations in town, then all of a sudden the consumer is king, and the consumer can choose which petrol station he wants to use, based on a whole different range of factors he cares about – service, hours, and prices. The petrol station owners have to start competing; they have to start ascertaining what the consumer wants and what the most efficient approaches are.
We want the same thing to exist with governments. For too long governments have acted like monopolies. Their so-called customers, taxpayers, are treated as if they were fatted calves waiting for slaughter. Politicians should be afraid that taxpayers are no longer a captive audience and that the goose that lays the golden eggs can fly away.
Tax competition is good because it leads to lower tax rates and to less double taxation. Why do we think that lower tax rates are a good idea? Why do we think that removing the various forms of double taxation and the penalties on capital are a good idea?
We think that these outcomes are good in part because of empirical observation. We see that the US has a lower tax burden than Europe, and that the US economy has grown a lot faster. We see that, even inside the European Union, countries that have lower tax rates, like Ireland, grow faster than countries that do not. We see countries like Hong Kong, which have had low rate flat taxes for a long time, and we understand that they have grown so much faster. There is now a wealth of evidence in the academic community on the importance of lower tax rates. Indeed, we are almost at the point where I think we can say that there is a consensus among public finance economists in favour of lower tax rates and a better structure of tax system – so that savings and investment are not being double-taxed. Even politicians from some of the left-of-centre parties say, ‘Yes, in theory it is a good idea,’ which is a remarkable development.
It is not just a question of lower tax rates and a better tax system. It is also the case that tax competition is very good for reasons of sovereignty. Estonia should be able to tell the Germans to go jump in the lake when they are talking about corporate tax harmonisation. I also think the Swiss should be able to tell Brussels to go jump in the lake when they are trying to destroy financial privacy.
Tax competition is, perhaps, even more important in terms of individual sovereignty. An individual taxpayer should be able to escape, or at least be able to put their capital out of the reach of a government that is being fiscally oppressive. Jurisdictional competition also plays a very important role in pension issues, healthcare issues and regulatory issues, and, for the same reason that tax competition is desirable, competition in all these other fields of government policy is desirable.
I always cite three examples that demonstrate why it is a good thing. I cite the Thatcher and Reagan income tax rate reductions, because not only did Thatcher and Reagan turn their economies around by dramatically lowering personal income tax rates, but they also forced just about every other developed nation in the world to do the same thing. I can assure you there are no Ronald Reagans and Margaret Thatchers in most of the other countries that had to mimic these reforms. They did it because they felt they were compelled by what was happening in the US and the UK.
Another example, perhaps even more powerful, is what happened when Ireland slashed its corporate tax rate. Ireland, of course, dramatically improved its economy. It went from being the sick man of Europe to being the Celtic tiger. Unemployment dropped from 17% down to 5% and, perhaps more importantly, this had a knock-on effect on the rest of Europe.
We have now seen these competitive corporate tax rate reductions in many countries. It has reached the point where corporate rates have come down so much in Europe that every single European nation, even welfare states like France and Sweden, now has a lower corporate tax rate than the US. This, of course, sticks out like a sore thumb, and shows that much work still needs to be done in the US to fix this problem. In general our taxes are lower, but the corporate tax system remains a significant problem.
Last but not least, we have seen flat taxes implemented throughout eastern Europe. Estonia was the first country to institute a flat tax rate, and it was copied by the other Baltic nations. Eventually that affected Russia, and then Ukraine, Romania, Slovakia, Serbia and Georgia all implemented a flat tax system.
What is perhaps more surprising is that there are lower capital taxes in places like Scandinavia – the epicentre of the welfare state. Tax competition has had an effect there, and they now have dual-income tax systems whereby they are taxing capital at a lower rate because they understand that it can escape. When the goose that lays the golden eggs can fly away, you had better do something to encourage it to stay in your country. In other words, tax competition is driving tax reforms.
For years I have been talking about tax reform. We have made very little progress in the US. Nobody seems to care. I do not think these people have ever read a Dan Mitchell paper. And if they did, would it matter? If I wrote a paper saying that a monopoly petrol station should lower its prices to charge the market rate, the owner of the station would say, ‘This guy’s a jerk.’
What will actually influence the behaviour of that petrol station owner is when the four other gas stations move into town and competition ensues. This does work. Likewise, countries are forced to change or, more relevantly, politicians are forced to change when they know they have no choice. Why does all this matter? Because it is making tax reform a reality.
What are the principles of this reform? The main principle is simple: one low rate, taxing income just once. We do not quite have that in the US. Not only do we still have tax rates as high as 35%, but, between the capital gains tax, the corporate income tax, the personal income tax and the death tax, a single dollar may be cycled through the tax system four times.
One of the reasons we are so excited about all the tax reforms taking place in Europe is that it gives us case studies. I used to approach members of Congress and talk about the theory of marginal tax rates and capital formation. People would start to nod off. But now I give concrete examples – what has happened in Russia, where personal income tax revenues have doubled in less than four years. Or this is what has happened in Slovakia. Or look how Ireland has grown since they slashed their corporate tax rate from 50% to 12.5%. Real-world examples are invaluable.
We have made some progress in the US. Tax competition has indeed played a role. When we had the discussion about getting rid of our death tax, much of the debate focused on the belief that ‘If we don’t get rid of it, people are just going to move their money offshore. Why do we want to drive money out of the US economy just to satisfy this punitive class-warfare tax that is a relic of decades past?’
Then, of course, President Bush has created a Tax Reform Advisory Panel. He wants tax reform. Are we going to go as far as Estonia or Slovakia or any of these other countries? No. Maybe you have to actually be in the depths of communism before you can really clean up your tax system. We never had the so-called benefit of learning that lesson, and so it might take us longer to get to the promised land.
Let me close by giving the outlook for the future and a message of optimism.
If you go back just four or five years, tax competition was under tremendous assault. There was the OECD’s so-called ‘harmful tax competition’ project. There was the European Union talking aggressively about corporate tax rate and tax base harmonisation. There was the EU savings tax directive. There were even people at the UN talking about global taxes and an international tax organisation.
Let us look at what is happening today. The OECD proposal is stymied and dead in the water. Yes, they have got some of the low tax jurisdiction to send so-called commitment letters, but all this was predicated on a level playing field, and since countries in the OECD like the US, the UK, Switzerland and Luxembourg are all tax havens for non-resident investors, there is no level playing field, and so low tax jurisdictions around the world are, for the most part, safe from OECD predation.
The EU savings tax directive did eventually come into force, but the US told the Europeans they were not going to participate, and the Swiss basically forced Brussels to water it down so much that it is now called the ‘dummy tax’, because only a dummy would not be able to structure their affairs to avoid the tax. Brussels had to completely give up on the notion of destroying bank secrecy. The UN proposals never even got off the ground. Even the Clinton administration never agreed to the idea, so I do not think we have any threat of global taxation or an international tax organisation.
These things are all helping create an environment in which, because of the tax reforms in Eastern Europe, because of what Ireland did in the very west of Europe, there is a pincer movement.
Put yourself in the position of a German or French politician. Over time, maybe two years, maybe five years – I do not know how long they can hold out – investment, factories and money will all be leaving these countries and, sooner or later, they are going to be forced to reform. It is the job of every one of us to do everything we can to preserve and promote tax competition, because the lesson that we should all have in our minds, as think tanks, as researchers, as people who follow these issues, is that politicians are never going to listen to us as much as they are going to listen to the real-world pressure of jobs crossing national borders to go to the countries that are implementing the right policy.
© Copyright; Foundation for Economic Growth and various authors. Individual authors retain their own copyright.
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