Thursday, 2 October 2003

Death By Taxes

In March 2000, EU leaders, assembled in Lisbon, outlined an ambition and set a target for the European Union: to create the most competitive economy in the world by 2010. Yet, three years later, the EU has not made much progress towards this goal.

With an average tax burden consuming almost 45 percent of GNP, workers in the current 15 EU member states are 20 percent less efficient than U.S. workers. And this will get worse because many European countries have huge government unfunded liabilities, particularly for pensions. By 2050, Europe will have 75 pensioners for every 100 workers. And since pensions in France, Germany and Italy are paid out of current tax revenue; tax will have to soar to fund this unsustainable system.

As the result of these anti-growth policies, unemployment remains very high and Europeans often try to make ends meet by shipping their savings to lower tax jurisdictions. But beware Europeans; the EU now wants this money too.

Today, the EU is at a crossroads. First, it can take the road of good tax policies, cut tax rates and stop punishing productivity and savings. This is the judicious choice made by Ireland in the 1980s. Ireland’s approach was a big success. The “poor man of Europe” is now the “Celtic Tiger” with the second-highest living standards in the EU behind tax haven Luxembourg. Interestingly, the EU reacted quite strongly when Ireland cut corporate taxes and continues to point at Ireland’s 12.5 percent rate as an example of “fiscal dumping.”

The EU’s second option is to undermine tax competition by making it impossible for money to escape Europe’s high-tax economies. Not surprisingly, this is the preferred choice of most Union leaders. In an effort to protect uncompetitive European nations from the discipline of market forces, the EU proposed an initiative seeking to mandate automatic and unlimited exchange of information between nations with regards to nonresident savings. As it is now, the EU taxes savings at an average rate of 53.5 percent. So many Europeans quickly figured out that they would be better off placing their savings in Luxembourg, Switzerland or in the United States, where it could be sheltered from such high tax rates. The measure is designed to make it easier for EU nations losing capital to lower tax jurisdictions to have access to this money and to tax savings outside their borders.

The plan, known as the “Savings Tax Directive,” would oblige all financial institutions to collect private financial data on non-resident investors so they can be turned over to European tax collectors. Under this scheme, when an Italian citizen invests savings in Luxembourg, the bank paying interest on the capital will either have to impose a withholding tax on such income at a specific rate or send information on the depositor’s investment earnings to enable the Italian government to levy a tax on the income. The idea is to eliminate the incentive to invest capital in lower tax jurisdictions since no matter where you invest you end up being taxed at your home-country rate. But the end result will probably be to destroy the small amount of legal savings by EU citizens and will increase their incentive to find illegal saving options.

Of course this is a very dangerous idea. The Savings Tax Directive is a significant threat to market-based policy and fiscal competition. But most of all it is a threat to all taxpayers. Any reduction in the savings rate in Europe would be a calamity. In addition, the EU wants low-tax countries; financial institutions to serve as vassal tax collectors for Europe’s welfare states. Moreover, it is an attempt to preserve bad tax policy since it assumes that there should be multiple taxation of income that is saved and invested. If implemented, it would undermine the right of nations to determine their own tax policy. The EU directive would give countries such as France or Sweden the power to impose oppressive tax rates on income earned in places like Luxembourg or Switzerland.

Fortunately, EU tax harmonization schemes required unanimous support from all member nations, as well as the participation of six non-EU nations, including Switzerland, the U.S., Liechtenstein, and Monaco (plus U.K. territories). Thanks to Austria, Belgium and the Luxembourg, the EU tax harmonization scheme was vetoed and thus defeated. Sadly, it did not take long for the EU to resuscitate its initiative.

The EU claims that the initiative’s “true” goal is to reduce tax evasion. According to EU Commissioner Frits Bolkestein, the complete destruction of financial privacy is the only way to address widespread tax evasion. Yet, economists have argued for years that lower tax rates and tax simplification are much more effective tools to prevent tax evasion. In addition, lower tax rates often bring in more revenue than high tax rates. So instead of trying to force nations to adopt their bad tax policies, European governments should try tax reforms for a change.

The good thing about this cartel-like initiative is that cartels are easy to destabilize. For that, you only need one country to do the right thing. The United States, Luxembourg or any rational European nation should rise to the occasion and save the world from tax harmonization and high taxes. It should be an easy decision to make since the EU tax cartel would have a terrible effect on European economy. If the Savings Tax Directive is implemented, Europe will lose even more capital – which means fewer jobs, lower wages and low rates of savings. Equally important, a EU victory will have a big impact on the individual European countries’ ability to ever reform its tax system in the future. Unless European nations have totally given up on their ambition to become competitive, they should oppose the EU Savings Tax Directive.

Veronique de Rugy

Veronique de Rugy is a policy analyst at the Cato Institute.

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