Wednesday, 4 February 2004

Good Unintended Consequences

According to the European economic growth agenda agreed to a few years ago in Lisbon, by 2010 the European Union should become “the most competitive and dynamic knowledge-based economy in the world.” Unfortunately, business regulation in Europe is increasing, in part because of the relentless barrage of new rules emanating from Brussels. The continued regulation of the labor market contributes to pitiful economic growth rates and the perpetual scourge of high unemployment in Europe. Yet, to paraphrase Karl Marx, a strange spectre is haunting Europe and that spectre is falling tax rates. Ironically, the unwitting hero of the European flirtation with sound tax policy is the bureaucracy in Brussels.

Europe’s corporate tax rates have been historically very high and its consumers continue to put up with a plethora of high value-added taxes and excise duties. Yet, even the most socialist of European states are cutting taxes. Between 1996 and 2003, Belgium cut its corporate tax rate from 40.2 percent to 34 percent; Denmark from 34 percent to 30 percent; Greece from 40 percent to 35 percent; Iceland from 33 percent to 18 percent; Ireland from 38 percent to 12.5 percent; Italy from 53.2 percent to 38.3 percent; Luxembourg from 40.3 percent to 30.3 percent; Portugal from 39.6 percent to 33 percent.

Even the French reduced their corporate tax somewhat — from 36.7 percent in 1996 to 34.3 percent in 2003. According to French Prime Minister Jean-Pierre Raffarin, “What we need in this country is to encourage employment… [and] create wealth before we can share the fruits of growth.” It is encouraging to hear the French leader accept that lower taxes are essential for economic growth. Liberal economists have always argued that high taxes reduce the productive efficiency of labor, serve as a disincentive to work, reduce the level and the efficiency of capital formation and encourage individuals to substitute less-desired tax-deductible goods for more-desired, non-deductible goods.

Why, considering that public debt as a percentage of GDP is rising in most European countries and that their long-term liabilities, such as public pensions, remain unfunded, are Europeans reducing their taxes? Because of the convergence of two factors: growing European bureaucracy and EU enlargement. Vigorous pursuit of harmonization of European rules and regulations by the bureaucracy in Brussels restrains European nations from offering businesses better conditions than their neighbors can. That leaves tax rates, which continue to be determined at a national level, as the primary policy tool to affect competitiveness of European companies. Lower taxes among countries that will join the EU in May 2004 gave the current EU members a further impetus to act.

For example, Estonia has a zero percent corporate tax on reinvested or retained profits. Lithuania has a corporate tax rate of 15 percent. Latvia, which has a corporate tax of 19 percent, will lower it to 15 percent in 2004. Hungary, which has an 18 percent corporate tax rate, will lower it to 16 percent in 2004. Poland plans a tax reduction from 27 percent to 19 percent. Slovakia has lowered its corporate tax from 25 percent to 19 percent. In response to tax cutting in the rest of the region, the Czech socialists announced a corporate tax reduction from 31 percent to 24 percent.

Of course, the EU accession countries use lower tax rates to compensate for the lower productivity of their workers and their high level of government corruption. But the tax rates in CEE are sufficiently low to get the attention of the current EU members. For example, Austria’s top corporate tax rate is 34 percent and the government of Chancellor Wolfgang Schüssel is coming under pressure to respond to the tax reduction in neighboring Slovakia. The German corporate tax rate, which fell from 57.4 percent in 1996 to 39.4 percent in 2003, is up for another cut this year. It is only a question of time before the United Kingdom, which used to be seen as a low-tax country with a 30 percent corporate rate, will have to undertake tax reduction as well. That is welcome news for British taxpayers, but not good news for the “tax and spend” Chancellor of the Exchequer, Gordon Brown.

It is equally bad news for the European Commission President Romano Prodi, who recently received a letter from the six biggest net contributors to the EU budget, informing him that those countries would prefer to cut their contributions from the current 1.24 percent of annual GDP to 1 percent. Judging by that letter, the EU bureaucracy has — once again — succumbed to the law of unintended consequences. By harmonizing European regulations, Brussels has forced the member states into a tax-cutting mode, which will result in less revenue for the bureaucrats to play around with. Well done!

This article first appeared on Tech Central Station