Thursday, 26 August 2004

A Pyrrhic Victory for Statism?

European pro-federalist politicians are patting themselves on the back after agreeing on a new constitution, but their self-congratulation may be premature. In part, this is because voters in several countries might decide that they do not want to be governed by hundreds of pages of dense bureaucratic prose. But even if the politicians manage to dupe people into approving the constitution (probably by forcing them to vote over and over again until they “get it right”), the document contains a landmine that will cause headaches for political elite in Brussels.

Notwithstanding efforts by high-tax nations such as France and Germany, the draft constitution retains the unanimity rule for tax matters. This means that a single country has the ability to block any and all tax harmonization proposals. This is important because “tax competition” has become a very powerful force for economic liberalization in Europe. But the handful of nations that are driving this process – including Ireland with its 12.5 percent corporate tax rate and Slovakia with its 19 percent flat tax – could have been out-voted and forced to raise taxes if the constitution relied on “qualified majority voting” for tax matters.

Leftist policy makers are very unhappy that the unanimity rule still exists. German, French, and Belgian officials made a last-minute push to water down the provision, but they could not even get agreement for majority rule voting for more limited issues such as tax fraud. Representatives from the European Commission also wanted the unanimity rule weakened, but (relatively) low-tax nations – including the United Kingdom, Ireland, and several new members from Eastern Europe – were not persuaded.

Politicians in high-tax countries are right to be concerned. There is every reason to believe that tax competition will become even more prevalent in the future. One reason is that the European Union has expanded to 25 nations, and several of those countries have aggressively reduced tax rates and implemented pro-growth tax reforms. In addition to Slovakia, the three Baltic nations have flat tax regimes, and countries such as Poland and Hungary have corporate tax rates of less than 20 percent. This almost surely will lead businesses to migrate eastward and pressure nations from “Old Europe” to lower tax rates. Indeed, the recent decision in Austria to lower the corporate rate from 34 percent to 25 percent was a direct response to the enactment of Slovakia’s 19 percent flat tax.

Another reason to expect further tax competition is that taxation is one of the few fields left where governments in the EU are allowed to compete. In some economic policy areas, such as trade, nations have no ability to compete by lowering tariffs. In other fields, like labor policy, there is a limited degree of national flexibility, but it is safe to say that national governments increasingly are playing second fiddle to the Brussels bureaucracy – and the draft constitution will further constrain their options. One of the biggest exceptions, of course, is taxation, which is why governments will be even more prone to use tax policy to improve competitiveness (much as airlines competed with better food and cute stewardesses back in the days when the Civil Aeronautics Board rigged fare prices).

While the prospect of enhanced tax competition should cause angst in Paris and Berlin, the battle is far from over. Advocates of tax harmonization have three potential options to undermine economic liberalization:

They can try to get unanimous support for tax harmonization schemes. This is unlikely, but not unprecedented. The European Union, for instance, obtained provisional approval for the savings tax directive (a proposal to more extensively double-tax income that is saved). But this effort – assuming it ever goes into effect – consumed several years and it unlikely to be repeated. Setting up another tax cartel is probably a futile exercise. Estonia, Ireland, and Slovakia are just a few of the nations that presumably would reject any proposals to hinder their competitive position.

They can try to use a provision in the draft constitution to thwart tax competition. This new language states that, “The Member States shall coordinate their economic and employment policies within arrangements as determined by Part III, which the Union shall have competence to provide.” Nobody seems to know what this nebulous prose means, but you can bet that France and Germany will argue that “coordinate” means “harmonize.” Given that the constitutional deliberations re-affirmed the unanimity rule, it is hard to imagine that this approach will succeed.

Last but not least, they can petition the European Court of Justice to rule that differential tax rates are somehow inconsistent with the “single market.” But this requires the Court to ignore the fact that an EU single market with disparate tax rates has existed for decades – a rather preposterous notion. Nonetheless, left-wing academics are promoting this theory, and high-tax nations presumably hope that some hand-picked judges might give them a back-door victory for tax harmonization. Like the other options, this seems to be a dubious proposition.

High-tax nations may not have a silver-bullet strategy, but they have no choice but to fight tax competition in every possible way. Welfare states are unsustainable when taxpayers cannot be treated like fatted calves waiting for slaughter. Mobility of labor and capital is a threat to big government. It is much more difficult to rob Peter to pay Paul when Peter can move across national borders.

The EU constitution is a statist document, but the failure to dismantle the unanimity rule was a major setback for left-wing politicians. But it is the only silver lining in a dark cloud for taxpayers in fiscal gulags like France, Germany, and Sweden. The future of Europe is still bleak, but tax competition may save the day by forcing high-tax nations to make dramatic reforms.

By Daniel J. Mitchell

This article first appeared on http://www.TechCentralStati…