Tuesday, 30 November 2004

The Cradle of the European Tax Rebellion: Estonia

At a recent ECOFIN meeting in Scheveningen (Netherlands), European finance ministers clashed over Franco-German proposals to harmonise EU corporate taxes to prevent lower-tax member states luring away investments from higher-tax members. More particularly, the French and German governments are pushing for minimum tax bands throughout the EU.

In order to bring about greater transparency and make bookkeeping easier for European companies, the European Commission has proposed to harmonise the basic rules for calculating company taxes throughout the 25 member states. But it strongly opposes any moves to eliminate the right of individual countries to set their own levels of tax. This position is supported by Britain, Ireland and new EU members in eastern Europe. Frits Bolkestein, until recently European Commissioner responsible for internal market taxation and customs union issues, supports competition in fiscal policy. In his view: ‘Taxes in Europe are too high and represent a threat to economic development.’ The British Chancellor of the Exchequer Gordon Brown, the fiercest opponent of the Franco-German initiative, commented in the same vein, insisting that he would resist any harmonisation. ‘We believe that tax competition is the best way forward … we will not support any move toward tax harmonisation,’ he said in Scheveningen.

But some big European countries do not agree. They see the low (corporate) tax rates as a threat, not only to investments but the welfare state at large. The French Finance Minister Nicolas Sarkozy, a possible French presidential candidate in 2007, has even gone so far as to bully the new member states, arguing that if they are rich enough to keep taxes low, then they should not seek billions of euros in structural aid funds from the older members. In doing so, he was more or less echoing earlier statements, in May, by the Swedish Prime Minister Göran Persson and German Chancellor Gerhard Schröder who have complained that the rich are not taxed heavily enough in new member states.

Of course these statements have provoked a fierce rebuttal from new members including Poland, Hungary, the Czech Republic, Slovakia and Estonia. In support of this stance, the new European Commission has also refuted the French proposals, saying that it rejected any links between tax rates and structural funds.

The new member countries are keen to replicate Ireland’s economic miracle. When Ireland joined Europe in 1973, its per capita income was just 62% of the EU average; by 2002 it was 121%. By slashing taxes and the state’s share of the economy, the Irish were able to exploit their access to the EU market and encourage a massive influx of foreign direct investment. By 1998 American multinationals accounted for 70% of Irish exports. The top corporate tax rate, once over 40%, now stands at 12.5%; the state’s share of GDP, which hit 54% in the 1980s, is now down to 33%. Unemployment is less than 5%.

But besides Ireland, the new member countries have another role model within their own ranks, the successes of which they are eager to emulate: Estonia!

How It All Began

Leading his coalition to election victory in the autumn of 1992, the ‘golden boy’ of Estonian politics, the then 32-year-old Mart Laar compiled a youthful government to push through many of the most difficult ‘shock therapy’ reforms, guided by an extremely liberal economic outlook. Mart Laar* was an historian with limited knowledge of economics. In the absence of a

‘driving manual’ on how to transform a command economy into a free market economy, he had to rely on some basic fundamental economic thoughts, such as the idea that lower taxes will lead to higher public revenues. This idea had been around for some time — many centuries and probably even millennia. But it was reinvigorated not earlier than in the seventies, when the American economist Arthur Laffer, sitting in a restaurant and explaining to a friend the mechanism behind it, depicted a graph on a napkin, which later became world-famous as the Laffer curve. Though modest tax reductions became fashionable in its wake, the idea had never been put into practice in a radical way. It was Estonia which set the ball rolling with a flat-rate 26 per cent income tax. The philosophy behind the flat-rate tax is simple. People that work more and earn more should not be punished for it. Progressive taxes act as a disincentive. In Estonia, the flat-rate tax fostered capital formation, lead to higher productivity levels, higher wages, and job creation. Moreover, a flat income tax rate is easy to collect and control. Today Estonia is even considering a further reduction in tax rate, to 20%.

Moreover, Estonia abolished all import tariffs, it introduced a balanced budget required by law, massive deregulation and so on. Estonia also abolished it corporate tax on reinvested profits. These lessons have subsequently been eagerly absorbed in other new member states. Now Poland, Hungary and Latvia have all cut corporation tax to below 20%. Slovakia has introduced a 19% flat tax for both corporate and personal income; whereas, in the founding member states it often exceeds 30 percent. In Germany the rate is almost 40 percent, and in Sweden it ranges between 30 percent and 60 percent.

In its economic policy design Estonia has followed Milton Friedman’s ideas of liberalism. As Mart Laar stated: ‘Especially in a transition country, where the economy has to move from a fully government-controlled system to a market based one, it is very important to free the private initiative and give freedom of action to create economic value. The government must not punish entrepreneurial people; it has to encourage them, also through the tax system. The government must ensure the fair play only.

This is all a far cry from the thinking which seems to prevail in an number of countries of ‘old Europe’. Proposals to harmonize taxes invoke images of tax cartels with minimum tax levels, squeezing the taxpayer and killing incentives.

Free Market Wind Blowing From the East

Mart Laar: ‘[...] if ‘old Europe’ is to compete effectively with ‘new Europe,’ it will have to lower taxes and rethink the social-welfare systems that high taxation supports. Ten years ago Estonia became the first country in Europe to introduce flat rate proportional personal income tax, a policy designed to energize our people and stimulate growth. It was a huge success. Latvia and Lithuania followed, then Russia, Ukraine and now Slovakia. [...] It looks quite possible that within five years the whole of Central and Eastern Europe will move to flat-rate income taxes.’

Mart Laar explains that the welfare state is considered to be a core part of European identity, despite its negative impact on European competitiveness, and despite the fact that it is unsustainable in the long run. Prime Minister Göran Persson and German Chancellor Gerhard Schroeder have complained that the rich are not taxed heavily enough in new member states and are seeking to extend the EU’s power into areas of taxation and take away the national veto in a number of areas of regulation. But Laar believes that this would have a negative impact on the new member states. It is very likely that such moves will reinforce the internal problems of current member states and, moreover would transpose them onto EU level, impairing the efforts of those economies that have increased competitiveness through radical reforms — reforms that have been suggested by every EU panel and expert group over the past decade, but which have been consistently rejected by European leaders for domestic political reasons.

According to Laar, enlargement should be the catalyst that at last forces their hand. Europe’s economic malaise must be confronted if it is to compete with its global rivals. The Continent needs a clear vision and a new agenda for the 21st century. The enlargement should provide the impetus to work out this agenda and regain the
momentum for reform. New member states are poor today and still bear the burden of their communist legacy, but if they stiffen their resolve and maintain their liberal approach and open economies they may succeed not only in improving their own countries and economies, but also in injecting all Europe with a new dynamism and momentum for reform.

Who could have believed some 15 years ago that the most powerful free-market winds would now be blowing from the East instead of the other way around?

* Mr. Laar was prime minister of Estonia between 1992-1994 and 1999-2002. Today he is member of the European Parliament.

By Hans Labohm

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