A Service of Leibniz-Informationszentrum econstor Wirtschaft Leibniz Information Centre Make Your Publications Visible. zbw for Economics Boss, Alfred Working Paper — Digitized Version Do we need tax harmonization in the EU? Kiel Working Paper, No. 916 Provided in Cooperation with: Kiel Institute for the World Economy (IfW) Suggested Citation: Boss, Alfred (1999) : Do we need tax harmonization in the EU?, Kiel Working Paper, No. 916, Kiel Institute of World Economics (IfW), Kiel This Version is available at: http://hdl.handle.net/10419/2268 Standard-Nutzungsbedingungen: Terms of use: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Documents in EconStor may be saved and copied for your Zwecken und zum Privatgebrauch gespeichert und kopiert werden. personal and scholarly purposes. 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Since the series involves manuscripts in a preliminary form, interested readers are requested to direct criticisms and suggestions directly to the author and to clear any quotations with him. Abstract For many years there have been political intentions to harmonize tax rates in Europe. As to capital income taxation, competition is often seen to be especially harmful. Facing a high degree of international capital mobility, every country is expected to reduce its tax rate in order to attract new capital or not to lose capital allocated in the country ("race to the bottom"). It is shown that the development of capital income tax rates in the European Union (EU) and in other industrialized countries as well as the development of corporate income tax revenues do not indicate that a race to the bottom has taken place. If tax competition should become as fierce as some observers seem to fear, the arguments in favor of tax competition instead of harmonization should be kept in mind. If tax rates are cut in a process of competition, govern- ment expenditures have to be reduced; this helps to avoid waste and inefficien- cies in the public sector. In addition, tax competition might help to find better tax systems, and every country could learn from the experiences of other countries. In contrast, tax harmonization would probably lead to higher taxes in the EU. JEL Classification: H 20, H 87 Keywords: Tax Competition, Tax Rate Harmonization, Value-added Taxation in the EU, Capital Income Taxation in the EU Table of Contents A. Tax Rate Differences in Europe — an Overview 1 B. Is VAT Rate Harmonization Necessary? 5 1. The Main Elements of Value-added Taxation 5 2. Is the Integration of Markets Impeded by Tax Rate Differentials? 6 C. Does Harmonization of Capital Income Taxes Make Sense? 10 1. The Problem 10 2. The Theoretical Background of the Harmonization Argument 11 3. What Happened to Corporate Income Taxation? 13 4. Germany: A Special Case 17 5. The Arguments Against Harmonization 17 6. Harmonization of Taxes on Interest Income in the EU? 21 D. Concluding Remarks 23 Bibliography 24 Do We Need Tax Harmonization in the EU? For many years there are political intentions to harmonize tax rates in western Europe. The Commission of the European Union (EU) even exerts some political pressure to adjust the value-added tax (VAT) rates in a union-wide system. The pressure probably will become stronger after the creation of the EMU. As to capital income taxation the harmonization issue is often debated under the headline of tax base erosion. The paper discusses the question if it makes sense to harmonize the value added tax rates or the capital income tax rates in the EU. It is organized as fol- lows: In an overview the most important tax rate differences between the EU countries are shown. The second section deals with the issue of VAT harmoni- zation. The third section investigates the issue of capital income tax harmoniza- tion; differences in the taxation of labor income (wage income tax, contribu- tions to social security (payroll tax)) will not be discussed. A. Tax Rate Differences in Europe — an Overview About 30 years ago, most of the European countries adopted a system of taxing net value added instead of gross sales of firms. Within the European Commu- nity (EC) respectively the European Union the VAT bases were adjusted to a large extent; the tax rate differentials became smaller in the course of time, tax rates still diverge, however (Table 1). The European systems of capital income taxation are difficult to explain and to compare. Firms pay — depending on their legal status — assessed income tax or corporate income tax and often some other taxes (e.g. property tax). Apart from the statutory tax rates many subtle and complex legal arrangements (e.g. rules for depreciation allowances) are important. Table 1 — Value Added Tax (VAT) Rates in the European Union, 1998 (p.c.) Regular rate Reduced rate(s) Zero ratea Austria 20 10; 12 — Belgium 21 1;6; 12 yes Denmark 25 — yes Finland 22 8; 17 yes France 20.6 2.1; 5.5 — Germany 16 7 — Greece 18 4; 8 — Ireland 21 3.6; 10.0 . yes Italy 20 4; 10 yes Luxembourg 15 3; 6; 12 — Netherlands 17.5 6 — Portugal 17 5; 12 — Spain 16 4; 7 — Sweden 25 6; 12 yes United Kingdom 17.5 5 yes EU15 18.5b — — EMU 18.3b — — Addendum: Switzerland 6.5 2; 3 Japan 5 — — Canada (federal) 7 — yes aZero tax rate for specific sales (e.g. sales of newspapers in Belgium and Denmark) combined with a credit (against tax liability) of the amount connected with the purchases. — "Weighted by 1997 GDP shares. Source: DATEV (1999); BMF (1998). It is not possible to characterize the main features of the systems and to assess their attractivity for investors in this paper. However, in order to give some information on the tax systems in Europe, the (statutory) corporate income tax rates for retained earnings are presented (Table 2). Discussing the topic "tax harmonization" it is useful to have a look at the development of the tax rates in the recent decades. All over the world, tax rates for retained earnings had risen in the sixties and seventies. They started to decline worldwide in the eighties (Koop 1993). Germany followed the develop- ment with some delay. Table 2 — Corporate Income Tax Rates in the European Union, 1998 (p.c.) Tax ratea Taxation of dividends*3 Austria 34 tax reduction Belgium 40.17 "classical" system Denmark 34 "classical" system Finland 28 tax reduction France 36.67 tax reduction Germany 47.48 integration systemc Greece 35 tax reduction Ireland 36 tax reduction Italy 41.25 tax reduction Luxembourg 31.2 tax reduction Netherlands 35 "classical" system Portugal 34 tax reduction Spain 35 tax reduction Sweden 28 "classical" system United Kingdom 31 tax reduction EU15 35.1d-e EMU 36.3d-f Addendum: Switzerland 8.5 "classical" system Japan 43.98 tax reduction United States (New York) 40.8 "classical" system including taxes of states and local governments. —- ''Correction at the firm or shareholder level in order to avoid double taxation af distributee profits. — cFor corporate and personal income taxation. — "^Simple average of tax rates. — e38.58 p.c. weighted by 1997 GDP. — f40.69 p.c. weighted by 1997 GDP. Source: DATEV (1999). In order to obtain comprehensive (statutory) tax rates, estimates of the average rate of local or state corporate taxes have to be taken into consideration (Rimbaux 1996, Appendix C). The (statutory) rates for Germany, France and the United Kingdom fell in the 1970-1995 period (Rimbaux 1996: 93). A breaking point occurred in the mid of the eighties (Figure 1). A phase of rate decline started when the United Kingdom lowered its rate from 52 to 35 p.c. Figure 1 — Legal Tax Rate Including Local Taxes p.C. 30 i—r "i—i—i—i—i—i—i—i—i—r I—i—i—i—i—i—i—i—i—i—r 1970 1975 1980 1985 1990 1995 Source: Rimbaux (1996: 93). between 1984 and 1986; at the same time expensing (immediate write-off) as a rule for measuring depreciation allowances was abolished. France followed rapidly. Germany, however, only reacted with a delay of about five years. The tax rate differentials between Germany and the United Kingdom and between Germany and France — both in the range of 10 percentage points in the seventies and part of the eighties — even increased somewhat because the rate cut in Germany was relatively modest. Nowadays, capital income — at least in the form of retained earnings of corporations as an important part of it — seems to enjoy a more favorable treat- ment than in the seventies.