Does the European Union Believe in Ghosts?: An Unwarranted Fear of Tax Competition

A spectre is haunting Europe: the spectre of tax competition. The cause for this fear is the upcoming entry of 10 new members into the European Union: Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, and Slovenia. According to reports, some European leaders fear the 10 new states will use their lower corporate tax rates – on average, 10 percent lower – to poach businesses from older EU members.

Fear of tax competition is especially acute in Germany. In March, German Chancellor Gerhard Schröder warned that the difference in taxation rates could spark a “competitive situation that is problematic for the current members of the European Union.” He has even branded German companies thinking of relocating to a lower-taxed EU jurisdiction as “unpatriotic.” Unfortunately, such overheated rhetoric is obscuring the benefits that tax competition could bring to the EU.

Capital mobility

Herr Schröder is not alone. Two years ago, American political scientist Kenneth Thomas gave an excellent summary of why some developed world governments fear the effects of tax competition. He began by noting that, “over the past 40 years, the world has witnessed a sharp increase in capital mobility.” The fall of the Soviet Union quickened the pace, as countries which previously rejected market economics sought to join the global market system. As capital mobility increases, states “engage in more intense efforts to compete for investment.” One of the most popular ways to do this has been by cutting corporate taxes.

Thomas also notes that, as taxes on capital fall, governments have to adjust by either raising other taxes, incurring greater debt, or cutting spending. However, politicians, as rational actors who seek re-election as their primary goal, hate having to make such hard choices. Raising taxes, borrowing money, and cutting spending are not exactly ways to make one-self popular.

When a leader such as Chancellor Schröder complains about tax competition, he illustrates Thomas’s contention that “governments are now attempting to jointly regulate their own behavior to reduce tax competition.” That is, they are tired of having to make hard fiscal choices and this risks upsetting voters. Discouraging tax competition provides a way to return to the “good old days” of taxing and spending without having to compete with lower taxing jurisdictions.

“Race to the bottom”

Opponents of tax competition say that interstate pressure to keep taxes low represents a destructive “race-to-the-bottom.” In Germany’s case, the Schröder government worries that lowering tax rates to keep German industrial firms from relocating to, say, Poland, would put undue pressure on the German welfare state and German labor laws.

However, contrary to Chancellor Schröder’s fears, tax competition would greatly benefit Europe. British pundits Barry Bracewell- Mil nes and Josephine Carr have made the case for tax competition as follows: Government spending and taxes always seem to go up in modern Western democracies. This is due to what they call “the pressures of lobbies for increased government expenditure and taxation.” No mystery here – politicians find ready supporters when they shower tax monies on some voting bloc. Thus, the incentive to tax and spend recklessly is great. This is where tax competition comes in. “Internationally,” Bracewell-Milnes and Carr note, “tax competition can provide an effective institutional counterforce” to this trend. Put another way, “governments learn good as well as bad tax habits from their neighbors.”

Further, they point out that attempts to “harmonize” corporate tax rates throughout the Union would “lessen the competitive strength of European economies” in relation to non-European jurisdictions.

The spectre haunting Europe is nothing to fear. A bit of intra-EU tax competition seems like just the thing to make sure the EU as a whole remains tax-competitive relative to North America and Asia. By these lights, the 10 new EU members are doing their neighbors a favor by creating pressures for low taxes overall.