Corporate tax race to the bottom: is harmonization on EU level the answer?

1. The reality of corporate tax competition

Both industrialised and developing countries will face a major public funding crisis if governments don’t stop the race to lower business taxes, a report from the International Confederation of Free Trade Unions states. Tax competition is a real problem and a race to the bottom is taking place. This is especially the case within the European Union as goods, labour, services and capital enjoy free movement within EU borders. The problem of lowering corporate tax is the effect it has on the redistributive nature of taxes. For as revenues from corporate tax diminish, taxes on labour will augment, widening the gap between capital and labour while this is not the preferred social optimum in the European welfare states. On the other hand it has to be said that tax competition within certain limits can be beneficial to boost countries with a lack of comparative advantage and to allow a ‘race to efficiency’ to countries where taxes are collected in an inefficient manner. This however does imply tax competition within certain limits which is not the case looking at corporate tax competition history.

The report from the International Confederation of Free Trade Unions gives further data on the corporate tax competition. Corporate tax rates have fallen from around 45% to 30% in the last 20 years in industrialised countries. The average rate between 1995 and 2005 fell by 8,1-10,8 in the EU. The recent EU-enlargement has intensified this mechanism as CEEC’s rely less on company taxation to finance their budgets to lure FDI. Austria for example lowered its rates from 35% to 25% in 2005, Finland and Greece has cut theirs by 3% and Germany has recently made a major corporate tax overhaul by cutting its rates from 38,7% to about 29% beginning on January the first 2008 transforming its corporate tax from Europe’s top levy to a levy that is broadly in line with the other rich countries of Western Europe.

2. The role of the EU

Since the beginning of the EC, company taxation was seen as an important element for the establishment and completion of the Internal market. It is however not a direct objective of the EU. The legal basis for corporate tax harmonization is formed by art. 100, which deals with the harmonization of laws in general. This general harmonization is obligatory only in so far as the establishment or functioning of the internal market is at stake. Additionally article 94 of the EC Treaty provides for approximation of such laws, regulations or administrative provisions of the Member States as directly affect the establishment or functioning of the common market. Thus harmonization of laws per se is not a stated objective of the treaties and clearly serves to safeguard the process of integration, i.e., the harmonization of corporate taxation serves to safeguard the four freedoms and to eliminate distortions of competition in the internal market as comparative advantages are distorted by tax differences. The findings of the Ruding committee for example prove that differences in corporate tax regimes produce significant distortions of investment and location decisions. In practice however harmonization has been minimal as it is limited by the limited qualification of the community and reluctance of member states to cooperate in a substantial harmonization as taxes are touching upon the heart of a member’s state sovereignty. As a consequence, member states are reasonably free to set their own levy, tax rates and tax base. There have however been important initiatives and directives coming out of the EU legislative body.

The three major advancements concerning corporate taxation originate in the sixties and have finally been approved in July 1990. The parent/subsidiary directive (90/434/EEC) eliminates double taxation of dividend payments paid by subsidiaries located in one member state to parent companies in another. The merger directive (90/435/EEC) ensures that capital gains are no longer taxed at the time of a merger but rather at the moment when the capital gains are collected, as such contributing to the formation of European firms. The arbitration convention on transfer pricing (90/436/EEC) aims for the elimination of double taxation that occurs through adjustment of profits by tax authorities through a code of conduct and common procedures.

The above directives, however, don’t deal with the problem posed here of a race to the bottom on corporate taxes. Four fields of interest are important here: the system of corporate taxation, the tax rate, tax base and tax incentives. First of all there is the system by which the corporate tax is collected. Up to 27 different tax systems are being used throughout the EU, here simplified into three major categories. The classical system is used by the Netherlands and Luxembourg which is characterized by a complete separation of corporate and personal income tax, that means that taxable income earned by a corporation and then distributed to an individual shareholder as dividend is thus taxed twice. The full amputation system is used by Germany and only taxes shareholders under the personal income tax, eliminating the corporation tax. The other countries use a partial imputation system that partially avoids double taxation by imputing part of the corporate profit tax to the shareholder’s tax liability. Proposals like those from the Neumark committee in 1963 (split rate system), Van den Tempel report in 1971 (classical system) and finally the 1975 commission proposal to adopt EU-wide partial amputation system every time stumbled over the reluctance of the member states. The 1975 proposal also included harmonization of tax rates that would be in the range of 45%-55%. This last proposal didn’t, as mentioned, make it. The proposal even met with opposition from the European parliament which claimed that it made no sense to harmonize tax rates and leave the tax base untouched.

Harmonizing tax rates without touching upon the important differences in tax bases and tax incentives makes indeed little sense. The tax base relates to the rules that govern the determination of taxable profits. Tax incentives are frequently given through the tax base. Harmonization of the tax base would basically make it inappropriate for member states to grant tax incentives through the tax base and force member states to do so using tax credits or direct subsidies. This has also been the position of the European commission since 2001 onwards. The policy towards a common tax base was established in 2001 with COM(2001) 582. In July 2004 after discussion in an informal ECOFIN meeting on an informal paper, a working group was set up with broad support to form a proposal: the Common Consolidated Corporate Tax Base Working Group (CCCTB WG). The CCCTB WG has been meeting since November 2004 till 10 to 12 December 2007. A working paper has been prepared: CCCTB/WP/057. Revolutionary as it is, the proposal will probably take some time to come to an agreement. It is even be doubtful if the proposal will get through as similar proposals have been rejected in the past (cfr. Ruding Committee, Neumark Committee,…) It would however be a major step towards a possible solution for the corporate tax race to the bottom. As transparency on corporate taxation grows, debate on the subject becomes easier and states can become more cooperative on the subject. The open method of cooperation could be an important tool in this context.

3. Conclusion

The question raised here is to what extent a race to the bottom is actually taking place and what the place could be for the European Union. It has been the conclusion of this paper that there indeed is a race to the bottom concerning corporate tax. This growing competition between member states touches upon the heart of market, state and society. It distorts competition within the EU as it changes the comparative advantages of member states towards capital investments as proved in the conclusions of the Ruding Committee. Corporate tax competition may prove to be a short-term remedy against a lack of comparative advantage in for example Estonia (with no tax on profit reinvested in the country) but in the long run it may prove devastating as the state looses a big share of its revenues. The state and society also suffer from the results of the corporate tax race to the bottom. As state capital revenues decline, taxes on labour will have to rise to maintain the same government spending. This causes a widening gap between capital and labour, deteriorating the gini coefficient and redistributive effect of taxes which is not the social optimum of European societies with their high level of preference for the welfare state. The harmonization of certain aspects of corporate taxation are in this respect very welcome. Especially the latest moves of the commission towards harmonization of the tax base are a great leap forward to combating harmful tax competition.

The conclusion of this paper is that states should look further then their short-term view on sovereignty and take example from the early steps towards integration of the EC. Integration has often shown not to limit sovereignty but to enlarge it due to interdependency as stated by Robert Keohane and Joseph Nye. This argument is obviously the case with corporate tax competition. A shift to sovereignty through integration should be welcomed and we may only hope that the recent suggestions of the CCCPTB WB will be seen using this logic.

---

International Confederation of Free Trade Unions, Having their cake and eating it too – the big corporate tax break, 2006. (20.01.2008, International confederation of free trade unions, http://www.icftu.org/www/pdf/taxbreak/tax_break_EN.pdf).

EURACTIV, Corporate tax’ race to the bottom’ hurts EU growth, 09.11.2006. (20.01.2008, Euractiv, http://www.euractiv.com/en/taxation/corporate-tax-race-bottom-hurts-eu-growth/article-156658).

DOUGHERTY, C., Germany to lower corporate tax rate, London, International Herald Tribune, 02.11.2006. (20.01.2008, International Herald Tribune, http://www.iht.com/articles/2006/11/02/business/tax.php)

VAN MOURIK, A., The economics of tax harmonization, Leuven, K.U. Leuven, s.d., 16-24.

EUROPEAN COMMISION, Company tax, 20.01.2008. (20.01.2008, European Commission, http://ec.europa.eu/taxation_customs/taxation/company_tax/gen_overview/index_en.htm).

VAN MOURIK, A., The economics of tax harmonization, Leuven, K.U. Leuven, s.d., 16-24.

EUROPEAN COMMISION, Company tax, 20.01.2008. (20.01.2008, European Commission, http://ec.europa.eu/taxation_customs/taxation/company_tax/gen_overview/index_en.htm).

VAN MOURIK, A., The economics of tax harmonization, Leuven, K.U. Leuven, s.d., 16-24.

EUROPEAN COMMISION, Common tax base, 20.01.2008. (20.01.2008, European Commission, http://ec.europa.eu/taxation_customs/taxation/company_tax/common_tax_base/index_en.htm).