Europe and the Mirage of Tax Competition

By Antoine Cerisier 

On 12 June 2013, the Gava courthouse in Barcelona filed a case against Lionel Messi. The Argentinean player and his father are suspected of using companies based in Uruguay and Belize to defraud the state of more than 4 million euros. A few months earlier, Bayern Munich’s general manager Uli Hoeness and French Budget Minister Jérôme Cahuzac were both accused of evading taxes through undeclared bank accounts in Switzerland. Ironically, the latter was leading the fight against tax fraud in France. A number of European multinationals, such as UBS and Vodafone, have also been suspected of taking part in proven or alleged evasion schemes. These high-profile cases have raised public awareness of tax dodging in Europe and given credit to its detractors. For instance, the Tax Justice Network estimated that 20 to 30 trillion dollars are currently held in tax havens worldwide. The issue is especially sensitive for European countries in the current context: securing stable tax revenue has become an urgent priority in times of recession and high public debt. Furthermore, the existence of tax havens within Europe – including Switzerland, Luxembourg and the Channel Islands – remains a pressing challenge for the continent.

French Budget Minister Jérôme Cahuzac “fighting against tax fraud” in November 2012

French Budget Minister Jérôme Cahuzac “fighting against tax fraud” in November 2012

The global financial meltdown cannot be fully understood without acknowledging the role of tax havens. While they did not cause the crisis, it was suspected that “the trillions of dollars flowing through secretive tax havens have created the conditions for the current global financial instability”. This suspicion may be justified for a number of reasons. First, havens aggravated the “too big to fail” banking problem by allowing large financial services companies to avoid domestic regulations and gain competitive advantage over smaller rivals. Second, they contributed to systemic risk and the lack of transparency of the international financial system. Indeed, numerous hedge funds located in offshore centres – the Cayman Islands in particular – engaged in risky shadow banking activities, including off-balance sheet securitisations and credit default swaps. This behaviour was largely responsible for the US subprime mortgage crisis which had a severe and long-lasting impact on the world economy. In sum, tax havens and the global financial meltdown are closely interlinked issues. This link is especially relevant for the European Union. A number of EU member states – including Greece, Portugal and Cyprus – have been hit by severe debt crises since 2008; tax dodging played a major part in those crises. It is usually recognised that fraud lies at the heart of the Greek financial collapse. In fact, rich tax debtors may owe as much as 13 billion euros to the government, only a fraction of which has been collected since the start of EU-IMF Troika intervention. The total cost of tax evasion is estimated at 55 billion euros – almost 20 percent of Greece’s GDP and enough to wipe out its annual budget deficit.

Despite that, there has been very little progress in recent years and many policymakers insist austerity remains the way forward. In the immediate aftermath of the financial crisis, the G20 claimed to launch a dramatic crackdown on tax havens. French President Nicolas Sarkozy and British Prime Minister Gordon Brown were particularly active. However, most of the current efforts are undertaken unilaterally by some European governments with very little coordination. Sceptics like John Kay insist “today’s political outrage is humbug” as the official discourse has seldom been followed by concrete action. Some of the most notorious tax havens are not even recognised as such by the OECD as powerful countries managed to get their names off the list. For instance, British Overseas Territories such as the Channel Islands are rarely mentioned in official reports. More disturbingly, even European countries struggle to reach an agreement about offshore financial centres or tax evasion and create common standards.

Laffer curve

While corporate interests and power politics may explain the lack of significant progress on the issue, one should not overlook a crucial factor: ideology. A number of economists and policy analysts praised tax havens and tax competition prior to the financial meltdown and continue to do so. Their inherent assumption is that lower taxes on corporate income and wealthy individuals are always beneficial for a country. Hence, tax havens are very valuable “because they discourage anti-growth tax policy”, according to the libertarian Cato Institute. The Adam Smith Institute, a conservative British think tank, even bluntly stated that “tax havens help the poor” as they encourage tax competition and foster economic growth, which in turn benefits the least well-off in society. This is a very shaky argument as there is no significant correlation between economic growth and reductions in top marginal tax rates. Nevertheless, neoliberals often rely on the much debated Laffer curve which predicts that government revenue starts to decline if taxes are too high. The empirical data confirms the race to the bottom predicted (and supported) by such ideologically motivated commentators. Indeed, the average corporation tax rate in the OECD has fallen from 47 to 27 percent in the last 25 years – a 43% decrease, as illustrated by the graph below. This trend was particularly salient in the 1980s following the conservative revolution undertaken by Ronald Reagan, Margaret Thatcher and their followers. Europe is no exception: average corporate taxes in the European Union dropped by more than a third since 1995 – from 35 to 23 percent. A similar trend can be observed for top personal income tax rates which dropped by 9 percentage points between 1995 and 2013.

Race to the bottom: OECD trends in corporate tax rates since the 1980s

Race to the bottom: OECD trends in corporate tax rates since the 1980s 

Did this fiscal race to the bottom foster economic growth or financial stability in Europe? The current crisis seems to prove otherwise. It could also be argued that tax competition brings little benefit in the long run. Indeed, the competitive advantage created by tax cuts soon disappears when other countries engage in the same policy. Since all EU member states significantly reduced corporate and top income tax rates in the last thirty years – albeit some more than others –, the marginal benefits associated with tax cuts are probably limited. This is especially true in times of economic recession and high public debt, as this strategy puts additional strains on public finances. Moreover, European governments often compensate for tax competition by slashing welfare spending and increasing consumption taxes such as VAT. According to Eurostat, the average VAT rate in the EU has risen by almost 10 percent since 2005. While it is an easy source of revenue for European governments, this trend is problematic. Indeed, it affects primarily the least well-off as consumption taxes are not progressive on income; besides, excessive taxes on consumption can hamper an already sluggish internal demand by increasing prices.

tbc

It is commonly argued that excessive taxation on high incomes deters entrepreneurs from investing in a country. The table above, which compares taxation levels in 11 EU member states and their links with foreign direct investment (FDI), seems to prove otherwise. Partly thanks to its low corporate tax rate, Ireland attracts more foreign investment than most other European economies: FDI inflows account for more than 14 percent of Irish GDP. However, there seems to be no clear relationship between low taxation and high levels of foreign direct investment for other countries. For example, low-tax Poland receives very little FDI while Belgium, Sweden and France attract considerable amounts of investment in spite of high taxes on personal and corporate income. Political stability, research and development, infrastructure, transport and an educated workforce are all crucial incentives for firms to invest abroad. Therefore, the exclusive focus on tax competition is clearly not the right strategy for European economies, especially in times of recession and high public debt. Instead, the European Union should lead the fight against havens – including those within its own borders – and create a more integrated tax system. For instance, the common consolidated corporate tax base (CCCTB) proposed by the European Commission could oblige companies to record their profit across all member states, thus halting the development of harmful tax havens in the old continent.

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