Harmonized tax zone may deter corporate investors, expert warns

By Peter Chapman

Date: 10/06/04

Franco-German plans to set up a harmonized tax zone of like-minded countries are a good idea - but corporate investors still might be tempted to put their money in lower tax countries elsewhere in Europe.

That's the warning from Peter Birch Sørensen, one of Europe's leading tax economists and a staunch critic of unfettered tax competition.

Senior German sources told this newspaper they believed a pioneer tax zone would be attractive to foreign investors because they would have just one harmonized corporate tax base - the activities that are taxed - together with harmonized rates, for a large part of their EU activities. This would wipe out the costs of complying with several different and complex tax codes - a powerful incentive to investors.

However Sørensen said there would be a limit to what company bosses would swallow before choosing another location.

He told European Voice: “Whether a harmonized corporate tax system will make the group of cooperating countries a much more attractive place to invest will obviously depend on the level at which taxes are harmonized.

“If the level is too high, peripheral countries with a milder tax climate may still offer an attractive alternative investment location.”

The average corporate tax rate in the ten new member states is around 24%. Estonia has even introduced a zero rate for some companies. By contrast, corporations in Germany and France pay more than 30%.

The Franco-German tax plan could well be another victim of the two countries'

well-publicized spat on industrial policy, after German investors in its drugs and engineering giants were rebuffed. Nevertheless, Sørensen said “a good case can be made for a binding minimum corporate tax rate within the EU to reduce the scope for beggar-thy-neighbour policies through unfettered tax competition”.

He said creating a zone of EU countries with a harmonized corporate tax base alone would pose practical problems that can only be solved by strict limits on the tax rates.

“It would reduce the costs of tax compliance for companies with operations in more than one country within the zone.

“However, since narrow tax bases often go hand in hand with high statutory tax rates, and vice versa, a harmonization of the tax base without any harmonization or approximation of tax rates could exacerbate existing differentials in the 'effective' corporate tax burdens within the zone.” This, he said, would “further distort the cross-country allocation of capital”.

“This provides a rationale for harmonizing rates as well as bases, although this would clearly be a big and controversial step. Another rationale for tax rate harmonization is that this would reduce the scope for corporate tax avoidance through the practice of transfer-pricing,” he said.

Clever companies can reduce their tax liabilities by transferring assets around different business units in different member states and charging themselves inflated 'internal prices'.

Other experts - including former Federal Reserve Bank economist Kevin Hassett, a fellow of the American Enterprise Institute, a right-wing Washington think-tank - have a less nuanced approach to corporate tax.

“Tax harmonization is an attempt by the more inefficient countries to stop competition. They likely pursue this strategy because they do not have the political will to change their own outmoded policies.”

Moreover, Hassett suspects German Chancellor Gerhard Schröder is incapable of choosing a low rate: “In a study I recently published, my co-author Eric Engen and I found that countries with lower corporate tax rates had significantly higher corporate tax revenue than countries with higher rates. Having a high rate, as Schröder recommends, is like shooting yourself in the foot. If he is successful, though, the long-run cost to the EU will be enormous. After all, the rest of the world is rapidly improving the efficiency of its tax treatment of capital. If the EU fails to keep up, the economic consequences will be dire.

“All of the new businesses will be in Asia,” warned Hassett.

Peter Birch Sørensen, a leading tax economist and critic of uncontrolled tax competition, has warned that French and German plans to use the 'enhanced co-operation' procedure to create a voluntary zone of harmonised corporate taxes, whilst a good idea, may cause corporate investors to put their money in lower tax countries elsewhere in Europe.