European Economic Perspectives 21

Discord over Harmony

Recent calls for tax harmonization across the European Union make an explicit analogy between low business taxes and illegal state aids. Timothy Besley and Paul Seabright argue that there are deep flaws in this view.

Germany has signalled that a top priority for its EU presidency will be the harmonization of business taxation. The aim is to prevent wasteful competition between member states trying to attract corporate investment and hence driving taxes below ‘reasonable’ levels. The Commission too, particularly internal market commissioner Mario Monti, argues that low business taxes should be treated just like illegal state aids: as ‘unfair’ subsidies to domestic firms at the expense of those based elsewhere in the EU.

On the surface, the analogy between tax competition and state aid seems reasonable. But it is deeply flawed for at least two reasons. First, not all state aids are illegal - only those that ‘distort competition in the common market’. And while the Commission lacks clear criteria for distortions of competition, economic analysis suggests that they can only be diagnosed when state aids in one country have a clear negative impact on the economy of another. This will be true of some but not all cases of aid; indeed, the Commission itself turns down less than 2% of all aid notifications.

State aid is most suspect when it aims to give a substantial commercial advantage to a domestic firm with significant market power - relative, that is, to other domestic taxpayers who provide the revenue to fund the aid. But here the analogy with the general level of business taxation is particularly poor. Taxes apply to all domestically established firms: they reflect the cost of operating in a particular tax jurisdiction with its public goods and services and regulatory framework. There is no more reason to expect these costs to be the same across countries than to expect the cost of labour or of traffic congestion to be the same across countries.

The experience of the United States is instructive here: US markets for outputs and inputs are fully integrated yet considerable variations in tax policies remain. Attempts to coordinate tax policy are mostly limited to informal meetings between elected officials, such as meetings of state governors. With business taxation, states have generally converged to a common base - that used by the federal government - but there is no obvious tendency for convergence in rates over time.

When US firms are asked about what influences their location decisions, taxes rarely figure among the numerous policy and non-policy factors they cite. Indeed, creating a business-friendly environment goes well beyond tax factors. For example, recent evidence suggests that union recognition laws may be particularly important. The US federal government accepts that these are policy decisions to be taken at a state level and it is hard to pinpoint the deleterious consequences.

If low taxes in one country really can harm another, this has to be argued on its own merits, not by a weak analogy with state aid. Take the case of Ireland, which has enjoyed an average growth rate of around 5% a year for the last decade and a half, and has also been spectacularly successful at attracting foreign direct investment. It seems reasonable to suppose that low taxes have played a significant part in Ireland’s economic success. But has this harmed other countries in the EU?

The answer is unclear. Some investment has perhaps gone to Ireland that might have gone elsewhere in the EU. But at the same time, some has come to the EU that would not otherwise have come at all. The investment in Ireland has probably been more productive than it would have been elsewhere. And Ireland's growth has probably had some modest yet positive spillover effects through trade with other EU members.

Arguably, the Irish experience has also had an important demonstration effect of the value of creating a business-friendly climate. To insist that the net effect on other countries has been negative is to go far beyond the available evidence. And a policy based on this uncertain claim risks blunting the beneficial incentives that have had such good outcomes in Ireland.

The second reason why state aid is a bad analogy for tax competition is that the latter puts downward pressure on the overall level of public expenditure while the former tends to increase it. Much of the EU effort to control state aid has been devoted to coordinating measures to reduce ‘excessive’ or ‘wasteful’ public spending. It is clear from recent decisions and policy documents that the Commission believes individual governments are subject to failures that result in excessive spending. The same belief has informed the post-Maastricht measures on debt and deficits as well as the common concern about unfunded pension liabilities. Coordination may be a good way to reduce public expenditure or raise taxes in the long term - but it is unlikely to do both.

A more subtle view of the problems of an EU without tax harmonization is that business taxes will be too low and personal taxes too high since capital is mobile and labour is not. But while this is a coherent argument, it is far from being established empirically. It also conflicts with the widely-held belief that tax policy should favour savings.

The general point remains: tax competition is not just like state aid - its impact is on the opposite side of the public accounts. And if you really believe that political forces result in public expenditure that is too high, then you should probably welcome tax competition if you think it will tend to cap taxes, since this adds to the pressure to cap spending.

Recent media discussion of tax harmonization has generated a number of other myths. One is that tax harmonization is intrinsically a worse infringement of national sovereignty than EU control of state aid. But if tax competition really does have bad effects on other countries, then it is reasonable to coordinate tax rates. The point is not that the argument could not possibly be true, simply that it has not been convincingly made.

A second myth, particularly prevalent among UK drinks manufacturers, is that harmonization is needed to achieve lower excise duties and hence reduce the loss of so much revenue from alcohol and tobacco to other member states. But this can be done without harmonization. The issue is not convergence: tax competition provides strong incentives for convergence anyway. It is whether to converge up or down - whether current EU tax rates are above or below their desirable long-term level. This question has not been properly asked, let alone convincingly answered.

A third myth is that tax harmonization is a requirement of the euro. But, as noted above, US states have their own tax rates within a single currency area with no apparent ill-effects. Arguments suggesting that monetary union requires curbs on deficit finance should not be confused with discussions about the appropriate structure and mix of taxation by individual members of that union.

These three myths - to take only the most striking - all have obvious flaws. The myth that tax competition is like illegal state aid is considerably more subtle. But it is time it was laid to rest.

Timothy Besley
Professor of Economics, London School of Economics, and Co-Director of CEPR’s Public Policy programme

Paul Seabright
Senior Research Fellow, Churchill College, Cambridge, and Research Fellow in CEPR’s Industrial Organization and Transition Economics programmes

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