What Does Moving Toward a More Competitive EU Tax System Mean?

“There are two kinds of European nations. There are small nations and there are countries that have not yet realized they are small nations.”

This quote by a former Danish Finance Minister drew British ire in the middle of the 2017 Brexit negotiations. However, the underlying message may be starting to enter the minds of European leaders.

Since the European Union’s election results in June revealed a shift to the political right, “competitiveness” has quickly reemerged as a key buzzword. In President von der Leyen’s recent speech introducing the next college of commissioners, she went as far as to claim that “the whole college is committed to competitiveness!”

However, competitiveness has different meanings. For some, competitiveness is the Trojan horse for government-led industrial policy, while others simply think it represents a government willing to outsource legislative power to corporate lobbyists.

When it comes to taxation, all Member States have opportunities to increase the competitiveness of their taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities.
systems by lowering marginal tax rates, improving capital cost recoveryCost recovery is the ability of businesses to recover (deduct) the costs of their investments. It plays an important role in defining a business’ tax base and can impact investment decisions. When businesses cannot fully deduct capital expenditures, they spend less on capital, which reduces worker’s productivity and wages.
policies, and raising revenue more efficiently. At the EU level, there are policies, such as completing the Capital Markets Union (CMU) and avoiding an international subsidy race, that can accelerate investment and long-term growth.

To find actionable common ground on tax policy, the debate over competitiveness should move from politics to principles.

Calls for a Mindset Change

The calls for a more competitive Europe are also coming from beyond the newly elected government. In the last month, both the Draghi report and the International Monetary Fund (IMF) have published alarming statistics on the state of European competitiveness.

For example, the Draghi report highlights the fact that “due to slowdown in productivity growth in Europe . . . on a per capita basis, real disposable income has grown almost twice as much in the United States as in the EU since 2000.” The report points out that, up until now, “slowing growth has been seen as an inconvenience but not a calamity . . . [but] Europe’s need for growth is rising.”

The IMF attributes Europe’s weaker business dynamism compared to the US partly “to constraints to scaling up—particularly in innovation” and suggests “removing barriers to goods, services, capital, and labor flows within the single market” as a large part of the solution.

It is also no surprise that both Draghi and the IMF compare Europe to the United States in their analysis. Authors of both pieces recognize that the geopolitical landscape is changing, and becoming more competitive is the key to Europe’s success. French President Emmanuel Macron even posited that the EU only has “2 or 3 years to stave off total US and Chinese market dominance.”

The EU needs to become more economically competitive, and the incoming commission has ambitious plans. But what does it mean in practice for tax policy?

What Is a Competitive Tax System?

In the European public debate, a competitive tax system is too often mistaken to simply mean a low corporate tax rate. While the corporate rate certainly alters investment decisions, having a structurally competitive system goes far beyond that.

According to Tax Foundation’s International Tax Competitiveness Index (ITCI), a competitive tax code keeps marginal tax rates low.

When firms make investment decisions, low marginal tax rates leave a larger after-tax rate of return on investment projects. This can make more projects viable, increasing the volume of projects undertaken. Investments like these are fundamental for a country’s long-term growth. This is especially important because capital, relative to labor or land, is highly mobile.

Conversely, high marginal tax rates not only lead to reduced domestic investment but can also lead to an increase in tax avoidance and planning behavior.

However, it’s not only about corporations. The importance of competitive marginal rates also applies to personal income taxation. Without competitive marginal rates, incentives and taxpayer behavior change for the worse, which generally has a negative impact on a government’s expected revenues.

Why Is Neutrality Important?

In addition to competitiveness, the ITCI also recognizes the importance of a neutral tax code that seeks to raise the most revenue with the fewest economic distortions. This means avoiding double taxationDouble taxation is when taxes are paid twice on the same dollar of income, regardless of whether that’s corporate or individual income.
of income that is saved and invested rather than consumed immediately, while limiting the tax breaks offered to individual sectors, firms, or groups of individuals. In general, complexity is the enemy of neutrality because it tends to create unintended incentives in the tax code that encourage groups of individuals or firms to make costly changes to their behavior to gain tax advantages.

In this vein, efficiently raising government revenue is key. Consumption taxes, like the value-added taxes (VATs) in all EU Member States, tend to be less distortive (more neutral) than income taxes on firms or individuals. Even though VATs can be regressive (depending on the measure), they are generally a more stable revenue source through economic downturns. This allows governments to maintain important resources in vulnerable times and decide how to target spending to those most in need to achieve their desired level of progressivity for the overall system.

In general, a competitive and neutral tax system “promotes sustainable economic growth and investment while raising sufficient revenue for government priorities,” as the ITCI puts it.

What About Stability and Simplicity?

The EU has recently pursued tax policies, such as the implementation of Pillar Two and temporary windfall profits taxes on oil and gas companies, that go against the principles of stability and simplicity.

Pillar Two has significantly increased complexity and is not expected to yield a significant amount of government revenue relative to fiscal needs. Furthermore, it has accelerated tax competition in the form of inefficient government subsidies that undermine the integrity of the Single Market rather than on low marginal tax rates. Policymakers would be wise to consider opportunities to “declutter” the system to reduce compliance and enforcement costs for companies and tax authorities alike.

Temporary policies used to plug short-term budget holes are distortive, create tax uncertainty that can lead to reduced investment, and therefore don’t usually generate the expected amount of government revenue. The temporary windfall profits taxes have not only failed to generate significant government revenue, but they have also reduced domestic European investment in energy and sent the wrong signal to important investors.

Recommendations

Broadly speaking, there are many opportunities for EU Member States to improve the competitiveness of their tax systems by raising revenue more efficiently through less distortive policies.

As the geopolitical scene continues to change, policymakers in Europe should focus on lowering effective marginal tax rates to drive much-needed investment and long-term economic growth. Improving capital cost recovery policies (by extending loss carryforwards and capital allowances), increasing tax certainty through sound and reliable tax policy, and avoiding the temptation to enter an inefficient subsidy race will give Europe a chance to compete.

Beyond tax policy, a well-functioning CMU and a deepening of the Single Market that removes barriers to the flow of goods, services, capital, and labor are essential. Increasing European investment to drive long-term economic growth should be at the top of leaders’ agendas. Otherwise, Europe risks falling behind its geopolitical counterparts at its own doing.

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