Taxing times

Mar 21st 2005
From The Economist Global Agenda

Germany’s chancellor has proposed a cut in corporate income tax. This might put Germany in a slightly better position to counter “harmful” tax competition from other European countries, but tax reform alone will not revive its flagging economy

A LITTLE over a decade ago, Americans were being bombarded with books threatening precipitous economic decline if they did not drop their hypercapitalistic ways and adopt the German “stakeholder model”, which allowed labour and capital to work harmoniously for economic growth. Nowadays, anyone coming across such a book could be forgiven for concluding that its authors were daft. German GDP growth has not broken the 2% barrier in four years, and unemployment is at levels not seen since the 1930s. In desperation, Germany seems ready to look to the hypercapitalists for ideas: Gerhard Schröder, the chancellor, has proposed a cut in corporate income tax, to 19% from 25%.

This is not quite as large a concession to big business as it sounds. The proposed change is designed to be revenue-neutral; what it gives in lower marginal rates, it takes back by closing loopholes, particularly the ability of companies to charge losses in previous years against current income. Germany currently has the highest corporate tax rates in Europe, but it also has some of the most generous allowances. Consequently, the corporate levy raises only 2.9% of total tax revenue, compared with as much as 20% in other rich countries.

But while the proposed tax cut may not do much to bring Germany’s ailing economy back to life, the announcement has nonetheless made economic observers sit up and take notice, for it seems to signal that the German government may be conceding defeat in the battle over “harmful tax competition”. Along with France and Belgium, the Germans have been leading the attacks on the practices of European Union members—primarily Ireland—who charge low rates of corporate income tax. For years they have been calling for tax harmonisation among members, code for forcing low-tax countries to raise their rates. The OECD, a club for rich countries, has also got involved: in 2000 it published a blacklist of 35 nations it identified as havens for large companies looking to shrug off their rightful tax burden.

Nonetheless, tax competition remains a bigger problem for European countries than for the rest of the OECD. In fact it is Japan and America, not Germany and France, which have the highest corporate taxes. It is probably not a coincidence that both are heavyweights without comparable counterparts in their region—Canada’s population is only a tenth of America’s, and Japan has no neighbours at all in the same GDP class. Geography thus insulates them, to some extent, from the consequences of high corporate taxes.

In Europe, on the other hand, efforts to keep taxes high have suffered a number of setbacks. Ireland is not merely recalcitrant, but is setting an example for the new kids on the block. Ireland’s stunning GDP growth—from 70% of the EU per-capita average in 1990 to 136% in 2003—has made the EU’s new entrants determined to emulate it. In large part, it seems, that means lower tax. Hungary has set corporate tax at 16%, Slovakia has a flat 19% levy for corporate and personal income, and Estonia levels no tax at all on reinvested profits. The companies of “Old Europe” have responded by moving production eastward.

Germany’s new tax cut will not put it in a position to compete with such low rates. The effective rate of its federal and local corporate tax will fall only to 32.7% (from 38.7%), still a hefty bite out of profits. It will, however, bring the rate in line with other rich countries, such as France and the Netherlands—and in Germany’s weak economic state, every little bit helps.

Europe has been in a long process of tax reform since the 1980s, when Margaret Thatcher and Ronald Reagan led the way with sweeping changes to their tax codes. Back then, top marginal rates of 70-80% were not uncommon, and tax laws everywhere were riddled with decades-worth of accumulated deductions. Mrs (now Lady) Thatcher and Reagan slashed top rates and eliminated many deductions, creating tax codes with lower marginal rates on a much broader tax base. This, it is generally agreed by economists, is a recipe for faster economic growth, and over the past two decades continental Europe has followed suit.

That hasn’t meant a lower tax burden overall. On the contrary, taxes as a percentage of GDP grew steadily throughout the OECD from the mid-1970s to 2000, falling only during the recent recession.

Now, however, tax reform may have entered a new stage. Even as the global economy recovers, its imperatives are making it harder for countries to levy taxes as they would like, particularly on capital. Freer trade makes it much easier for companies to move to low-tax locations (it is not much good relocating your factory to Hungary if your goods face a 50% tariff going back to the home country). And faster communications make it ever easier to locate new services abroad.

It’s about more than tax

Does this mean that rich countries with fat welfare states are doomed to a “race to the bottom”, slashing spending on social programmes in order to keep their tax rates attractive? Probably not. More likely, taxes will simply fall more heavily on labour, which is less mobile than capital. Sweden and Denmark, which have the heaviest tax burdens in the OECD as a percentage of GDP, are among the least dependent on corporate income tax for revenue.

Moreover, while taxes are an important factor in corporate decisions about where to put facilities, they are not the only, or even the biggest, one. Germany’s corporate-tax burden may be twice the rate levied in some Central European countries, but its wage costs are six times as high. And though the recent Hartz reforms have begun to stir Germany’s sclerotic labour market, the country is still widely regarded as a difficult place to do business. As long as hiring and firing are wrapped in a thicket of red tape, it will take more than a tax cut to induce companies to create jobs.

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.