IREF - Institute for Research in Economic and Fiscal issues
Fiscal competition and economic freedom
In the recent past, many States resorted to public spending increases in order to boost their shaky economies. At present, they have to face great deficits. They believed, no doubt, that there is no need to obey to financial constraints, but the market reminded them that any debt has to be reimbursed some day. Indebted and weakened governments are now forced to cut on spending and increase taxes. Hence an urgent need for a scapegoat. Fortunately enough, there are still some places to turn to for a credible alternative. Analysis from Jean-Philippe Delsol.
Angela Merkel is doing a U-turn
Angela Merkel has promised tax cuts and free-market policy. She is doing exactly the opposite. Taxes won’t be decreased and she is even asking for the introduction of a new tax on banks. She has also decided unilaterally to control short saling. –The truth is: she doesn’t want to know about market anticipations and she is forbidding market instruments pretending that they promote speculation, while those instruments are actually revealing the difficulties economies are going through. She is also supporting the tax on banks proposed by the EU Commission.
True, she no longer has absolute majority. But maybe she could have kept it if her views had been less volatile and more consistent with her past promises. David Cameron could meet the same difficulties after he recently announced an increase taxes on interests.
EU Commission is eager to tax and regulate financial institutions
Internal Market and Services Commissioner Michel Barnier said: “It is not acceptable that taxpayers should continue to bear the heavy cost of rescuing the banking sector”. This is surely a valid point, but the proposed solution—to tax all banks regardless of their position and behavior, in order to refill the money tank of international funds—is highly inappropriate. This proposal represents one more step torwards European fiscal harmonization, which will for sure not be in taxpayers’ interest.
The European Commission is also in favor of a regulation of hedge funds. This will prevent many of them, especially those domiciled in tax havens, to have access to the European market. The principal losers from this situation will be European firms for which hedge funds are an important source of capital. In 2008, hedge funds have lost on average about 20% of their value, while French CAC 40 lost 40%! But hedge funds are a perfect scapegoat, because most people are ignorant about their functioning.
To put an end to fiscal specialization as in the US?
More intelligent is the reform already voted by the House of Representatives and the Senate of the United States that abolish forced specialization between deposit and investment banks. It is not unusual for banks to buy derivatives with their clients’ money, except if there is another explicit arrangement between the bank and its client.
The separation of deposit and investment banking, called “bank specialization” by the founder of Crédit Lyonnais Henri Germain, was often presented as a useful instrument for small investors’ protection. In fact, it made it impossible or more difficult to finance job creation (investment) by short term resources (deposits), although banks know how to offer interest-bearing current accounts and can consolidate more liquid deposits. The reform therefore goes in the right direction. The dark side of it however is that, at least in the US (Volcker plan), the banking sector will be controlled and sanctioned by supervising authorities that has proven their inability to forecast and avoid the subprime crisis. Moreover, the two institutions Fannie Mae and Freddie Mac, responsible for the beginning of the crisis and still suffering heavy deficits (to be covered by American taxpayers’ money), are not concerned by the reform! The views of American democrats are definitely ideological.
Local administrations are pretending to be asphyxiated by the banks
During the times of prosperity, local administrations grabbed every opportunity to increase their debt at low interest and gladly followed advises given by the banks to purchase some very sophisticated financial products. Thanks to those products local administrations (municipalities, counties, districts) were able to borrow at relatively low rates (3.61% on average), but those were adjustable rates and the loans were spread in the long term, sometimes 35 years. In France, it is the state-owned Dexia bank, which granted most of those loans, to not less than 2800 local administrations. For example, the Council of the department of Seine Saint Denis has a debt of € 900 million and 95% of it is made of structured products.
In Italy, local governments have also borrowed a lot of “derivative” loans for a total cost of € 9 billion. Today, those governments complain that banks are strangling them demanding important amounts of money in order to transform the adjustable rate of the loans in a fixed one. Banks, they say, are forcing them to increase taxes. Some local governments are even bringing suits against their banks. The City of Saint Etienne, France, brought suit against Deutsche Bank, while Milano indicted four banks for having received undue payments relative to the interests on its loans. But none of those local administrations could pretend to have been forced to borrow at the conditions offered by the banks. They had the opportunity to check the soundness of the contract’s terms, for example by asking for external expertise. They rightly wish to be in charge of local taxation, but, at the same time, they clearly show how incompetent they are.
Iceland also tried to accuse banks, but again the report from the parliamentary commission in charge of investigating the October 2008 crash of the Icelandic banking system denounced the “extreme negligence” of the government and of the central bank.
Everything is to be blame on the crisis
Yet, the crisis does not explain all the troubles. In France, the socialist president of La Cour des comptes, Didier Migaud, considers that the crisis is responsible for three fourths of the increase of the deficit and for 80% of the drop in fiscal revenues. The rest, he explains, is “the consequence of poor management of expenses and of decisions taken before the crisis”. He is giving for example the decision made prior to the ciris to decrease VAT for the (fast) food sector; a decision that did cost € 1.3 billion to the budget.
But Mr. Migaud’s anaysis remains a socialist one; that is, partial and sweetened. As a matter of fact, the real sources of trouble stays with on one hand theexcessive leveles of taxes and social contributions and, on the other hand, the lack of flexibility on the markets, especially on the job market, that are impeding any initiative. Regulations and compulsory payments in the United States are still much less constraining than they are in Europe, and the economic activity is there starting to recover – the GDP growth is estimated at 3.2% for 2010, while in Europe it is only at 1.2%.
The flat tax is coming up in Europe
However, the taxation landscape is not entirely dull and depressing. For there are several good news, especially regarding the coming up of the flat tax in Europe. For example Estonia, the most northern of Baltic countries, is hoping to adopt the euro on January 2011. After a harsh crisis in 2009, a slowdown of 14.1% of the GDP and unemployment rate of 14%, this little country of 1.2 million inhabitants is already getting back on its feet. Estonia opted for an exceptional rigor, including the suspension of public expenses and a cut in wages (Estonian ministers accepted a 20% cut in their salaries during the crisis). The budget deficit in 2009 has been limited to 1.9% of the GDP and the public debt to 7.2%. The fact that Estonia adopted since 1994 the flat tax at a rate of 20% could also explain the rapid recovery.
Poland, the only European country with positive economic growth during the crisis (1.7%), is on its way to become a flat-tax country with Corporate income tax rate at 19% and only two brackets for Personal income tax with rates at 18 and 32%.