IREF - Institute for Research in Economic and Fiscal issues
Fiscal competition and economic freedom
It’s not unusual to hear people criticise the fiscal competition states engage in, pretending that such practices lead to losses in tax revenues. In this matter, the expression “harmful fiscal competition”, which is notably retained by the European Union, is often used, though sometimes inappropriately. The “harmful” character of fiscal competition between states is actually rather questionable and one may seriously doubt the very existence of such a harmful character, regardless of its form and the circumstances that accompany it.
I would like to demonstrate bellow that fiscal competition is, on the contrary, in its principles and its applications, lawful both for states, private enterprises and individuals who are its ultimate recipients, as well as being beneficial for the economy as a whole.
Europe and its two main income tax systems
Globally, Europe is divided into two sides which, without recourse to caricature, can be defined as follows.
In the west, in that part of Europe which has sometimes in a more controversial context been styled the “old Europe”, we find those countries which lie to the west of the iron curtain of former days, and which maintain a progressive tax system by bands. In a nutshell, this system implies that the more one earns, not only the more one pays in taxes, but also the higher the tax rate for the last slice of taxpayers. This progressive system is, in varying degrees, accompanied by numerous exceptions, consisting in reductions either of the amount due in taxes, or the taxable basis in itself. The pretexts invoked to justify these tax reductions are numerous: economic policy, social benefits, promotion of certain types of ecological behaviour, disguised subsidies to certain sectors of the economy or to specific companies, agreements concluded after collective actions of certain professions exercising their influence upon the state, etcetera…
To the east of the former iron curtain, virtually every country uses a very different system, based on the idea of a “flat tax”. An enlarged tax liability is designed to include, in principle, every possible type of revenue whilst avoiding every form of exemption (apart from the bare subsistence incomes) is taxed at a relatively low rate (of about 10 to 15% in general).
These “new European” countries have used this flat tax system in order to revive their economies, crushed by decades of collectivism. They did so with success, in most cases.
It should be noted that the “flat tax” system has also been applied by some western European countries though, paradoxically, to certain specific types of income only. Thus, in several European countries, investment income is subject only to a flat tax which usually consists in withholding the taxed part of the revenue at the source. This flat tax system, applied only to certain types of revenue, preferred to others, is reserved for moveable income such as moveable capital and which are the ones most fit to benefit from fiscal competition by means of relocation.
Finally we find countries, such as Belgium, which generally make use of a progressive tax rate except for investment income which is generally subject to a flat tax at a rate of 15% but in which the scale mounts so fast that the basic income of a workman reaches 42.5% whilst the rate is capped at 50%. This country has thus invented a new system: the semiflat tax at rates which, elsewhere, correspond to the marginal maximum rate of the progressive tax scale.
The lawfulness of fiscal competition for countries
In countries that use a flat tax, the competition is obvious, like with big businesses selling the same product, because, if the basis doesn’t have too many exceptions, it’s enough to compare the rates to appreciate the level of taxation. In those countries that use a progressive tax system with lots of exemptions, the comparison is a very difficult one to make since one has to compare the numerous different rates, the income levels starting at which those rates become applicable, and on top of that one also has to keep in mind the numerous exemptions and reductions.
We are of the opinion that the competition in countries that apply a flat tax is healthier firstly because the “consumer”, in other words the taxpayer, is better informed of the choices that are open to him and secondly because governments can’t favour certain groups in comparison to others by means of tax exemptions. The flat tax has the merit of being “neutral” when it’s not accompanied by too many exemptions or reductions.
Progressive tax systems with multiple exemptions imply, on the contrary, a direct and voluntary intervention by the government, whose fiscal policy not only consists in levying the taxes and fixing the tax rates necessary for covering the state’s expenditure but also in establishing distinctions between all kinds of taxpayers by means of exemptions, fixed rates or tax credits. Thus can appear artificially created economic sectors (such as windmill energy), based exclusively on tax exemptions and reductions, which benefit certain categories rather than others, depending on the country’s policies.
Even when they are explained by the application of economic policy, these fiscal advantages constitute a form of internal and often even international “fiscal competition”: tempting the taxpayer to adopt certain types of behaviour rather than others by means of tax benefits. Taxes cease to be neutral and to serve the one goal of dividing the cost of state, becoming a political instrument used by national governments.
International fiscal competition
Strangely enough, the processes of competition which are used, now to promote the socalled “green economy”, then to answer the demands of certain social groups (the farmers, the road transport drivers and over 200 other categories in a country like France), are criticised when their purpose is to benefit the economy as a whole such as is the case for tax reductions and, especially, tax reductions for businesses. When European countries like Romania, Bulgaria or Ireland, apply significantly lower tax rates to businesses than others, critics sometimes occur, some people going as far as using the absurd notion of “fiscal dumping”.
Furthermore, when the target is to attract foreign industries or service industries by means of specific tax reductions, people start speaking of “harmful fiscal competition”; nevertheless, the strikingly official partisans of this notion have never explained… to whom this competition is supposed to be harmful.
This step is none the less identical to the one traditionally followed every time when a fiscal exemption is accorded to a determined group or activity: during the elaboration of the budget, this “fiscal expenditure” has to be compensated by the tax payer yet, he doesn’t benefit from the measure, which is hence… harmful for the taxpayer. On the contrary a linear reduction of the tax rate would grant the same advantages to all.
In reality, it has not been established that even the most extreme examples of “fiscal competition”, against which sanctions are taken at the European level, are, in fact, harmful at all to the European Union as a whole. They might be harmful for certain individual states, unable to cope with the competition, but the true question isn’t to determine whether harm is caused to “certain” states but to all of them considered together, and perhaps even more importantly to determine whether this competition is in fact harmful to the citizens and businesses of all of these states: one cannot suppose that the interest of the citizens match, de plano, to the interest of the states.
In every sector, the existence of competition can only lead to the blooming of the most efficient, and to the improvement of the condition of the consumer. In the tax field, it is important that the highest quantity of consumers, that is to say, of taxpayers, have the greatest possible amount of choices in order to avoid facing a state-run monopoly, which, like all monopolies, ends up by abusing the situation, producing mediocre products at excessive prices. This way of thinking can also be true when considering the relations between government and citizens.
The European Union, one of whose principle responsibilities is to guarantee effective competition, would be well advised to do likewise in the field of taxation.
Better competition with “flat taxation”
As in the field of business competition, it’s always preferable that this competition is expressed in the clearest terms possible for the consumer, who will then be able to make an informed choice. In the commercial field, companies are obliged to show prices in order to allow comparison with the ones of their competitors. In the countries that operate a flat tax system, things work similarly and, in general, it’s enough to compare the tax rates in order to determine which alternative is the more advantageous. This does not work this way for the countries of Old Europe, where the multiplicity of rates and exemptions make the comparison both difficult and misleading.
Furthermore, justice is rarely to be found in a system where the fiscal benefits are generally obtained by pressure groups whose main characteristic isn’t to be representative but rather to be both powerful and well organized.
In Europe, the most heavily taxed continent in the world, the establishment of the most transparent form of fiscal competition possible is essential in order to limit the capacity of states to further increase the burden of taxation, especially since the latter is already excessively heavy in comparison to the most efficient countries.