Monthly Proposal No.5: agree on an uniform corporate tax rate for Europe

Not only is the prisoners’ dilemma a well-known example in game theory. It is also a central issue in political negotiations. One of these negotiations that has to be conducted concern corporate taxes.

It was one of our past ministers of finance, Karl Heinz Grasser, who meant that he loves competition and that it was a good idea to compete with other countries by means of reducing the corporate tax rate. The incentive is clear: Lower corporate tax rates attract firms and firms crucially determine economic growth and employment. Business administrators and politicians might think that this indeed is the end of the story and so far it seems to be a reasonable plan.

However, economists know it better. Following the logic from above, any other country has an incentive to lower their corporate tax rates too. Furthermore, if they love competition as much as Karl Heinz Grasser and exhibit the same lack of information, they will continually underbid one another. Economists call this process the race to the bottom.

Theoretically, this race only ends as the public budget is not able to refinance the gifts anymore, which they handed to enterprises in terms of low tax rates or even subsidies. The burden of this policy has to be borne by households.

While this issue alone can already be criticized, it does not even take the instability and the transition costs that have to be avoided into account. So, for just a moment ignore whether the mistakes occurred in Austria or Ireland or elsewhere. Maybe in the short run even abandon the determination and enforcement of the so called efficient corporate tax rate. Just ensure that it is uniform, at least within Europe.

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14 thoughts on “Monthly Proposal No.5: agree on an uniform corporate tax rate for Europe

  1. I must admit that I haven’t done my homework on this, but is there really any strong, causally proven relationship between low corporate tax rates and business activity? I mean, if we assume the effective corporate tax rate of country X is 10% and apply this to a business that has profits equal to 10% of its turnover (both assumptions don’t seem outlandish), then taxes as a percent of turnover are 1%. Sure, it’s part of the equation, but to me it would seem there are much important institutional factors determining where a company goes and where it does not than the simple corporate tax rate. In other words, it might be we are not only “trapped” in a prisoner’s dilemma kind of situation, we might be “racing to the bottom” with no significant benefit (even in the short-term until everyone else adjusts).

    • I agree that politicians probably exaggerate the negative effects of the relative height of tax rates. Nevertheless, we can observe that low coporate tax rates attract firms (or at least their revenue, often seperated from the value adding process by impudent constructions of tax accountants). Anyway, these firms and revenues are missing in other countries. So there is some begging-your-neighbor policy ongoing even within Europe and the European Union. This has to be stopped.

  2. There are some points in Timon’s argument and a harmonized corporate tax in the EU is highly discussed in academia as well as policy making. However, I believe that the corporate tax is only a small part of a much larger work package that is ahead of us. In the internal European market, the Acquis Communautaire requires all member states to have common policies with respect to business policies. This comprises the “four freedoms” and much more regulations and directives. Policies that are still carried out on a national level are mainly fiscal ones, in particular tax policies. National governments are (for some good, but mostly for myopic reasons) unwilling to give up these competencies. That includes the corporate tax of course (about 5 billion in Austria), but also other taxes and fiscal instrument. In my belief, the EU should focus on the competition towards the USA and other global economic areas. Consequently, the right level of subsidiarity for the entire tax policy is the Union, not the member states.

  3. I fully endorse this proposal, and the uniform rate should be 0!
    The revenue from corporate taxes is small (5.5% of total tax revenue in Austria), even though rates are sizable (in Austria 25% of corporate income), which indicates that it creates large distortions. For example, one big distortion it creates is an incentive for excessive leverage, because interest on debt is deductible. It seems to me that the only real beneficiaries of the corporate tax are the legions of accountants, lawyers, and consultants hired with the single aim of saving taxes for their employers, which is not precisely a socially productive employment.

    @Flo: I think turnover is not a good standard of comparison, because corporate taxes are essentially a tax on the return on equity. I couldn’t find estimates of average RoE in Austria, but i believe it is in the area of 20%. If I’m correct the burden of the tax for businesses would be 5% of equity, which is not much, but not nothing either.

    • I might add that, although theoretically sound, there is precious little evidence for the race-to-the-bottom hypothesis. Here is revenue from taxes on business income as a share of total tax revenue in the EU27 (Source Eurostat’s Structure of taxes by economic function):
      1995: 5.8%, 2000: 7.9%, 2005: 7.6%, 2010: 6.3%. No trend there. The race to the bottom was not happening during the past 15 years.

      • The race-to-the-bottom mentioned above refers to the (marginal) coporate tax rate. Do not confuse it with absolute values! The (absolute) share of corporate taxes is also determined by economic growth, the attraction of foreign firms’ revenue and the development of the other shares of total tax revenue. Therefor, there is a race-to-the-bottom as long as corporate tax rates did decline – and they did.

      • Well, the corporate income tax is usually a proportional tax, so marginal=average rate. But never mind. The average corporate tax rate in the EU17 was 36.8% in 1995, and was 25.9% 2013. That is a decline, but hardly a “race” – and far away from the bottom. The importance of corporate income taxes as a source of government revenue has not declined, but stayed pretty much the same since 1995 (except for cyclical fluctuations). This is what my numbers were supposed to show.

      • Good point. I might add that headline corporate tax rates can be misleading, it’s effective corporate tax rates you want to be looking at (p. 16 in the .pdf I’m linking to, the difference is not as big as I had imagined though). But there does seem to have been a considerable drop (whether you want to call it “race to the bottom” is a different question) over the past decade (p. 20). It would seem that particularly the new member states are “racing to the bottom” to try and outflank the older members. Again, I am still not convinced corporate tax rates matter all that much to begin with, but just as a sidenote.

        http://ec.europa.eu/taxation_customs/resources/documents/taxation/gen_info/economic_analysis/tax_papers/taxation_paper_14_en.pdf)

      • That’s a fair point, but it’s not really relevant. The race to the bottom is supposed to be bad insofar as it leads to loss of revenue for the government. So looking at marginal tax rates (effective or not) is not what you want to do. You want to look at the absolute amount raised. And as far as I can see from the official statistics I quoted there is no downward trend in corporate tax revenue (neither as a share of total revenue or a share in GDP).

        http://epp.eurostat.ec.europa.eu/cache/ITY_SDDS/EN/gov_a_tax_str_esms.htm

  4. Let’s skip 1995 and start your row of figures by the on referred to a politically important year for Austria and Europe with an sufficient interval to cold war, 2000: 7.9 … 7.6 … 6.3 … still no trend? All I want to say hereby: don’t try to judge just based on four figures, when it is not much better than a “proof” based on just three of these figures, maybe even worse.
    However, lets assume the share of taxes provided by corporate tax is constant. Then apply the naughty neoclassical assumption of increasing marginal costs on the provision of markets. Describe the size of the market by the sum of transactions or rather take GDP. Both was and is increasing over time. Considering the previously stated assumption of increasing marginal costs that implies the need for a disproportionately higher public spending. And so on and so forth. All I want to say hereby: There is no economic rule, that determines a constant share of taxes provided by a specific source is the right share or even captures the right absolute amount.
    So for now you just have to accept: Refering to corporate tax rates there is a trend downwards and therefor there is just by definition a race-to-the-bottom. You can just claim that you prefer the bottom (0% corporate tax rate) and argue why.

    • Oh come one, you can get pretty much any trend you like if you pick the right starting point. 2000 was of course a boom year and 2010 a recession, so some downward tendency in corporate tax revenue between those two dates is to be expected. Look at the whole period for which data exists and the trend disappears. You are just cherry picking the data. That’s exactly what people do who say there has been no global warming because average temperatures have not risen since 2000.

      I guess I am still in the position that a decline over 15 years from high rates to modest rates cannot be called a race to the bottom. I never claimed 7% of total tax revenue is the right amount – I think there is a good argument to be made that 0 is the right amount and I provided a sketch of that argument. I just made the empirical observation that the share of corporate taxes shows no downward trend over the period for which we have consistent data.

  5. So what’s the story behind obviously falling corporate tax rates yet seemingly trend-less corporate tax revenues? Other taxes dropping by basically the same extent? The long-lost Laffer Curve finally found?

  6. From the paper Max posted:

    “In addition, the strong cuts in the CIT statutory rate should increasingly translate in lower revenues. One interesting issue in this respect is how the ITR on capital could keep increasing until 2007 despite such marked drops in the statutory tax rate of the CIT, one of its main components. One explanation is simply linked with the business cycle. Furthermore, however, it seems likely that the measures to broaden the corporate tax base, which have very frequently accompanied the statutory rate cuts, have been playing an important role in sustaining the ITRs; and a series of measures taken at EU level to limit harmful tax competition may too have had an impact. Eventually, however, both factors should fade out: cyclical effects depend largely on the existence of carry-over provisions for losses incurred in previous years and on capital gains, and base broadening has its limits, suggesting that a decline will take place in the coming years. One imponderable, however, is the possibility, that, stimulated by the steep fall in corporate tax rates, which in some countries are now well below the top PIT rate, growing incorporatisation has been boosting CIT revenues at the expense of the personal income tax.”

    • That’s a neat summary of possible explanations. If it were just a cyclical thing, then we should see a large decrease in CIT revenue after 2009, which we don’t. My guess is it’s a combination of base broadening (closing of loopholes) and increasing incorporatisation. Would be an interesting research question, but no time right now.

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