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Given the remarkably low effective tax rates in Switzerland, it is natural to think of direct democracy as an important institutional determinant of the tax burden. There is indeed an ample body of research analysing tax policy in Swiss cantons and municipalities which confirms this hypothesis. For example, Feld and Matsusaka (2003) and Feld and Kirchgässner (2001) show that localities with referenda on tax policy have lower levels of government spending and taxation compared to those in which parliament decides alone.
In representative democracies, the electoral system may have an impact on the overall tax burden. In countries with proportional representation, coalition governments are common, while in countries with a plurality system, typically one winning party alone forms a government. Since in a coalition more special interests are represented, it is harder for such a government to reduce spending since they have to please all those interests. Thus taxes are likely to remain high (see Persson and Tabellini, 1999, 2001, Milesi-Ferretti et al, 2002, and Stegarescu, 2005). A similar effect may be at work in countries with a bicameral or presidential system where law making effectively needs the consensus of both major political camps. The high effective tax rates in Germany, Italy, and France fit this explanation. Conversely, the fact that the United Kingdom taxes more moderately may be attributed to the generally clear majority of the ruling party in Britain’s Lower House.
A further characteristic distinguishing Switzerland from most of the other countries is her federal structure and the strong tax autonomy enjoyed by jurisdictions at the subnational level. Since Swiss cantons and municipalities experience tax competition even inside their own country, they have a stronger incentive to keep tax burdens on mobile capital low than a unitary state where such internal tax competition is absent. As shown by recent theoretical (Keen and Kotsogiannis, 2002) and empirical (Esteller-Moré and Solé-Ollé, 2001) research, however, the joint exploitation of the same tax base by several layers of the state induces excessively high tax rates in federations. A similar effect occurs when local jurisdictions participate in a system of equalizing grants (see Bucovetsky and Smart, 2002, Büttner and Schwager, 2003). Despite the unquestionable relevance of tax competition on the municipal level, Germany has exceptionally high effective tax burdens on companies.
Preferences for redistribution.
Alesina et al. (2001) discuss the causes for the different extent of the welfare state in the United States and Europe. Based on many indicators, they show that the majority of the population in the United States are much less inclined to support the poor and to redistribute income via the public budget than the electorate in most European countries. By consequence, the higher overall level of taxation in most continental European countries may simply reflect the citizens’ stronger taste for redistribution. In that respect, the two English speaking European nations in our sample, the United Kingdom and Ireland, seem to be closer to the United States than to Europe.
Similar to a revenue requirement deriving from flaws in the electoral system, also the revenue requirement originating from a desire to redistribute income mainly explains the tax burden on employees. Nevertheless, the tax burden on capital may in itself be considered an issue for social justice, in the sense that equity requires to tax capital at least as heavily as labour income. If this is the case, a high effective tax rate for companies follows from a strong demand for redistribution alongside a high tax burden on qualified labour.
Globalisation and growth.
The position of a country in the growth process may be important for her choice of tax strategy since it affects the benefits and costs of taxing capital for redistributive reasons. Whereas the countries in our sample belonging to the EU 15, with the exception of Ireland, are characterized by a high GDP per capita and low growth rates, the accession countries are fast growing, but starting from a very low level. By consequence, in the EU accession countries there is very little capital which could be expropriated by taxation, implying that it is not really worthwhile to impose high corporate income taxes. Contrary to that, company taxation in the EU 15 countries generally promises substantial revenue and thus a high effective tax rate on companies is attractive.
The cost of redistributing income by capital taxation is also closely linked to a country’s growth rate. It is likely that in relatively poor countries, a high effective marginal tax rate on investment is particularly harmful in terms of foregone growth since the potential for growth is still large in such countries. It is striking that in our sample, the Eastern European countries typically choose a strategy of low or very low company taxation, combined with a relatively high tax on skilled employees. In 2004 this strategy of the enlargement countries is confirmed by a further significant decrease of the company tax burden in Poland and the Slovakia. Thus, while these societies seem to adhere to the continental European model of the welfare state, they are not ready to jeopardize their growth prospects by taxing corporate investment heavily. An observation confirming this conclusion is the prevalence of specific investment incentives e.g. in Slovenia and the Czech Republic which particularly reduce EMTRs, the measure of tax burden relevant for the level of investment.
All countries are exposed to globalisation, but not all are so to the same degree. According to international trade theory, small countries generally benefit from international trade and factor movements and thus are more open than large countries. Consequently, small countries should be more aware of tax induced international relocation of capital than large countries.
Since EATRs are relevant for location decisions, this fact implies that we should expect small open countries to display comparatively low EATRs, whereas large countries are more likely to stick to high EATRs despite globalisation. The results are largely in line with this hypothesis. The big European countries Germany, France, and Italy impose high effective tax burdens on companies while smaller countries like Switzerland, Ireland, Hungary, Slovenia, Sweden, Finland, Luxemburg, and Belgium display lower company tax burdens. This is particularly remarkable in the cases of Belgium and the two Scandinavian countries which definitely do not follow a general low tax – low spending strategy. Instead, these countries keep personal income taxes high so as to finance the desired amount of expenditure, but they explicitly want to attract internationally mobile firms by reducing company tax burdens, for example by a dual income tax regime. The most striking example here is probably the United States. Despite a culture of low state involvement and low taxes, the US tops the list of effective average tax rates on companies. A possible explanation for this fact is that the US is so large that an international relocation of production is relevant for only a small fraction of her companies. By consequence, the pressure to keep profit taxes low is felt much less intensely than in other countries.
There is yet another possible interpretation of the strategy pursued by the USA, France, Germany, and Italy in the process of globalisation. Since companies do not only pay taxes but also benefit from public infrastructure, it might be that these countries try to position themselves as suppliers of high value public goods which are worth the high price in terms of taxes. Compared with the Eastern European countries, the superior infrastructure in these countries certainly compensates to some extent for the tax differential. However, Switzerland, the Scandinavians, and Luxemburg are able to offer a similar package of public services together with lower tax rates, not to mention Ireland. Thus, the benefit provided by high taxes can at best explain a small part of the difference in EATRs measured.
4.3 Policy Implications
For Germany, the results of our study bear the clear message that, despite recent reforms, effective tax rates are still high in comparison with other countries. Inasmuch as high taxes are considered to be harmful for growth, Germany should reinforce her efforts in reducing the overall tax burden, especially for companies. However, the above discussion suggests that a majority of the German population may be willing to accept lower growth as a price to be paid for social justice. In particular, the Nordic and Eastern European strategy of selectively reducing corporate income taxes is inconsistent with the ideas of distributional justice held by some commentators in Germany (Kirchhof, 2002).
It is possible, however, that a consensus is about to emerge in Germany to accept lower public spending so as to be able to reduce tax burdens. If this is the case, institutional reforms may be helpful to promote a tax-reducing agenda. The collusive behaviour of state and federal governments in deciding tax policy may be a major cause for persistently high taxes (cf.
Blankart, 2000). By consequence, a more decentralised allocation of powers to legislate taxes, with some tax autonomy on the part of the Länder, might help to reduce effective tax rates in Germany. The Swiss example furthermore suggests that referenda on fiscal issues could be a way of curbing government spending and reducing tax rates.
For the European Union, the policy conclusions are different. On average, Europe does not suffer from poor growth, implying that an overall reduction in tax rates is probably not the top priority. On the other hand, the strong dispersion in EATRs across EU countries may cause firms to choose locations according to tax differentials rather than according to productivity (see Devereux et al., 2003). The ensuing inefficiency will be reduced by a co-ordinated tax base.
Several caveats are appropriate here, however. First, as shown by Sørensen (2004), a harmonisation of capital income taxes restricted to the European Union is likely to provide only moderate welfare gains. Second, harmonisation of taxes may be harmful if it allows selfinterested politicians to extract political rents from the citizens (see Edwards and Keen 1996).
Given that in the EU, decision procedures are certainly not closer to the individual citizens than in the member states, a transfer of taxing power to the European Union should be handled with care.
Finally, low corporate income taxes appear to be an integral part of the growth strategy of the new member states. It would be short-sighted to take this instrument away from these countries. If forced to raise their tax rates, they probably will react by intensifying competition in other location factors such as labour market or environmental regulation. Most importantly, because of intensified trade and reduced regional aid, the EU 15 countries will probably benefit more from dynamic growth in the recent member states than they lose through tax induced relocation of companies.
5 Summary and Conclusions
Under competitive markets for capital and highly skilled manpower, company taxes and taxes on highly skilled labour both influence the attractiveness of a particular region as a location for investment. By measuring the effective tax burden on capital investment and on highly qualified labour for 33 selected locations across Europe and the United States, we find that there is great dispersion in the effective tax rates of both factors of production. Based on that analysis, the aim of this paper is to combine these findings and to study the correlation of both types of tax burden. By doing so, we obtain a more complete picture of tax policy strategies pursued by the countries studied.
We identify three potential causes in order to explain the different tax policy strategies of different countries: (1) political institutions, (2) preferences for redistribution and equality, and (3) the position in globalisation and growth. Our findings on the effective tax rate of companies and highly skilled manpower strongly reflect these different tax strategies. However, each country shows a mix of tax strategies which lead to the country-specific tax burdens.