Relative taxation and competitiveness in the European Union: what the European Union can learn from the United States

Journal of Policy Modeling24 (2002) 401–410

Relative taxation and competitiveness in theEuropean Union: what the European Union

can learn from the United States

Dominick Salvatore∗

1 Red Oak Road, Bronxville, NY 10708, USA

Received 5 January 2002; received in revised form 30 January 2002; accepted 1 March 2002

Abstract

In recent years, there has been a great deal of discussion and controversy about theneed to harmonize taxation in the European Union (EU). High-tax countries such asGermany, France and Italy are demanding the harmonization of taxes in order to estab-lish a level-playing field and thus avoid the loss of foreign direct investments to countriessuch as Ireland and the United Kingdom, which have much lower corporate and personalincome taxes. The paper presents reasons why tax harmonization in the EU countires maybe neither feasible nor desirable and concludes that there is much that the EU can learnfrom the United States in the tax field.© 2002 Society for Policy Modeling. Published by Elsevier Science Inc. All rights reserved.

Keywords: Effective tax rate; International competitiveness; Level-playing field; Relative taxation;Statutory tax rate; Tax harmonization

1. Introduction

In recent years, there has been a great deal of discussion and controversy aboutthe need to harmonize taxation in the European Union (EU). Even after the wave ofrecent tax reductions, some countries, such as Germany, France, and Italy, remainhigh-tax countries. These countries are demanding the harmonization of taxes in

∗ Tel.: +1-914-961-2917; fax:+1-914-771-7791.E-mail address: [email protected] (D. Salvatore).

0161-8938/02/$ – see front matter © 2002 Society for Policy Modeling.PII: S0161-8938(02)00119-9

402 D. Salvatore / Journal of Policy Modeling 24 (2002) 401–410

order to establish a level-playing field in the EU and, thus avoid the loss of foreigndirect investments and, indeed, the migration of some of their firms, entrepreneursand highly skilled people to countries such as Ireland and the United Kingdom,which have much lower corporate and personal income taxes.

In this paper, I will conclude that, although differences in taxation affect inter-national competitiveness, tax harmonization in the EU countries may be neitherfeasible nor desirable. Here, there is much that the EU can learn from the UnitedStates — a country with the most competitive economy in the world and with lowertaxes than most EU members — and where there is not even a thought being givento harmonizing taxes among states. Indeed, in the United States, taxation is animportant element of interstate competition in attracting investments from otherstates and from rest of the world. Trying to harmonize taxes across EU countriesis neither feasible nor desirable.

2. Relative tax pressure in EU countries

Taxation can influence the international competitiveness of a nation in a crucialway. Indeed, EU countries seem to increasingly compete with tax policies.Table 1shows the relative tax pressure in the EU members in 2000. Column (2) ofTable 1shows that the corporate tax rate ranged from a low of 24% in Ireland to a high

Table 1Relative tax pressure in the EU, US, and Japan in 2000

Country Corporate tax rate Income tax rate Governmentfor individuals spending

Austria 34.0 32.0 51.8Belgium 39.0 40.0 49.6Denmark 32.0 35.0 53.7Finland 29.0 27.0 45.3France 41.7 35.0 52.6Germany 40.0 31.0 47.6Greece 40.0 15.0 43.3Ireland 24.0 27.0 28.9Italy 37.0 34.0 48.1Luxembourg 33.0 11.2 37.2The Netherlands 35.0 37.5 45.2Portugal 32.0 25.0 46.6Spain 35.0 25.0 40.6Sweden 28.0 31.0 54.9United Kingdom 30.0 20.0 39.1

Average EU 34.0 28.4 45.6

United States 35.0 15.0 28.9Japan 30.0 10.0 39.3

Source:WEF, 2000–2002.

D. Salvatore / Journal of Policy Modeling 24 (2002) 401–410 403

of nearly 42% in France, with an average of 34% for the 15-member EU. Thecorporate tax rate is relatively low in Sweden (28%), Finland (29%), and the UnitedKingdom (30%) and relatively high in Italy (37%), Belgium (39%), and Germany(40%). These compare with a corporate tax rate of 35% in the United States and30% in Japan. Thus, if a multinational corporation, European or otherwise, shopsaround (as it often does) for a lower corporate-tax-rate country in which to set upproduction and sales facilities, it surely has ample choice within the EU, and itis the loss of such investments that high-corporate-tax countries experience thatleads them to demand tax harmonization.

Column (3) ofTable 1shows that personal income tax rates also differ widelyamong EU countries. They were lowest in Luxembourg (11.2%), followed byGreece (with 15%), the United Kingdom (20%), Portugal and Spain (25%), Ire-land (27%), Sweden and Germany (31%), Austria (32%), Italy (34%), France(35%), the Netherlands (37.5%), and Belgium (40%), with an average of 28.4%for the 15-member EU in 2000. These rates compare with the very low rate inthe United States (15%) and Japan (10%). It is clearly advantageous for highlyskilled individuals and entrepreneurs to work and start new economic activities inLuxembourg and the United Kingdom, within Europe, and especially in the UnitedStates, outside Europe. Although Japan has the lowest personal income tax rate,it imposes many restrictions on the migration of even highly skilled people andentrepreneurs and on the setting up of new firms as not to provide much attractionfor individuals and entrepreneurs to relocate there.

Finally, Column (4) ofTable 1shows the level of overall government expendi-tures as a percentage of GDP in the EU member countries, and in the United Statesand Japan in 2000. These figures can be used as a general index of total fiscalpressure in the various nations. The values range from a low of 28.9% for Irelandto a high of 54.9% for Sweden, with an average of 45.6% for EU in 2000. Germanyhas a rate of 43.3%, Italy 48.1%, and France 52.6%, as compared with 28.9% forthe United States and 39.3% for Japan. Europe is simply a high-tax-pressure areain relation to the United States and Japan.

3. Statutory and effective corporate tax rates in EU countries

The official or statutory tax rates given inTable 1hide many exceptions, sub-sidies, and other tax benefits as to make official tax rates highly suspect as thetrue measure of fiscal pressure in a country. To overcome this problem, the DutchFinance Ministry commissioned a study to calculate effective corporate tax ratesin the various EU countries (Buijink, Janssen, & Schols, 2000). These are shownin Table 2. Column (2) ofTable 2shows the official or statutory average corporatetax rate from 1990 to 1996, and Column (3) shows the corresponding effective ratein the various EU countries (unfortunately, more recent data are not available oreasily obtainable). From Columns (2) and (3) of the table we see that effective taxrates differ widely from the statutory rates. The difference is highest for Portugal


Table 2Effective tax pressure in the EU: 1990–1996 average

Country Statutorycorporatetax rate (%)

Effectivecorporatetax rate (%)

Difference ineffective rate inrelation to average

Survey result ontax system incountry (1999)a

Austria 36.0 17.7 −9.2 4.0Belgium 40.3 21.0 −5.9 2.5Denmark 35.8 29.4 2.5 2.7Finland 34.0 29.8 2.9 4.0France 34.7 32.8 5.9 2.1Germany 50.1 38.5 11.6 2.3Greece 32.5 20.9 −6.0 3.1Ireland 21.9 13.9 −13.0 4.7Italy 50.5 35.3 8.4 2.2Luxembourg 39.4 34.1 7.2 5.4The Netherlands 35.0 31.8 4.9 4.4Portugal 39.3 17.2 −9.7 3.3Spain 35.3 24.1 −2.9 3.5Sweden 28.5 27.5 0.6 2.6United Kingdom 33.4 29.0 2.1 4.3

Average EU 36.5 26.9 – –

Sources: for corporate tax rate,Buijink et al. (2000); for survey, WEF (2000).a Tax system in your country promotes bus. Competitiveness: 7, strongly agree; 1, strongly disagree.

(22.10), Belgium (19.29), and Austria (18.35) and smallest for Sweden (1.07),France (1.88), and the Netherlands (3.20), for an average difference of 9.59 for the15-member EU countries. Thus, looking at the statutory rate gives a very distortedpicture of relative corporate tax pressure in the various EU countries.

Column (4) shows the difference in the effective corporate tax rate in each EUmember with respect to the EU average and, thus provides a more appropriatemeasure of the relative corporate tax pressure in the various nations. The datain Column (4) show that Ireland has the lowest tax pressure with an effectivecorporate tax rate 13% below the EU average. It is followed by Portugal with anindex of −9.7, Austria with−9.2, Greece with−6.0, Belgium with−5.9, andSpain−2.9. All other countries face an effective corporate tax pressure above theEU average, which is 0.6% above the EU average in Sweden, 2.1 in the UnitedKingdom, 2.5 in Denmark, 2.9 in Finland, 4.9 in the Netherlands, 5.9 in France,7.2 in Luxembourg, 8.4 in Italy, and 11.6 in Germany. Thus, Germany, Italy, andFrance have the highest effective corporate tax pressure among EU countries andthat explains why these nations are clamoring for tax harmonization.

The last column ofTable 2shows the result of a survey conducted by the WorldEconomic Forum (WEF) in 2000 in which a large sample of corporate CEOs in EUcountries were asked to rank from 7 (the highest) to 1 (the lowest) the statement:“the tax system in your country promotes business competitiveness.” A survey is,of course, a very subjective measure, but it does indicate the perception of CEOs


as to how they view the tax system in their country, and it is on these perceptionsthat they often base their investment decisions. For example, an Italian CEO willlook to invest elsewhere (say in Ireland or England) if he or she believes thatthe tax system in other countries promotes business competitiveness much morethan in Italy. The survey result show that the highest score (i.e., the nation wherethe tax system is perceived to be most supportive of business competitiveness) isLuxembourg with a score of 5.4. It is followed by Ireland (4.7), the Netherlands(4.4), the United Kingdom (4.3), Austria and Finland (4.0), Spain (3.5), Portugal(3.3), Greece (3.1), Denmark (2.7), Sweden (2.6), Belgium (2.5), Germany (2.3),Italy (2.2), and France (2.1), for an average of 3.4 for all EU members. Althoughthe rank correlation between the effective tax rate and the survey results is not veryhigh (32.5%), the survey results do show that German, Italian, and French CEOsperceive their countries to be high corporate-tax-pressure countries, as shown inColumn (3) of the table.

4. Relative taxation and the international competitiveness of EuropeanUnion countries

Relative effective taxation affects the international competitiveness of nations.One measure of the overall international competitiveness of nations is calculatedby the Institute for Management Development (IMD) in Lausanne, Switzerland.IMD defines international competitiveness as the ability of a country or companyto generate more wealth for its people than its competitors in world markets. Fourbroad factors were used to measure the relative productivity of each nation. Theseare: (1) economic performance; (2) government efficiency; (3) business efficiencyfinance; and (4) infrastructure (the extent to which resources and systems areadequate to serve the basic needs of business). IMD used 286 criteria, grouped inthe above four categories, to come up with an overall competitiveness of variousnations.

To be sure, measuring international competitiveness is an ambitious and diffi-cult undertaking and, although useful, it faces a number of serious shortcomings.One is the grouping and measuring of international competitiveness of large andsmall countries together. It is well known, however, that large and small coun-tries have very different industrial structures and face different competitivenessproblems and so the results are difficult to interpret. Another serious shortcomingis that the correlation between the international competitiveness and the real percapita income of different nations does not seem to be very high. For example,the international competitiveness index is higher for Greece than for Italy eventhough the real per capita income is much higher in the latter than in the former.The question that naturally arises is: if Italy is less internationally competitive andproductive than Greece, where is its much higher per capita income and standardof living coming from? In economics, we like to think that productivity determinesper capita incomes and the standard of living, and so it is disconcerting to see such


a blatant variance between expectations and reality. Despite these shortcomings,however, the international competitiveness results presented above do retain somevalidity because these are the general factors that investors examine in decidingwhere to invest.

Krugman’s (1994)criticism that “international competitiveness is an irrelevantand dangerous concept because nations simply do not compete with each other theway corporations do, and that increases in productivity rather than internationalcompetitiveness are all that matter for increasing the standard of living of a nation”is not really valid. It is true that a country’s future prosperity depends on itsgrowth in productivity, but this can certainly be influenced by government policies.Nations compete in the sense that they choose policies that promote productivity.As pointed out byDunning (1995)andPorter (1990), andSalvatore (1993, 1998,2001), international competitiveness does matter.

Column (2) ofTable 3shows the international competitiveness index calculatedby IMD (2001) for the 15 EU nations in 2001. As the most competitive amongthe 15-member EU nations, Finland is assigned an index of 100. Luxembourg issecond with an index of 99.3. This means that, according to this index, Luxembourgis about 0.7% less internationally competitive than Finland. The Netherlands isthird with an index of 97.7 and Ireland is fourth with an index of 95.0. Theyare followed by Sweden (93.4), Germany (88.7), Austria (86.9), Denmark (86.2),Belgium (79.1), the United Kingdom (77.6), Spain (72.1), France (71.5), Greece(59.8), Italy (59.5), and Portugal (58.0) for an average of 81.7 for all 15-memberEU. The United States is the most competitive nation in the world with an index of119.9, while Japan has an index of 68.9, which is the lowest for the G-7 countries,with the exception of Italy.

Column (3) shows the degree of inefficiency of each EU member relative tothe EU average. That is, Column (3) gives the difference between the internationalcompetitiveness index of each EU country with respect to the EU average of 81.7in 2001. These data provide, of course, the same information as Column (2), butpresent that information in a way that permits combining the competitivenessresults shown in Column (3) with the effective corporate tax rate results presentedin Column (4) (repeated fromTable 2).

Column (5) ofTable 3shows the sum of the inefficiency index with respect toFinland of each EU country in Column (3) and the effective corporate tax rate inColumn (4), and provides a measure of the effect of the relative effective corporatetax pressure in each EU country on its level of international competitiveness. Thedata in Column (5) show that Ireland, with a small index of relative inefficiency(5.0) with respect to Finland and the lowest effective corporate tax rate (13.9),has the smallest index of competitive and tax disadvantage among EU countries(18.9). Finland comes second with an index of 29.8; Austria is third with an indexof 30.8, all the way to Spain with an index of 52.0, France with 61.3 and Italy with75.8, for an average of 45.2 for all 15 EU countries.

Column (6) ofTable 3shows the overall index of the combined competitivenessand tax advantage (−) and disadvantage (+) of each EU member with respect

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to the EU average. Ireland comes out with the highest relative competitivenessand tax advantage with an index of−26.3. This means that taking into accountthe international competitiveness of Ireland, as modified by its relative effectivecorporate tax rate, investing in Ireland provides an overall competitive advantageof 26.3% with respect to the average EU country. Finland provides an averagerelative advantage of 15.4%, Austria 14.4%, the Netherlands and Sweden 11.1%,Luxembourg 10.4%, Belgium 3.3%, and Denmark 2.2%. All the other nations facean average overall competitiveness and effective corporate tax disadvantage. This is4.6% for Greece, 6.2% for the United Kingdom, 6.8% for Spain, 7.2% for Germany,14.0% for Portugal, 16.1% for France, and 30.6% for Italy. In conclusion, the datain the last column ofTable 3show that there are very powerful forces for EUand outside multinational corporations not to invest in Italy, France, and Portugalbut to prefer Ireland, Finland, Austria, the Netherlands, Sweden, Luxembourg,Belgium, and Denmark, in that order, among EU countries. Competition amongEU countries to attract inward investment is likely to intensify as a result of thecreation of the euro at the beginning of January 1999 and its circulation at thestart of 2002 since the single currency removes exchange rate risks and makes itmore tempting for firms to shop around about where best to locate their businesseswithin the EU (see,OECD, 1998).

5. Tax harmonization in EU countries

The data ofTable 3show that differences in effective corporate tax rates oftenreinforce rather than dampen differences in international competitiveness in EUcountries, in encouraging or discouraging investing in the nation on the part ofthe nation’s and foreign multinationals. For example, Ireland does well both oncompetitiveness and on taxes, and it represents the best location for business toinvest. Indeed, and as we have seen, the data in the last column ofTable 3showthat Ireland provides an overall competitiveness and tax advantage on investingthere in excess of 26% with respect to the EU average. On the other hand, Italyhas both a competitive and a tax disadvantage of 22.5% with respect to the EUaverage.

These results would seem to lead to the conclusion that tax harmonization in theEU countries is absolutely essential in order to establish a level-playing field forall types of investments (domestic, EU, and others). This, however, is not the case.The reason is that the tax pressure in a country only shows the costs of taxationwithout showing the benefits provided by tax money and both benefits and costsare necessary to properly evaluate the incentive or disincentive that the nation’s taxsystem provides in investing in the nation. A high-tax country may, nevertheless,be a good place in which to invest if the nation uses the tax money efficiently toprovide infrastructures and other services that would be more expensive for thefirm to provide for itself. A firm is willing to pay even a high tax for the privilegeof doing business (i.e., producing and/or selling) in a rich market, in a market


with good schools and a healthy environment in which the firm’s officers andemployees would be willing to work and raise their families, and in a market withgood infrastructures and a well-trained labor force and a well-functioning labormarket. But it is impossible to determine the incentives or disincentives providedby the nation’s tax system without at the same time estimating the benefits thatfirms get from the tax money that they pay.

For example, in the 1980s, both Switzerland and Germany imposed a tax oninterest income generated in their country, but the Swiss tax was successful andit was retained because the Swiss banking system provided adequate benefits toinvestors (not least of which was bank secrecy), while the Germany tax was afailure and had to be removed because little or no direct benefit was received byinvestors from the tax paid, and if Germany had not removed the tax it wouldhave lost this tax base in view of the high international mobility of capital thatexisted even then. Thus, looking only at the tax burden without at the same timealso looking at the benefit from the tax tells us very little about the effect of thetax on the location decision of firms and individuals.

Since the tax benefits that firms get from their tax money differ from firm tofirm, however, tax harmonization may neither be feasible nor useful in the EU.This would be like wanting to charge the same price for products of differentquality. What EU nations should strive is to provide services to businesses thatjustify the tax money that they pay (i.e., link benefits more closely to taxes) ratherthan try to harmonize taxes. A high-tax country would not be at a disadvantage inattracting and retaining firms, highly skilled workers, and entrepreneurs in relationto a low-tax country if the high-tax country provides services commensurate withthe high taxes. In short, the countries with the highest-tax benefit/cost ratio willattract and retain firms and individuals, while the countries with a low ratio willlose them (see,Fratianni, Salvatore, & von Hagen, 1997). Thus, one way for acountry to improve its position would be either to reduce taxes or increase thebenefit that firms and individuals receive from the taxes they pay. Hence, thefear that tax competition will reduce taxes excessively in the EU countries isunfounded — unless firms and individuals were not to behave rationally or wereunable to calculate correctly the benefits that they receive from their tax money.But as the results of the survey shown inTable 2show, this does not seem to be thecase. Tax competition among governments may be as beneficial as competitionamong firms — it should be encouraged, not discouraged.

To be sure, statutory corporate tax rates have fallen by several percentagepoints in the EU during the past 3 years and more reductions are likely to fol-low in the near future particularly in those countries, such as Italy, which seem tohave the lowest tax benefit/cost ratio. In any event, tax harmonization as called bythe German and French governments is next to impossible because it requires una-nimity in decision-making, and low-tax countries such as Ireland and the UnitedKingdom are strongly opposed to it. Most other countries are also opposed to taxharmonization because fiscal measures are some of the few remaining policy op-tions left to them. Most firms and individuals in the EU are strongly opposed to


tax harmonization because of their strong suspicion that taxes would be harmo-nized upward. Knowing the quarters from which the calls for tax harmonizationin the EU come from (i.e., France, Italy, and Germany — some of the highest-taxcountries) this suspicion cannot be said to be entirely misplaced.

What tax competition is likely to do is to reduce the number and level of re-distributive taxes in the EU since, by their very nature, they are non-benefit taxes.The EU finance ministers did agree in December 1997 on a voluntary code of con-duct in business taxation so as to avoid or eliminate “harmful” tax competition, bywhich they meant special tax regimes considered to be discriminatory by business.EU officials are now investigating some 200 tax breaks thought to be harmful (taxdumping) and subject to being abolished by the year 2003 — but this is not taxharmonization. Of course, tax competition occurs not within the EU but also be-tween the EU countries and other countries, particularly the United States, whichdoes better than any EU country on international competitiveness and probablyalso on tax competition. Here, there is not even the talk of tax harmonization. ButOECD (1999)is developing an international code against “harmful” tax compe-tition. And with the world becoming more and more open to international tradeand factor movements, it is crucial for EU member countries to link more closelytheir taxes to the benefits that they provide — lest they lose even more interna-tional competitiveness to the United States. In fact, most EU member countrieshave reduced or are moving toward reducing taxes.

References

Buijink, W., Janssen, B., & Schols, Y. (2000, January 1). Evidence of the effect of domicile on corporateaverage effective tax rates in the European Union.MARC Working Paper 3/2/2000-11.

Dunning, J. H. (1995). Think again professor Krugman: Competitiveness does matter.The InternationalExecutive, 37(4), 315–324.

Fratianni, M., Salvatore, D., & von Hagen, J. (Eds.). (1997).Handbook of macroeconomic policies inopen economies. Westport, CT: Greenwood Press.

Institute for Management Development. (1998/2001).The world competitiveness yearbook. IMD:Lousanne.

Krugman, P. (1994, March/April). Competitiveness: A dangerous obsession.Foreign Affairs, 28–44.OECD. (1998).Harmful tax competition: An emerging global issue. Paris: OECD.OECD. (1999).EMU: Facts, challenges and policies. Paris: OECD.Porter, M. (1990).The comparative advantage of nations. New York: Free Press.Salvatore, D. (Ed.). (1993).Protectionism and world welfare. New York: Cambridge University Press.Salvatore, D. (1998). Globalization and international competitiveness. In J. Dunning (Ed.),Globaliza-

tion, trade and foreign direct investments (pp. 1–18). New York: Praeger.Salvatore, D. (2001). The economic performance of small versus large countries. In D. Salvatore & M.

Svetlovic (Eds.),Small states: Challenges and opportunities (pp. 71–90). New York: Palgrave.World Economic Forum. (2000–2002).The global competitiveness report (2000–2002). Geneva: WEF.

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Relative taxation and competitiveness in the European Union: what the European Union can learn from the United States