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Veronique de Rugy

December 2001

European Union Tax Cartel is Bad for US Economy

By Veronique de Rugy, Policy Analyst at the Cato Institute

Because it is increasingly easy for investment funds to cross national borders, politicians must exercise a certain degree of fiscal discipline in order to attract jobs, capital and entrepreneurs instead of losing them to another country. This is known as "tax competition" and the United States is the world's biggest beneficiary of this process.

America's modest tax burden, combined with privacy laws for foreigners seeking to escape oppressive fiscal systems, has helped attract more that $9 trillion of foreign investments to the US economy. This inflow of assets is a key determinant of American prosperity since this money is put to work for the nation and produces more jobs, higher standards of living, and general prosperity.

Naturally, high-tax nations resent tax competition. European politicians, for instance, get upset when their taxpayers shift their money to low-tax jurisdictions like Switzerland and the United States. They even have a plan the European Union "Saving Tax Directive" that would give them the power to impose their burdensome tax rates on income earned in places like America.

This is a dangerous idea. In effect, the European Union (EU) wants U.S. financial institutions to serve as vassal tax collectors for Europe's welfare states. Moreover, the EU is interfering with U.S. tax policy by asking the World Trade Organization to rule that some provisions of the U.S. tax code are impermissible because they create too much tax competition. If implemented, this initiative would undermine the right of the US to determine its own tax policy.

The United States should reject these ludicrous schemes. Unfortunately, some of the bureaucrats at Treasury and the IRS want to help prop up Europe's over-taxed economies. Almost a year ago, the IRS issued a proposed regulation (REG 126100-00) that would force U.S. banks to report the bank deposit interest they pay to nonresident foreigners. The purpose of the regulation is to help foreign governments collect tax on U.S. source income.

This would be a major mistake. America does not share common interests with high-tax nations. It makes perfect sense for uncompetitive, overtaxed nations to try to set up a tax cartel and slay tax competition. After all, high tax countries suffer from tax evasion, capital flight and brain drain.

Consider the case of France: According to the French tax authority, 25,000 taxpayers leave France every year for tax reasons, including many of its most talented workers. Furthermore, the estimated level of tax evasion is a whopping 17%, higher than most developed countries. Numerous studies have also demonstrated that over half of France's underground economy is tax driven, and that tax avoidance is widely practiced. With a tax burden of 45.5% of GDP (including a top personal income tax rate of 54% and an average value-added tax of 19%), it's little wonder.

To prevent further erosion of its tax base, France has two options. The first one is to cut tax rates. This is the judicious choice made by Ireland in the 1980s after the Irish government decided to try "Reaganomics." Ireland's approach was a big success. The country now enjoys the second-highest living standards in the EU.

France's second option is to use international bureaucracies like the EU to undermine tax competition. Not surprising, this was the preferred choice, not only of France, but other high-tax nations like Germany and Sweden. These regimes want to buttress their tyrannical tax systems by gaining the power to tax income earned outside their borders. This would require a global tax cartel and a systematic elimination of financial privacy.

This tax cartel would have a terrible effect on US economy. A study by the Center for Freedom and Prosperity highlights how international tax harmonization schemes would undermine America's competitive advantage. Much foreign investment is attracted by low tax rates. With few exceptions, the U.S. government does not tax the investment income of foreigners and does not report this income to foreign governments. Low taxes and financial privacy really make the US a tax haven for taxpayers around the world.

If the EU wins, the U.S. economy will lose savings and investment because foreign governments will get the power to tax income earned in the United States. As a whole, the US economy would suffer drastically at a time when it needs this capital the most. At a minimum, the EU tax cartel would drive a $1 trillion out of the country. This will soon translate into less jobs and lower incomes for Americans.

This critical issue also will have a big impact on the US ability to reform its tax system in the future. For instance, the EU scheme would make a flat tax or some other tax reform plan impossible. As such, policy makers ought to consider seriously whether propping up nations like France is worth this level of damage to our economy.

Tax competition is good for the US but it is also a desirable force in the world economy. Ever since the Reagan tax cuts, tax rates around the world have been falling. This has helped boost growth rates in many nations and forced politicians to be more responsible. For the sake of American taxpayers, the Bush Administration should reject the EU's "Savings Tax Directive."


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