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September 6, 2004
The Right Way to Harmonize Taxes
By Daniel J. Mitchell
Multinational companies in Europe enjoy the ability to easily operate in 25 EU nations. That's the good news. The bad news is that have to fill out 25 different tax returns for those 25 different
nations. This is a paperwork nightmare, and dealing with varying tax rates is just the tip of the iceberg.
The biggest challenge is that every nation has a different measure of income. This creates a huge
compliance burden since corporate tax law is far more complicated than individual tax law. Moreover, this system misallocates resources since many productive people in a firm spend their time and energy preparing
multiple tax returns using multiple definitions of taxable income. Company officials also must engage in extensive tax planning to ensure that only one government is taxing each unit of income.
Even though
the business community is justifiably concerned that European politicians want to thwart tax competition in order to facilitate higher taxes, this convoluted system of multiple tax returns based on different rules
is so frustrating that a number of industry representatives have decided that some form of harmonization of the "tax base" is the lesser of two evils. In other words, the thirst for simplification is so
strong that many companies are willing to let European politicians choose a universal definition of taxable income. This would not necessarily eliminate the need to file 25 tax returns, but at least it would greatly
simplify the process.
Companies may get their wish. High-tax nations like Germany and France favor a common tax base as part of their overall pro-harmonization efforts, and the European Commission already has
endorsed tax-base harmonization and may put forth a proposal later this year.
But as the old Chinese proverb warns, be careful what you wish for. A unified tax base could be a good idea if taxable income is
properly defined. But is it realistic to think that revenue-hungry politicians would make the right choices? After all, governments would have more money to spend if they required companies to exaggerate annual
income. Thanks to punitive depreciation schedules and other antigrowth policies, this already is a common practice in many industrialized nations.
This is why a common tax base is only a good idea if there is
some curb on the propensity of politicians to make bad decisions. Specifically, any universal definition of taxable income should be predicated on the ability of companies to opt out of the system. This is because
politicians are much more likely to implement good policy when they know that businesses -- and the tax revenue they generate -- can shift across national borders. In effect, the simplicity of a harmonized tax base
must be matched with the liberalizing power of tax competition.
There are three ways of providing a common tax base. Two of those systems facilitate jurisdictional competition, while the other would create a
cartel for politicians:
Option No. 1: The optional European company charter would give a firm the choice to register -- at least for tax purposes -- as a pan-European company. The rules for this new entity,
including the definition of taxable income, would be determined in Brussels. Such a system might even allow a company to file just one tax return, with the money then allocated to individual nations based on a
neutral criterion such as the company's sales. This would reduce compliance costs compared to the current system while also containing a built-in safety mechanism to protect against higher tax burdens. Simply
stated, if European politicians and bureaucrats got too greedy and adopted a flawed measure of taxable income, companies could stick with -- or return to -- the status quo. This freedom of choice would ensure that a
common tax base could not be used as a tool to raise business taxes.
Option No. 2: Optional home-state taxation would give a firm the ability to choose the tax base of its home country (presumably where it is
headquartered) and to use that definition of taxable income for all 25 EU nations. This would eliminate the complexities of using 25 different methods of calculating income, and it also would facilitate competition
between nations since companies presumably would gravitate to the nations that had the most pro-business tax base.
Even if companies did not want to move their headquarters (assuming this is how
"home-state" would be defined), they would have a strong incentive to make sure that their government did not utilize a disadvantageous definition of income. This approach, by giving companies the ability
to choose their tax base, ensures that a common tax base could not be used as a tool to raise business taxes.
Option No. 3: A mandatory European tax base would require all companies in all nations to
calculate their taxes based on a single definition of income. This monopoly approach would make it easier to file 25 tax returns, but governments would be tempted to increase the aggregate tax burden by selecting
the wrong common tax base in the absence of jurisdictional competition. Why exercise fiscal discipline, after all, if they think corporate taxpayers are a captive audience?
While there is growing pressure in
Europe for a common tax base, it is not clear which approach will prevail. French and German politicians are agitating for the last option, and they openly state that they see this as merely the first step toward
complete harmonization -- including a single tax rate. On the other hand, the European Commission acknowledges that opposition from low-tax nations might require a version of the first option -- allowing companies
to choose whether to employ a tax base concocted in Brussels.
Last but not least, European Union finance ministers are reviewing a plan allowing smaller firms to use some form of home-state taxation.
For European businesses saddled with the burdensome costs of 25 different tax regimes in the EU's 25 nations, a harmonized tax base has great appeal. But simplicity should not trump all other considerations, and it
certainly should not rank above tax competition -- which is a desperately needed force for liberalization in Europe. Fortunately, European companies need not sacrifice competition in the name of simplification. Both
an optional European charter and home-state taxation can greatly simplify business taxation while simultaneously discouraging politicians from killing the geese that lay the golden eggs.
Mr. Mitchell is a
senior fellow in political economy at the Heritage Foundation in Washington, D.C.
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