SECTION 1: GOVERNMENT ECONOMIC POLICY

SUSAN GRANT

Tax harmonisation is the standardisation of tax rates, tax base and tax regulations throughout a given area. Since its inception there has been some movement on tax harmonisation in the European Union and with the removal of other barriers on free trade in the EU, attention is now shifting to differences in tax rates and, in particular, to differences in taxes on businesses and savings. The European Commission is seeking to achieve a greater degree of tax harmonisation in order to reduce what it sees as unfair competition and to eliminate tax evasion. However, whilst most of the member countries, particularly Germany and France, are in favour of such a move, others, like the UK, argue that it may result in a loss of jobs in the EU.

There are, currently, noticeable differences in tax rates and tax coverage throughout the EU. For example, whereas most of the EU countries impose VAT on food and newspapers, the UK does not. Personal income tax rates in the UK are also comparatively low. However 'sin' taxes (i.e. taxes designed to discourage unhealthy living) on alcohol and tobacco and taxes on petrol are high in the UK.

In February 2000 Forbes Global published a survey in which it assessed tax rates in the EU, Japan and the USA. It constructed a 'tax misery index' for each country by adding up its tax rates on personal and corporate income, plus VAT, wealth taxes and social security taxes. On this basis it concluded that the USA, Ireland and the UK were low tax countries whereas Germany, Austria, Italy and France were high tax countries.

However, whilst corporation tax rates are low in the UK, studies indicate that the overall corporate tax burden is high. According to OECD calculations, when tax allowances, depreciation rates and tax base are taken into account, the UK corporate tax burden is actually much higher in the UK than in Germany, Italy and France. These findings were confirmed by a study published by Pricewaterhouse Coopers in May 1999, which stated that 'overall corporate tax burdens are actually higher in supposedly 'low tax' countries such as the UK and Ireland than in some supposedly  'high tax' countries such as Germany and France.'

On 1 December 1998 Germany and France issued a joint statement calling for  'rapid progress towards tax harmonisation in Europe'. Germany, France and Italy are particularly concerned about firms moving to countries where they believe the burden of corporation and personal income tax rates are low and .il'oul tax evasion on savings.

Germany is pressing for a 20 per cent 'withholding' tax earned by non-residents on savings. Currently 13 of the 15 EU countries do not tax non-residents on what they receive in income from interest. So, in effect, EU countries can act as tax havens to the residents of other countries. Germany is concerned that some of its people are moving their savings to Luxembourg and to London to evade paying tax.

Tax harmonisation was on the agenda at the formation of the European trading bloc (which was initially called the EEC, then the EC and now the EU). The Treaty of Rome stated that 'harmonisation of the legislation concerning turnover I axes, excise duties and other forms of indirect taxes is a principal objective'. Right from the start there was standardisation of two main taxes. Firstly, tariffs on all imports from outside the EU pay the same rate whichever EU country they are going to. Secondly, it was agreed that the main form of indirect tax to be used would be VAT. This was based on the indirect tax system that had been operating in France.

Some time elapsed before the issue of tax harmonisation came to the fore again. What led the European Commission to readdress the issue was the decision, in 1985, to create a single market by removing non-tariff barriers to the free movement of goods, services, capital and labour. Lord Cockfield, then European Commissioner, was asked to draw up a paper identifying what barriers still existed and to make recommendations as to how these could be eliminated. He identified three barriers. Two were physical barriers such as frontier controls and technical barriers such as different product standards. The third type involved fiscal barriers in the form of different rates of tax and different coverage of taxes.

He proposed removing all border controls; adopting a single EU-wide excise duty for alcohol, petrol and tobacco; and grouping VAT rates into a standard band of 14-20 per cent together with a reduced rate of 4-9 per cent for products that countries wish to keep low in price for social reasons.

The actual measures adopted did not go this far. In June 1991 it was agreed that the minimum standard rate of VAT from January 1993 would be 15 per cent throughout the area and that there should be one or two optional reduced VAT rates of not less than 5 per cent. However, differences in the coverage of VAT, the variations of rates and the treatment of small firms for tax purposes still exist.

The European Court of Justice has acted to reduce tax differences. It has the right to overrule national sovereignty in tax matters where the exercise of that sovereignty clashes with other aspects of European law. Taxes within the EU are not supposed to favour domestic producers over other EU producers, and the Court has intervened to implement this policy. One such case was the UK's policy of placing a noticeably low tax on beer, which is mainly domestically produced, and a high tax on wine, which is largely imported from France and Germany. It was instructed to reduce this differential.

There are many different approaches to tax harmonisation. One is the equalisation approach. This seeks to achieve the highest degree of harmonisation by the adoption of uniformity of the tax base and tax rates within an area. This approach seeks to achieve competition on equal terms and puts the interest of the area as a whole above that of individual member countries.

Another approach is the differentials approach. This is based on the belief that the adverse effects of one member's tax system on other members' tax systems should be minimised. However, given this proviso, it is argued that the output of the area will be increased by permitting each country to use its tax system to manage its economy so as to maximise its economic welfare. What the EU is currently considering is a mixed approach, seeking greater uniformity on saving, corporation and most indirect taxes whilst permitting greater differentiation on income tax and  'sin' taxes.

The main argument is based on reducing tax competition. The term 'tax competition' refers to a country gaining a competitive advantage in the sale of its products, or the attractiveness of its location for firms and labour, by operating low taxes. It also covers a country treating foreign firms and/or domestic firms that set up in particular areas of the country more favourably in terms of taxation (tax subsidies).

The concern with tax competition is that it can result in inefficiency and lower overall output by permitting firms to gain an unfair competitive advantage in producing products in which they do not have a comparative advantage and encouraging firms to set up in what are really high cost locations.

For example, the abolition of border controls has made cross-border shopping easier. This has led to increased concern that countries may set indirect tax rates at a low level in order to attract customers from countries with high indirect taxes. It is thought that a number of EU countries, including Ireland and the UK, are using low personal income and corporate tax rates to attract inward investment from other member countries and from Japan, the USA and other non-member countries.

Germany is currently considering lowering its corporation, top rate and standard income tax rates because some of its managers and firms are leaving the country. For example, BASF has recently chosen London for the location of its pharmaceuticals headquarters and Commerzbank has picked London Docklands for the head office of its Comm Direct Electronic Bank. Some economists and politicians are concerned that with the removal of other barriers and the inability of the euro area countries to resort to devaluation, member countries may be even more tempted to resort to tax differentials to gain a comparative advantage. Tax competition can also reduce inefficiency by forcing countries to adopt second best tax systems. This is because countries, afraid of losing firms and trade to other countries, get involved in a 'tax war', lowering tax rates and tax coverage to a point where the revenue earned by governments is insufficient to cover its spending commitments. France and Germany, both of which have expensive welfare systems, are particularly concerned about this. In addition to reducing tax competition, tax harmonisation would reduce the problem of tax evasion. Currently, some savers in the EU place their savings in other member countries, earn gross interest and then do not declare their earnings. The level of tax evasion on savings income is high in a number of countries, particularly Germany, Belgium and Austria.

The UK is opposing the withholding tax. This is because of its concern that the tax will hit the UK's financial sector, particularly the eurobond market (which pays interest gross). The eurobond market is a big earner for the UK. Some claim it will cost thousands of jobs in the City of London; moreover, such damage to the UK as a financial centre would also hit the EU as a whole. Research has shown that the concentration of financial services in London provides the EU with savings on the cost of financial services of 17 per cent and it is argued that the EU would lose some of these services. Taxing saving at source via the withholding tax may encourage some savers to move their funds out of the EU to, for example, Liechtenstein, Switzerland or New York to avoid paying the tax. Instead of the withholding tax, the UK favours the exchange of information between member states to end evasion of savings tax.

Some economists claim that it is important to permit countries to operate different tax systems where they have different degrees of  locational advantage. For example, a country far from the centre of the main market may offset its cost disadvantage by levying lower taxes. However, others argue that this may not be the appropriate way of tackling the problem.

A case can also be made for different tax rates if countries are at different stages of the economic cycle. Countries experiencing high levels of unemployment and low output may wish to stimulate economic activity by cutting tax rates, whilst those whose economies are overheating may wish to raise tax rates. However, the EU is seeking greater convergence of its member country's economies and this is a condition of membership of the single currency.

Countries may also wish to operate different 'sin' tax rates if they have different views on the extent of the harmful effects, including negative externalities, of smoking and drinking. In addition, the level of government spending, and the taxation needed to finance it, supported by the population varies between the member countries.