Paris, 14-15 October 2004


The New Debate: Does Financial Solidarity in the Enlarged EU Require Fiscal Harmonisation between Old and New Member States?

Tamás Szemlér
Ph.D, senior research fellow
Institute for World Economics of the Hungarian Academy of Sciences


Financial solidarity is one of the central debate issues of European integration for decades. Discussions sharpen especially before the beginning of new mid-term financial periods and at the time of important changes in the integration process (be it deepening or widening). At present, both conditions are fulfilled: the since May 2004 25-member European Union (EU) has to decide about the financial framework for the period 2007-2013.

Debates on the proposals of the European Commission published 10 February 2004 are sharp; in fact, they began earlier, by mid-December 2003, when six actual net contributors of the EU budget expressed their unwillingness to agree with a budget bigger than 1% of EU gross national income (GNI). This approach is anything but new in the history of budgetary debates in the EU: the dispute between net contributors and net recipients has always been one of the key budgetary conflicts.

The idea of Mr. Nicolas Sarkozy, French Minister of Economy and Finance to link support from the EU budget to taxation, is, however, something new in this debate. According to Mr. Sarkozy's proposal, only those countries could receive structural and cohesion transfers from the EU budget, in which the corporate tax rate achieves EU average. The reasoning behind this proposal is that it should not be allowed to support the development of countries that, by maintaining their corporate tax level low, drain investment (and thus growth and employment) from the net contributors of the EU budget.

The discussion following Mr. Sarkozy's proposals is intensive. By the nature and the importance of the issue, it is not (just) an academic discussion; economic interests, but also political elements are often mixed in the debates. The present contribution is, of course, not free from such elements, either. It tries to summarise, why - according to the author - the proposal of linking financial solidarity with fiscal harmonisation is not the right reaction today to EU budgetary conflicts.

1. Regional and national tax differences

Taxes - including corporate taxes - show considerable differences across countries. This fact in itself does not often lead to intensive debates. The question here and now is whether it should be regarded as anormal in an integration like the EU. My answer to this question is that - at least at the present state of economic integration - there is no reason to penalise differences in corporate tax levels.

Even within the old member states of the EU, regional tax allowances are a widely acknowledged tool of regional development. If it can work within countries, where - depending on their structure - 30 to 50% of GDP is redistributed by national budgets, why should not it be so among countries in the EU - sovereign members of the integration -, where the common budget redistributes only about 1% of GNI?

The new member states established their relatively low corporate tax levels in order to enhance the restructuring of their economies. In the transition process, it was very important to give thus a realistic chance for newly established private enterprises to survive and to strengthen. However, no one at that time questioned the right of foreign investors to enjoy the same low rates - the first protests against any kind of discrimination would have probably come from (enterprises of) EU member states like Germany or France.

The transition countries committed themselves - in their own economic interests, but also because of the Copenhagen criteria for membership - to build up market economies on the ruins of central planning. The rapid restructuring of the economies in many transition countries - now members of the EU - have been in many aspects much more successful than the - quite costly ad not always market-friendly - management of the German unification.

I would also like to stress that the Economic and Monetary Union (EMU) is "monetary", but not "economic" in the strict sense of the expression - important elements of a theoretical economic union are missing. The same is true for the Single European Market (SEM), but for its still missing elements, it would be unjust to blame the newcomers, while biggest arrears are noticed by European Commission reports in the case of France.

2. International competition vs. internal politics

With all that has been said above, a harmonisation of corporate taxes is still conceivable. But how should it be realised? To my opinion, would there be a harmonisation, could it only mean a decline in the corporate tax rates of the higher-rate countries.

In principle, an increase in the corporate tax rates in the low-rate countries would also be possible - but with what consequences? According to the French (and also German) logic, capital would leave these countries, and choose other, more attractive locations - e.g. China. At this point, it should be added that it is first of all not tax rates, but labour (combined with logistics) costs that influence such decisions (apart from basic qualitative requirements as economic/political stability, availability of (qualified) workforce, etc.). Labour costs attract capital from Europe (and from other parts of the world) to China and South-East Asia - would it be positive for the EU to strengthen this process by forcing higher corporate tax rates in its most dynamic member states? My answer to this question is no.

The above logic seems to be easy to understand - what then impedes high-rate countries to decrease their corporate tax rates? The main reason is that tax income has to finance the quite costly form of welfare state these countries have, and it would be hard to decrease income, while costs - due to the changes of the society and to the lack of substantial reforms of the system -. are increasing. This is, of course, an important question - but a question of national economy, or even more of national politics; it is not a very constructive solution to find external scapegoats for a clearly internal problem.

It has to be added to this point that the crisis of the "old" welfare state is clear for at least three decades. A more effective welfare state does not mean "social dumping" or the "americanisation" of the society. Such tendencies are not characteristic for the new members of the EU, either, while positive examples of restructuring the welfare state successfully can be found in older member states of the EU (Finland, Sweden).

3. Growth potential and its consequences in the enlarged EU

Economic growth shows considerable differences between old and new member states of the EU; the differences are even more pronounced if we compare the growth rates of the two biggest EU economies (Germany and France) with those of the newcomers. While on the one side, a 2 per cent annual real growth is seen almost as a dream, on the other side, growth rates around or over 5 per cent are usual. The dynamic development of the new member states (following, as it has been said, a fundamental restructuring of their economies) should not be stopped by imposing them conditions that slower the pace of growth in the core economies of the EU (failing, I repeat, to make decisive steps in the way of restructuring).

One has to add to the debate, that it is by far not clear, how much the high-tax member states lose (or maybe win) on the ouward foreign investment of "their" companies. Intra-company transfers are difficult (in many cases impossible) to follow. In low-tax countries, there are sometimes fears that foreign companies transfer their profit outside the country - back to their home country or elsewhere. Of course, such fears are difficult to justify - about just as difficult, as to prove losses of high-tax economies due to divestment.

Stronger growth in the less developed member states also means stronger catching up to the EU average. As a consequence, structural and cohesion transfers will be needed for a shorter period of time and in smaller amounts - the effect of a 3 per cent growth differential can be measured in years and several billions of euros in the case of a single country. With this process, the new members can also earlier share the burden of (net) financing of the EU budget. Looking at the prospects of the next enlargements (including also Turkey), this will be an important contribution - instead of momentary political interests, we should take into consideration the development of integration on the long run.

4. The question on the long run

With all that has been said above, one must admit that the very idea of (corporate) tax harmonisation is theoretically not unfounded. However, the idea of linking it with financial solidarity is not a solution for today - not only because of obvious political obstacles, but also due to the present state of integration.

Actually - as we have already mentioned it - about 1% of EU GNI is redistributed by the EU budget. Structural and cohesion tranfers for the new members will probably be in the order of magnitude of 0.2-0.3% of EU GNI. Obviously, the source of French
and German problems (e.g. with meeting the Maastricht public deficit criterion) is not this amount - would it be so, some still acceptable "creative accounting" would probably help, as it already did in France in 1997.

The question is seen from a different angle if the EU develops towards a federation. Then, a considerably higher concentration of powers and a correspondingly higher concentration of financial resources (in the spirit of the MacDougall report) could be justified. The fulfilment of the adjective "economic" in EMU, and the entire realisation of the SEM would then also be logical. In such a case - it means, on the long run - the harmonisation of (corporate) taxes could be a logical step - well-founded and clearly regulated exceptions, just like in nation-states today, should, however, not be excluded. Competitiveness considerations would probably support also in the future a harmonisation downwards, while political correctness requires a common decision instead of enforcing the will of some on the others.

Such a development in itself, however, will not solve the present (already long-term) problems of the core economies of the EU. The problems of the financing of the old welfare state need a substantial systemic reform - political rhetoric is not enough.

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