The EU Commission’s tax policy shift

On March 7, 2018, European Union Tax Commissioner Pierre Moscovici remarked, that the EU Commission – the governing body of the European Union – attacked what he and the Commission called “aggressive tax planning” by “seven EU countries: Belgium, Cyprus, Hungary, Ireland, Luxembourg, Malta and The Netherlands.”

Commissioner Moskovici suggested, counter-intuitively, that these seven countries “increase the burden on EU taxpayers” by keeping their taxes lower than other countries.

Since March, the EU Commission has grown increasingly impatient with low-tax jurisdictions under its realm. Therefore, on Oct. 23, 2018, the EU Commission published its Work Program 2019 where it declares its intent to increase “the use of qualified majority voting and allow more efficient decision-making in key fields of taxation and social policies.”

This move, would constitute a major shift in the status of the European Union relative to its member states. A qualified-majority rule would allow for the EU to pass new laws, including the introduction of new taxes, against the will of some member states.

There is both a constitutional and an economic side to this move, both of which will have major impact on Europe’s future. Constitutionally, the establishment of majority rule would codify the European Union as a traditional government body, as opposed to a cooperative structure for member states. That, in turn, would open for a new level of legislation with significant impact on taxation, government spending and other areas.

From an economic viewpoint, the biggest impact of majority legislation (even if qualified as opposed to simple) will will be on taxation. Commissioner Moscovici’s negative branding of low-tax states was a direct lead-up to the Commission’s declaration that it intends to pursue the majority rule. Therefore, the most important question at this point is: how high will taxes go when EU member states can no longer veto unionwide taxes?

The first clue toward the answer is in the aforementioned Work Program 2019, where the Commission sums up its view of the European economy in two sentences: “Europe’s economy is performing well. Growth reached a 10-year peak in 2017. Employment and investment have returned to pre-crisis levels and the state of public finances has significantly improved.”

The EU-wide growth rate for 2017 was 2.43 percent (2.38 for the euro zone). For the first two quarters in 2018 the average growth rate has been 2.21 percent, but there are indications of a further slowdown. So far, four countries have reported GDP for the third quarter: Austria, France, Lithuania and Spain. All of them report a decline in annual growth from the second quarter.

While unemployment has fallen to its 2008 levels, the same cannot be said for business investments. In 2007, the last year before the Great Recession, investments grew by 6.2 percent, EU-wide, in real terms. The average for the four quarters Q3 2017 through Q2 2018 was three percent. Since business investments start falling a year before a recession, 2007 is the appropriate point of comparison.

Public finances have indeed improved in the sense that deficits are much smaller – in some countries replaced with surpluses – but this has not come through economic growth. For the EU as a whole, government revenue as share of GDP has risen from just above 43.5 percent in 2008 to almost 45 percent in 2018. The reduction of deficits has happened on the shoulders of taxpayers and at the expense of economic growth.

This last point is important in the context of the EU Commission’s campaign for easier tax legislation. At no point has the Commission expressed concerns over the impact of high taxes on the European economy – quite the contrary, in fact. The EU has an established record of hostility toward low-tax jurisdictions: in 2015, Dan Mitchell exposed a black list, produced by the EU, of what it considered to be “the world’s 30 worst-offending tax havens”.

I followed up on Mitchell’s analysis in the January issue of the Cayman Financial Review: “The European Union has created a new kind of blacklist of 17 jurisdictions, and a “watch list” of another 47, branded as “tax havens” or “noncooperative” countries and territories. This list, which has been long in the making, vilifies countries and territories for no other reason than providing residents and investors with low taxes and financial privacy.”

Several countries aspire for the title as the highest-taxed country in the EU. Currently, in six countries government revenue claims more than half the economy: Belgium (57.4 percent of GDP), Finland (55.0), France (54.8), Denmark (52.6), Sweden (52.0) and Austria (50.4).

By contrast, Malta, Slovakia, the U.K., Lithuania, Spain, Cyprus, Romania and Ireland all maintain government revenue below 40 percent of GDP. As I explained in the January article, the tension between high- and low-tax EU countries is growing; with it, so is the intolerance of the EU Commission toward the persistence of comparatively low taxes within its jurisdiction.

Romania is a telling example of what this intolerance can lead to. In 2005 they substantially reduced income taxes, leaving a progressive system behind for a flat tax. The top rate of 40 percent was replaced with one 16 percent rate. Corporate income taxes were cut from 25 percent to 19 percent. The effect on the Romanian economy has been substantial: After a growth spurt in the early years after the Millennium Recession, it lost steam toward 2004-2005; after the tax reform it sustained annual real growth rates in excess of six percent for almost three years. See figure 1

Figure 1 - Government spending, tax revenue, percent of current-price GDP

Low taxes have undoubtedly played a key role in bringing the Romanian economy back to high growth after the Great Recession.

The effect of the tax reform is even more pronounced in business investment data:

  • Already in the second quarter of 2005, capital formation accelerated sharply, exceeding eleven percent on an annual basis;
  • For 2005 the Romanian economy saw businesses grow investments by 13.6 percent, followed by 20 percent in 2006, 49.6 percent in 2007 and 20.1 percent in 2008;
  • Meanwhile, the EU as a whole experienced investment growth at 3.5 percent in 2005, 5.8 percent in 2006 and 6.2 percent in 2007.

The EU entered the recession in 2008; notably, the Romanian economy got an extra year of growth before it followed suit.

It is not difficult to imagine what substantially higher taxes would do to the Romanian economy. However, enforcement of economic conformity from Brussels would not be limited to high taxes. Current variations in taxes in the European Union are the result of different policies regarding government spending.

It may seem like a redundant point to make, but the reason why taxes are high in the EU in general is that most of its member states have elected to create and maintain large welfare states. The most prominent feature of a welfare state is a large, complex set of entitlement programs that drive government spending; to fund those programs, governments need high taxes. Countries that keep taxes low can do so because they hold back government spending (non-EU countries included for comparison): See figure 2

Figure 2 - Ral GDP Growth: Romania vs. EU Average

Lower levels of welfare state spending tend to correlate with higher growth, both in the economy as a whole and in personal income and wealth. Tax competition forces big welfare states to rethink their ambitions in terms of economic redistribution. Therefore, regardless of whether the EU leadership wants to or not, their campaign against low-tax jurisdictions is de facto an ideological declaration in favor of egalitarianism.

This political preference helps explain the antipathy in Brussels against tax competition. If the Commission can use qualified-majority legislation against low taxes, it can eliminate the macroeconomic advantage that those countries can offer vs. larger welfare states. Thereby, big spenders like the Nordic countries, France and Belgium will no longer have to fear economic competition from member states that put more emphasis on economic freedom.
A qualified-majority vote system would also allow the EU to create its own welfare-state budget. Funded by EU-level taxation – the next step in the campaign against low taxes – it would neutralize attempts by individual member states to put personal responsibility and economic choice over tax-paid entitlements.

The desire to “harmonize” social expenditures across the EU were expressed already around the time of the formation of the Union. Over time focus has been primarily on synchronizing legislation, but shifted more recently in favor of spending. In 2016, the EU published a report by the so-called High Level Group on Own Resources that argued for a bigger EU budget. Part of the purpose was to increase spending for “social sustainability” and “social inclusion”. The report made clear that the path to a bigger welfare-state budget for the EU was taxation at the EU level.

The idea of bigger welfare-state spending was further highlighted in a May 2018 press released by the EU Commission. Proposing a “pragmatic, modern, long-term budget” for the EU, the Commission motivated its desire for direct taxation with a need to promote “social fairness”. This, the Commission explained, would further “a strong and stable Economic and Monetary Union.”

It remains to be seen how the “harmonization” of government spending across Europe will change the way entitlements are designed and funded. It is not far-fetched to assume that there will be EU funds designated for the purposes of social expenditures, such as health care, welfare and general income security. Those funds would come with strings attached, regulations that de facto extend the high-tax cartel into a welfare-state cartel. While the details, again, are a bit speculative, the developments on the spending side of the EU budget are going to be indicative of how far they will go in formalizing the campaign against low taxes.

Fortunately, there is a silver lining in the EU Commission’s communications about taxes and majority votes. They have not sprung their intentions on the public, and on investors, over night. The current plan is to build support for the qualified-majority reform over the next several months, toward a planned implementation date in May 2019.

It is unlikely that a majority-vote reform itself will have any immediate repercussions on the willingness to invest in Europe. The economic consequences will materialize as new legislation goes into effect. However, the close ties between the push for a majority-vote system and the campaign against low taxes is a red flag worth taking seriously. One might even ask if the majority-vote reform would be this high on the EU Commission’s agenda were it not for their very plans to eliminate tax competition in Europe.

Prudent investors can start rethinking their commitments in Europe already now.

Unfortunately, Europe’s middle class does not have that option. They will be the big losers as the Eurocrats in Brussels ramp up their attacks on the forces of economic freedom and prosperity.

Sven R Larson, Ph.D., associate scholar, Center for Freedom and Prosperity