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They say tax competition, we say tax dumping

Posted by Richard Monday, May 03, 2004

Analysis

Helen Szamuely

Despite the huge celebrations that seem to have gone on throughout May 1 (and let us recall that April 30 is Walpurgis Night in central and northern Europe, when the witches ride through the skies) and the inane comments made about being in Europe or on Europe’s doorstep or rejoining Europe by the leaders of the EU member states and some of the revellers, who do not appear to understand anything, it is clear that not everything is rosy in connection with the “historic” enlargement. Why, otherwise, would the EUphoric pronouncements be punctuated so often and so urgently by assurances that this move is to the benefit of all?

Bertie Ahern, Jacques Chirac and Pat Cox have used their speeches to call for a speedy acceptance of the Constitution, thus destroying the hopes of those (many of them British) who had assumed that widening and deepening were mutually incompatible and if we widen the Union, we cannot possibly deepen it. It has been clear from the very beginning that the powers that be do not see it that way. For them, the only way a European Union of 25 member states could be run is through a more integrated political structure. Enlarging the European Union had to be accompanied by a final push for uniting the continent. If that did not happen, the project would disintegrate. Hence the rather desperate insistence on the 300-odd page long Constitution.

Tony Blair has assured the British people that they have nothing to fear from enlargement. And, indeed, for once, he is probably telling the truth. Gerhard Schröder has also assured the sceptical German people that they had nothing to fear. Here, however, matters become more complicated. While uttering assurances, Herr Schröder also growled warnings to the newcomers, repeating those issued a day or so before that by the Finance Minister, Hans Eichel, in an inteview with the magazine Der Spiegel. In brief, they both warn the accession countries not to indulge in what they call tax dumping and most of us call tax competition.

The background to this is quite simple, though it was not discussed much during the enlargement negotiations. Nor has it been referred to in the jubilant comments made by Prime Ministers Blair and Ahern. Strangely, not even the incoming East European leaders have mentioned any of this, at least, not in public.

Yet, it is all so simple. When the East European countries emerged from the ruinous fifty years of Communist rule, they realized that the only way they could even begin to compete with the advanced West was to cut their taxes, in particular their corporation tax. That, coupled with lower levels of regulation, appeared very attractive to western investors and money poured into the post-Communist countries, much of it from German investors, who saw no profit in putting money into their own ruinously highly taxed, highly regulated economy.

Germany’s reaction was predictable. As a recent paper from Cato Institute, the Washington think-tank, put it:
“On his [Schröder’s] watch, the German economy slowed down and, last year, contracted. So did private investment, which declined 12.1 percent over the last three years. Most analysts agree that Germany is plagued by deep structural problems and business-killing taxation. Unfortunately, Schröder can't do much to change that because he needs tax revenue to pay for a bloated welfare state, and welfare cuts are made virtually impossible by the size and strength of his domestic opposition. Schröder could, of course, show political leadership and use his parliamentary majority to impose changes on his country in the way that Margaret Thatcher did in Great Britain. Instead, he has chosen to extend the German economic malaise on the accession countries as well.”

Before the east-ward enlargement took place Germany and, indeed, other EU member states were in a dilemma. If they kept the East European countries out, investment would flow there; if they let them in and imposed all the high taxes and high regulations on them, their workers would pour into the western member states and undermine the various rather cushy and impossibly expensive social welfare arrangements. The solution seemed to be to take the post-Communist countries in, impose the regulations on them – those 100,000 pages of the acquis communautaire – and curtail their rights to move west and take jobs in the richer sections of the EU. In this they were helped along by the easily whipped up alarm of the media across the Union.

However, this is not enough. Clearly, a country with high corporate tax that has no intention of doing the sensible thing and lowering it, cannot have neighbours with competing, low taxation rates. Hence the veiled threats uttered by Eichel and Schröder. Behind all the talk of the need to be European, to play by the rules, to be communautaire (how often have we heard that expression before when Britain tried, vainly, to fight for some national advantage?) there is the clear message: Germany is the biggest paymaster of the Union and Germany will not allow the money to go into the East European countries if they persist in “using” those funds to keep their own taxes low.

Given the already disadvantageous terms on which the enlargement agreements were made, the East Europeans are going to find it hard to deal with yet another blow at their competitiveness. They will receive little sympathy from other member states, even those, like Britain, who had fought for their entry. At a recent meeting of the National Farmers’ Union, for instance, the author of a research paper on the advantages enlargement might bring to British farmers, proclaimed jubilantly that the process was very cheap to us. The amount of money the EU is spending on the new entrants is about one third of the Marshall Aid that had helped to put western Europe on its feet after the Second World War. It was less than West Germany had spent on East Germany alone after unification. And, on top of that, the young researcher added, the East European farmers will have so much trouble coping with all the regulations, they are not going to be much of a danger to their western competitors.

This raises several problems. In the first place, threats like this indicate that the question of harmonized taxation has not gone away, no matter what Tony Blair says about red lines. In the second place, it undermines the position of those optimists who argued that the entry of the more dynamic and competitive new economies of eastern Europe will necessarily undermine the bureaucratic and sclerotic economic structure of the existing EU and energize its modernization.

Finally, there is the question of the future developments in the new members. All the arguments about the great advantages of enlargement to the existing members were predicated on the extending market. There will be all these extra millions of customers. The equation was already rather wonky in that the living standards of those extra consumers was much lower and the spending money much more limited (except for that of the new eurocrats, of course). What will happen if, thanks to all the new regulations and the forcibly raised taxes the competitiveness of the East Europeans will be destroyed to the point of an economic collapse? Then the extra consumers will not be able to buy anything. More to the point, will the rest of the EU pump in aid money to help stem serious problems? Where will that come from at a time of economic stagnation? And if there is no help and the economically deprived East Europeans are stopped from coming west to get jobs, will that result in political unrest? Just asking.