Tax Cut Fever

The only question is how much to slash

When Strasbourg-based Transgene needed to create a subsidiary to test a new kind of gene therapy, it shunned the vine-trellised region of Alsace-Lorraine as a site for the new business. Keenly aware that it takes more than a good Riesling to lure biotech specialists, Transgene instead set up the unit in Massachusetts. One reason: punishing French taxes, which can gobble up more than 60% of the gross earnings of highly paid workers. "We are facing more and more difficulties attracting people to France," says Bernard Gilly, Transgene's CEO. "If the French government does not react very rapidly, there will be enormous difficulty for the high-technology sector."

After years of resistance, European governments may be starting to hear the message Gilly and other corporate chiefs have been sending with increasing urgency. Leaders of both left and right in Germany, France, Spain, and Italy are either cutting taxes or thinking about it. The net result could be a round of reductions that pumps hundreds of billions into the European economy.

The numbers under discussion are huge. Take Germany. Chancellor Gerhard Schroder's government is set to slash corporate and personal taxes by $36 billion by 2005. It's his bid to stem a years-long flood of jobs and investment--not to mention celebrity tennis players--to places where levies are less severe. France is planning $18 billion in tax relief by 2003. Other European countries are paying attention. Italy's central bank has hired a Frankfurt law firm to provide an analysis of the planned German tax cuts. Spain's ruling Partido Popular party, which has already cut corporate and personal income taxes, has made more cuts a central theme in elections in March. Smaller countries like the Netherlands, which cut tax rates years ago to boost growth, may have to cut further to maintain their competitive edge.

Could this be the beginning of a European bidding war, in which countries scramble to offer the lowest tax rates and lure investment? "You are seeing competition already," maintains Michael Saunders, head of Western Europe economics for Salomon Smith Barney in London. Fast-growth countries such as Ireland, which lured foreign manufacturers and financial service companies with a tax rate of just 10%, are watching nervously. "It increases the pressure," concedes Pat Byrne, vice-president for marketing at Ireland's Industrial Development Agency.

One thing is certain: Taxes in Europe's biggest economies are heading decisively south for the first time in decades. The euro single currency has made capital more portable than ever before, so that investment flows quickly to wherever conditions are most favorable. Before the euro's launch, Germany and France moved only tentatively to lower taxes, while other countries around the world moved much more aggressively. Now the big European governments realize they are dangerously out of step.

Luckily, better times are giving governments more breathing room. Euro countries will see growth of 2.8% this year, up from 2.1% last year, according to Goldman, Sachs & Co. estimates. That boosts tax revenue and makes cutting less painful. And Germany politicians have discovered tax cuts are a popular way to ease the otherwise painful process of reform.

The effect on the European economy could be dramatic, especially if others follow Germany's example. Besides cutting the corporate rate, Schroder wants to eliminate the capital gains tax companies pay when they sell stakes in other companies, a measure that's expected to create a wave of restructuring and boost company profit. The Chancellor also plans to cut the top income tax rate to 45% by 2005 from 53% last year. The measures could add 1.25 percentage points to the annual growth rate within two years, says Goldman Sachs economist Thomas Mayer. "Germany has made a significant step forward," he says. "It has leapfrogged France and Italy."

But France could go further. The government is trying to figure out what to do with a $4.7 billion surplus in 1999 caused by economic growth. A similar windfall of up to $5 billion is expected this year. Amid a predictable debate about what to do with the money, what's striking is that even die-hard Socialists like National Assembly Speaker Laurent Fabius agree taxes need to be cut. It's likely that individual taxpayers, rather than businesses, will benefit from the planned $18 billion cut.

The European Commission is also looking more favorably on tax cuts. Under EU President Romano Prodi, the commission has been less obsessed than before with forcing governments to cut deficits. "The previous commission didn't want to hear about tax cuts," says Gerassimos Thomas, an EU official. "But now we see room for cuts, provided there's no problem with the public finances."

FEW CHOICES. One country absent from the tax-cutting party so far is Italy. Its corporate tax rate of 41% will be the highest in Europe after German reforms take hold. Italy also has one of the highest rates of income taxes and social security levies, measured as a percentage of labor costs. "It is very possible that Italian companies, when expanding, will take advantage of the more business-friendly environment in other European countries," warns Antonio D'Amato, adviser for southern Italy of industry group Confindustria. Although it's watching its neighbors with concern, Italy probably can't do much to respond. With growth at just 1%, big tax cuts are unlikely.

And Germany and France still have a lot of work to do. Even after reforms, Germany's effective corporate tax rate will be 38.6% in 2001. France's rate is 40%, even after several cuts. That compares with 30% in Britain, which began cutting corporate rates in the mid-1980s. Companies aren't going to flee Ireland for Germany just yet. "The tax rate was very attractive to us when we made our decision to locate here and it remains very attractive to us," says Bill Riley, public affairs manager for semiconductor maker Intel Ireland Ltd., which employs nearly 4,000 people. Still, tax cuts say a lot about the changing business climate. "For foreign investors it's very important," says Wolfgang Althaus, a Frankfurt tax lawyer. "I'm sure companies are already starting to think and plan." If so, 2001 could be a vintage year for the European economy.

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