Tax Harmony, EU Fracas

Germany and France are raising tempers by pushing for a minimum corporate tax

What would a supermarket do if a rival down the road reduced its prices to bring in more business? Doubtless it would sell its goods more cheaply to keep its customers loyal. So you'd think Europe's high-tax countries, which are losing investment and jobs to low-tax neighbors, would try to do the same: cut spending and trim taxes so their companies won't be tempted to move abroad. But such market-oriented logic seems lost on the governments of Germany and France, the European Union countries that levy the highest taxes on corporations. Faced with competition for investment from the 10 low-tax countries that joined the EU on May 1, the two are instead demanding that the EU force the newcomers to raise their tax rates. "That is what's needed to prevent unfair competition," says German Chancellor Gerhard Schröder.

At a meeting in Paris on May 14, Schröder and French President Jacques Chirac announced that they would push the European Commission, the EU's executive branch, to harmonize corporate taxes by setting a minimum rate applicable right across the EU. That's to prevent so-called "fiscal dumping" -- EU policy jargon for the practice of slashing taxes to attract business while letting high-tax member countries shoulder more of the burden of EU-wide programs. "It is more necessary than ever before to take steps to create as tax-neutral a single market as possible," the two leaders argued in a joint paper to other EU governments.

Germany and France, whose corporate tax rates are 38.3% and 34.3%, respectively, have long griped about lower taxes in member countries such as Ireland, with its 12.5% rate. Britain and Portugal, with rates of 30% and 27.5%, also undercut the Germans and French. But the issue has taken on greater urgency with EU expansion. Slovakia and Poland, for example, impose just a 19% tax on corporate earnings, while Estonia doesn't charge any tax at all on reinvested profits. Partly as a result, the new members are attracting increasing volumes of investment from companies headquartered in the high-tax countries. Both Schröder and Chirac say they have no problem with fair tax competition but say it's unfair of the new EU members to levy artificially low rates in a blatant bid to lure businesses. That's because the profit a company makes from a subsidiary in one EU country is taxed in that country, no matter where it is headquartered.

But the Franco-German tax harmonization push has met with strong protest from other long-standing EU members. British Chancellor of the Exchequer Gordon Brown, Irish Prime Minister Bertie Ahern, and many Eastern and Central European leaders have denounced the plan. "We simply dismiss any efforts leading to harmonization in the area of taxes," says Slovakian Finance Minister Ivan Miklos.

Given that tax matters have to be decided unanimously under EU rules, there seems little chance that Germany and France will get very far with their harmonization efforts -- though proponents note that the EU already has a harmonized value-added tax, with a 15% minimum. Some observers in Brussels say the proposal is so controversial that it could complicate negotiations over the new European Constitution, which is expected to be completed by the end of June. Britain's Brown, for example, has asked his staff to scour the proposed charter to ensure tax harmonization can't be brought into that document through the back door. "How the harmonization push is resolved could affect the future structure and working of the EU," says Katinka Barysch, chief economist at the Center for European Reform.

The low-tax states have powerful allies in Europe Inc. Although most business executives favor harmonization of the corporate tax base across the EU -- which would make for easier accounting -- they oppose the idea of a minimum rate that would guarantee higher taxes across the board. "I think [Schröder and Chirac] should leave all this alone and try to reduce their tax rates rather than force other countries to raise theirs," says Robin Chater, Secretary of the Federation of European Employers. Business officials note that corporate tax rates in Germany are already much higher than in parts of Asia and the U.S. Forcing up corporate taxes, they say, will only prompt companies based in Europe to move manufacturing and research operations overseas.

LABOR ADVANTAGE. The ultralow corporate tax levels in Eastern and Central Europe are already attracting new investment from European multinationals. Germany, where more than 10% of the workforce is unemployed, is particularly worried. According to the German Federation of Chambers of Commerce, the country is losing around 50,000 jobs a year to cheaper countries.

To be sure, taxes aren't the only factor that companies take into account when deciding where to manufacture. The average labor cost in the 10 new EU member states, for instance, is just $5.05 per hour, vs. $31.84 in Germany. But low taxes add to the region's allure. Take French carmaker PSA Peugeot Citroën (PEUGY ). Europe's second-largest auto maker is investing $840 million in a new factory in Slovakia that will employ 3,500 people. Although Slovakia cut its corporate tax to 19% after Peugeot announced plans to build the plant, project director Alain Baldeyrou says the generally lower corporate tax environment in Eastern Europe was "one attractive point" in the carmaker's decision to build the facility.

German and French officials, when asked why they don't cut their own taxes rather than ask others to raise theirs, point out that they are already in breach of EU strictures to keep their deficits to less than 3% of their gross domestic product. More important, they note that the newest EU members are getting billions of euros in infrastructure, agricultural, and other subsidies from the Brussels budget, which is largely funded by German taxpayers. On Apr. 29, German Economics & Labor Minister Wolfgang Clement said he might demand cuts in the subsidies if new member states won't raise taxes. "If Central and East European countries say they can't accept tax harmonization, then a country like Germany will ask if structural aid should continue at its current levels," he said.

But the EU's newest members have no intention of bowing to German pressure. Leaders in these countries counter that lower taxes help them attract more business so they can catch up with the rest of the EU. Plus, they say that the best way to increase tax revenue is by encouraging business growth, not by jacking up rates. "They should try to be more like Britain, which has lower corporate taxes than they do," says one Central European central bank official.

Schröder says Germany and France will press ahead with tax harmonization among a core group of EU members no matter what. "If we fail because of vetoes by certain member states, we will do it with the states that are ready," he says. That, of course, puts the rich Western European nations at loggerheads with their neighbors running that supermarket off to the East. Europe may have a single market, but real unity is still a dream.

By David Fairlamb in Frankfurt

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