Taxes: A Race To The Bottom

As Eastern Europe lures business with lower levies, the pressure is on to cut rates

Corporate taxes aren't a big issue for Daniel Bain, CEO of Galvex, a maker of galvanized steel with a plant in Tallinn, Estonia. The country's tax rate on profits reinvested domestically is zero. And even though Galvex, based in New York, doesn't pay taxes in Western Europe, Bain would be happy to see those countries cut, too -- because it would be good for his customers. "It would be nice if all countries had a tax system as simple as Estonia's," says Bain. "That would help industry all over Europe."

Chances for just such economy-boosting tax cuts are looking better. German Chancellor Gerhard Schröder, desperate to get companies to invest and create jobs, has proposed slashing six percentage points from the country's nominal corporate income tax. That would take the effective rate down to around 32% when local levies are figured in. If, as expected, opposition leaders agree, Germany will boast a corporate tax rate lower than that of France or Italy and close to Britain's -- sharpening the race to attract foreign investment and putting the onus on other countries to respond. "In Italy, there is a lot of attention on the German move," says Maria Cecilia Guerra, a professor of finance at the University of Modena.

Hard to believe that only last year, Germany was among the ringleaders of an effort to force low-tax countries like Estonia to raise their rates. Now, Germany, whose current rate of about 38% is the highest in Europe, is facing reality. "The eastern countries are advertising lower tax rates and that has definitely created pressure," says Jörg Otto Spiller, a member of Parliament who is tax policy spokesman for Schröder's Social Democrats.

For businesses, this is one of the welcome effects of the European Union's expansion last year. Corporate tax rates in the core of Europe had already been falling, from an average of 38% in 1997 to about 31% last year, according to KPMG International. But the entry of 10 new members in May, 2004, has sparked a race to the bottom. Eager to attract business and raise living standards, the new entrants in Eastern Europe and the Baltics are touting rates ranging from 15% for Lithuania and Latvia to 28% for the Czech Republic. (Estonia charges 24% on distributed profits.) Ireland also has used its superlow 12.5% rate to drum up foreign investment.

Business is taking notice. The number of German manufacturers planning to ramp up foreign investing is at a record high of 42%, according to a survey earlier this year by the German Chamber of Commerce & Industry. The new EU members in the East are the most popular destination.

The lower tax rate, combined with a superb infrastructure, should make Germany an easier sell to foreign investors. "This is the biggest problem when we talk to American investors -- the tax system is too complicated," says Urda Martens-Jeebe, managing director of Invest in Germany, an economic development agency in Berlin. In truth, German taxes aren't always as onerous as they seem. Munich-based Siemens (SI ) paid German taxes of only 16% in 2004 on pretax profits of $5.7 billion, in part because a $638 million gain from asset sales was tax-free under German rules.

There is still a risk that Schröder's proposal -- like so many other promising reforms -- will fall victim to political wrangling. And even if it passes, there is still a need for further changes, particularly for small businesses, which often pay higher effective rates than multinationals. What's more, the economic stimulus -- estimated at around $4 billion -- will be muted by measures to offset the revenue loss, such as higher taxes on dividends and elimination of some tax shelters.

What's really needed in core Europe is a dose of the optimism that prevails in countries like Estonia. "It's a very positive place to do business -- young, entrepreneurial, and dynamic," says Bain, a California native. Still, there's nothing like a tax cut to brighten a CEO's day.

By Jack Ewing in Frankfurt, with Maureen Kline in Milan

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