Taxes

Europe's Tax Competition Is Unfair and Inefficient

It would be cheaper to compensate small countries for lost revenue than to continue tolerating tax avoidance.

From Saul to Paul?

Photographer: THIERRY CHARLIER/AFP/Getty Images

European Commission President Jean-Claude Juncker stretched credulity when he told the European Parliament he had known nothing about Luxembourg's sweet tax deals with large companies; he'd served as finance minister and then prime minister as the small country struck the deals.

What Juncker knew aside, one might ask: Is there is any other way for small nations to survive among behemoths than to provide loopholes for the global rich, or at least ultra-low tax rates? The answer is no, and yes. Small countries can't compete without an incentive to offer investors; but there are better ways than current practice.

Juncker's "see no evil, hear no evil" testimony was an extension of the LuxLeaks scandal that first broke in 2014. It transpired that more than 300 global companies, including Pepsi, McDonalds, Deutsche Bank and Amazon, had secured individual, secret tax rulings in the Grand Duchy. The scandal was huge, but its consequences haven't lived up to the hype. Luxembourg codified its tax-ruling procedure, making it theoretically more transparent, but it hasn't stopped issuing the rulings. McDonalds moved its European tax headquarters to the U.K., but there have been no other high-profile departures. Amazon recently won a major court victory over the U.S. Internal Revenue Service, which had challenged its Luxembourg-based tax scheme. The effective tax rates of the companies in question haven't gone up. (The whistle-blowers haven't been so lucky: Luxembourg courts have sentenced the PricewaterhouseCoopers employees who had exposed the secret tax rulings.) 

Now, a similar, if smaller-scale, scandal has enveloped Malta, the other tiny nation that essentially sells access to the European Union's huge market. Malta, whose population, at 430,000, is about two-thirds that of Luxembourg, is less well-known as a tax haven -- but it does charge the lowest effective profit tax in the European Union, 5 percent. Malta charges a 35 percent tax on locally registered companies' earnings, but then refunds 85 percent of that to companies whose profits are made overseas. One could say that in this way, Malta lost some 1.7 billion euros ($1.9 billion) in taxes in 2015 -- a huge amount for a country whose government spends about 3 billion euros a year. But one could also say it gained 248 million euros in international taxes that same year, because had it not been for Malta's tax system, the international companies -- such as the German chemical giant BASF -- wouldn't have registered there.

Both Luxembourg and Malta-- the European Union's two smallest members -- have paid lip service to international efforts to plug these loopholes for the rich (Malta even has a scheme that sells its own passports). Both countries, like the rest of the EU, have signed up for the automatic exchange of tax information to be introduced this year. But neither of the small EU countries is really interested in establishing a strict tax regime. Malta, which holds the rotating EU presidency now, has even pushed against anti-tax-avoidance reforms on the EU level. 

Both Luxembourg and Malta also boast budget surpluses. Maltese Prime Minister Joseph Muscat even talks of an "economic miracle" achieved without resorting to austerity; the country's economic output increased 5 percent last year, an incredibly high rate for a European country. Luxembourg wasn't far behind: Its economy grew 4 percent in 2016 and is expected to add 3.4 percent this year. The Grand Duchy is lowering both individual and baseline corporate income taxes. 

These miracles wouldn't be possible without tax regimes that attract business that could otherwise go elsewhere. Luxembourg accounts for about 40 percent of Europe's outward foreign direct investment flows because of its tax regime. Even taxed at very low rates, that money in the country's financial system is the reason it's wealthy and stable. Malta would be forced to cut government spending by up to 20 percent without international tax and passport-selling revenues. During his questioning at the European Parliament, Juncker was accused of "turning from Saul to Paul" because, as European Commission president, he's been pushing for "fair tax competition" and promising to fight tax evasion.

It's important to understand, however, what "fair" means in this context. There's a certain amount of fairness in letting small countries such as Malta and Luxembourg lure big corporations and wealthy outside investors with exotic breaks and deals, because these nations have little else to sell.  It's not fair to cut special deals with certain investors and exclude smaller businesses that cannot establish such tax structures.

But there is a larger fairness issue here. It is inefficient for big nations to lose as much as they are in potential tax revenues just so that the EU's tiniest nations could enjoy deficit-free budgets. (Because of the way the EU works -- every country, no matter how small, has a veto over important reforms, so smaller nations cling to their freedom to levy whatever corporate taxes they want.)

Under a fiscal union, there would presumably be a floor on corporate taxation, just as there currently is for value added tax. Above that, rates could fluctuate. Larger EU nations would likely then collect much of the 2 billion euros in taxes that Malta levies on companies' overseas operations; they could easily afford to pay the island nation the 250 million euros it made from creating the loophole. Luxembourg would also require relatively small compensation for eliminating its tax-ruling regime.

Of course, smaller countries aren't about to give up their prerogative and may not trust the larger nations to keep the transfers going over time. That's too bad. Tax-dodging multinational companies would be the big losers from such a solution. These companies wouldn't leave the enormous European market if they had to pay taxes like everybody else.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

    To contact the author of this story:
    Leonid Bershidsky at lbershidsky@bloomberg.net

    To contact the editor responsible for this story:
    Therese Raphael at traphael4@bloomberg.net

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