The Politics of Corporate Taxation in the European Union

Knowledge and International Policy Agendas

Claudio Radaelli

• Publisher: Taylor & Francis
• Year: 2013
• eBook ISBN: 9781135106317
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

This study explores the formation of the European Union's tax policy and asks why member states did not raise objections to it. The author's analysis is enriched by two further levels of inquiry. Firstly, he examines the 'Europeanization' of domestic tax policy in Italy and the UK, asking how domestic policy has changed and what is meant by 'Europeanization'. Secondly, he puts the European Union tax policy in the wider context of tax globalization. Will the liberalization of capital movement, tax havens and the flexibility of multinationals in managing their taxable incomes wreck the European Union's fragile tax policies?

1 Introduction

International tax complexity as a political problem

The politics of international taxation is one of the less explored aspects of globalisation. Lawyers¹ have documented the growing complexity of tax laws affecting the cross-border activity of transnational corporations and individuals, and economists² have measured tax-induced distortions of economic activity, but the analysis of actors, principles, norms, rules, models of behaviour, and organisations dealing with the international tax order has barely emerged (Bird 1988; Tanzi 1995) and therefore deserves more in-depth analysis. There are several reasons for analysing international taxation from the perspective of political science. First, the liberalisation of capital movement (Sinn 1990) and the increasing mobility of skilled labour (Tanzi 1995) represent an objective threat to the link between taxation and representation. In the most extreme scenario, capital income taxes will be lowered, perhaps to zero, by the dynamics of tax competition and governments will be obliged to impose an increasing tax burden on unskilled labour and landowners, which are the only two immobile factors in a deeply integrated economy.

As a consequence, highly-skilled or wealthy citizens will have the option of paying low taxes (or no taxes at all) in countries other than those in which they are resident. This is tantamount to saying that a political time-bomb has been placed at the core of the welfare state by deep economic integration (Sinn 1990): redistributive policies would no longer be feasible. Conflicts are bound to be rife in political systems that would place the whole tax burden on certain segments of their populations, particularly low-skilled labour. Economic resources for welfare states, currently provided by wealthy citizens, would flow elsewhere should a state seek to impose more than zero-rate (or merely virtual) taxes. The fundamental link between taxation and representation would be relevant for some citizens, but not for others. A departure point of this book is that the internationalisation of taxation is not limited to the problems created by wealthy individuals who can hide their income abroad. Quite the contrary, the essential problem of the international tax system concerns sophisticated tax payers such as transnational enterprises. One of the characteristics of deep internationalisation (Tanzi 1995) is that a number of activities of transnational enterprises have now become mobile: examples are provided by head offices, central services, offshore banking centres, and captive insurance companies (OECD 1996b: 9). A recent OECD report explains that ‘the introduction of new technologies and advanced communication networks combined with the removal of non-tax barriers, has given multinational enterprises a wide discretion in locating these central services’ (OECD 1996b: 9). Accordingly, countries compete to attract activities which need not be location-specific. The competition for capital income and mobile activities of transnational enterprises has already generated important transformation in the structure of domestic corporate tax systems because countries cannot afford to tax companies without considering what other countries are doing. Corporate tax policy is thus made in a strategic context. As a consequence, the idea of sovereignty has been severely limited in corporate tax policy. Deep internationalisation of taxation (i.e. tax globalisation) hence contributes to the fragmentation of the state. Accordingly, analysing international taxation is part of the conceptual effort to understand and explain the transformation of the state.

Second, international taxation is a policy in search of institutionalisation. Although the challenge of setting up an international tax order was addressed by the League of Nations in 1928, with a report by four ‘wise men’ on international tax issues (Picciotto 1992: Chapter 1), there still remains a fundamental difficulty in building legitimacy around policy solutions and organisations. The uncertainty about ‘what can be done?’ is a radical form of uncertainty as it implies the question ‘which institutions for which problems?’ And indeed formal institutions capable of governing international taxation have not as yet emerged. Political scientists, whose professional remit is to explain the emergence of political order, are potentially qualified for studying this fascinating aspect of globalisation. Yet the study of international direct tax policy is a field characteristically free of political scientists³.

A third reason for investigating the political aspects of international taxation is the political trade-off between tax competition and tax coordination (Edwards and Keen 1996; Frey and Eichenberger 1996). Given the current entropy of the international tax system, both solutions are available to policy-makers. In general terms, tax competition, as shown by the theory of fiscal federalism and by the school of public choice, curbs political distortions, whilst tax co-ordination has the advantage of mitigating tax-induced economic distortions. Why should tax competition be preferred to tax co-operation? Essentially, because politicians and political parties may pursue goals that deviate from citizens’ preferences (Brennan and Buchanan 1980). In this classic public choice scenario, politicians and political parties form a cartel against voters. High and uniform taxes across jurisdictions – the argument goes on – will restrict the ‘exit’ option and citizens will face high costs in raising their voices against centralised governments (Frey and Eichenberger 1996; see Hirschman 1970 for the concepts of exit and voice). In addition, in the case of the European Union, citizens do not even have the right to sanction the government by not re-electing it. Tax competition is therefore advocated.

However, if tax competition works reasonably well in mature federations, in which there is a democratically elected federal government, a single currency, and appropriate stabilisation mechanisms for absorbing asymmetric shocks that hit certain areas of a federation, the dynamics of tax competition in the global economy can be far from optimal. As mentioned earlier, tax competition for portfolio investment can indeed trigger an unbridled competition for attracting capital. This phenomenon of tax degradation has raised the question of whether capital income taxes can be sustained at all in a world of capital movement liberalisation (Gordon 1992). Even regional integration, such as a uniform tax regime for capital income in the European Union, can become an idol with feet of clay if aggressive tax havens (Doggart 1993) are prepared to lure portfolio investment (Razin and Sadka 1989). Not only does tax globalisation affect portfolio investment, but foreign direct investment of transnational corporations is also sensitive to differences in tax regimes. Accordingly, economic theory has explored the possibilities for strategic use of corporate taxation by countries that want to attract investment and retain the most valuable functions of their transnational corporations (such as R&D and headquarters) at home (Bond and Samuelson 1989; Hamada 1966; Janeba 1995). A general result of this theory is that non-co-operative games between nations who engage in strategic use of corporate taxation produce a non-efficient equilibrium: capital stock is inefficiently allocated in a non-co-operative tax world. This is why a measure of co-ordination can be advocated.

The concrete specification of tax co-ordination is puzzling. What should be co-ordinated and for solving which problems? An extreme measure of co-ordination such as the harmonisation of tax systems, tax rates, and tax bases raises immense political and administrative costs. In addition, how could a tax rate (or a range of tax rates) be chosen? The different rates that countries have chosen reflect alternative conceptions of public policy and the welfare state that have been legitimated by democratic elections (Tanzi 1995: 119). Moreover, there is no tax rate that could be considered an optimal ‘anchor’ around which national tax systems ought to converge (Tanzi and Bovenberg 1990). Economic theory cannot help in selecting a widely agreed ‘objective’ reference point for harmonisation, and predicts that full harmonisation is bound to decrease the world welfare.

The political trade-off between co-ordination (i.e. the limitation of economic distortions) and competition (i.e. the mitigation of political distortions) can only be tackled politically. Of course, economic theory suggests that the two extremes of unbridled tax competition and full harmonisation should be eschewed. However, economic criteria do not provide a socially optimal position on the possibility frontier relating economic and political distortions, and economists such as Frey and Eichenberger (1996: 336) have therefore contended that an ‘inward shift’ of the possibility frontier can be achieved by manipulating ‘institutional conditions’ and the ‘rules of the game’. Here is where political science is most obviously needed. Can international regimes improve the trade-off between competition and co-ordination and, if so, how do they emerge? How do political conflict and consensus shape the struggle for creating tax rules in supranational polities such as the European Union and in international policy fora such as the Organisation for Economic Cooperation and Development? Will European institutions play the role of a ‘Stackelberg’ leader⁴ capable of curbing the most dangerous consequences of the prisoner’s dilemma triggered by competition for capital? These are the questions that economists and, most crucially, policy-makers, interest groups and citizens address to political science.

The political trade-off between tax co-ordination and tax competition faced by policy-makers is compounded by another trade-off relating to the preferences of the business community. Indeed, firms’ preferences are inherently ambiguous. On the one hand, an international tax order provides stability and mitigation of double taxation, two aspects that firms appreciate. On the other, however, a certain degree of entropy offers huge opportunities for tax arbitrage and tax avoidance. As a consequence, there is a trade-off between the benefits of co-ordination and the advantage of tax planning. The latter has its own cost, of course, but when tax planning can be exploited widely there is a prima facie suspicion that firms could prefer tax entropy to tax order. Thus the following questions arise: do firms seek a level playing field in international business taxation? With reference to the European Union, do business groups advocate tax co-ordination as an indispensable element of the single market, or, alternatively, do they prefer to rely on the exploitation of tax loopholes, special tax regimes, conduit companies, tax arbitrage with third countries outside the European Union, and all the paraphernalia of tax planning?

A final reason for analysing the politics of tax globalisation relates to the European Union. At the outset of the single market project, most notably in the widely quoted Cecchini report (Cecchini 1988), optimistic predictions were formulated on the advent of a single market in which people, goods, firms and capital could move completely freely. The 1993 deadline has passed and the progress of the single market bears witness to many achievements, such as capital movement liberalisation. Yet the phenomena of double taxation and other distortions still existing in business taxation show that the single market project has not been completed. Four years after the 1993 deadline expired, the European Commissioner for tax policy, Mario Monti, argued – see Agence Europe No. 6905, 1 February 1997 – that ‘in tax matters the European Union has now reached a point where competition between the different national systems and schemes produces destructive effects, both on the functioning of the internal market and on the fiscal revenue of member states’ (also see Commission 1996). Why did tax co-ordination evolve so slowly in the European Union? What are the political constraints hampering the consolidation of a neutral (in the sense of not distorting economic choice) tax regime in Europe which could be so beneficial to the single market? And finally, looking ahead at the new challenge of the European Union, i.e. the single currency, can European countries really enter a monetary union with complete neglect of tax issues?

Moreover, tax competition can compound the problem of sustaining national welfare states which already have been hit hard by the strict economic policies necessary for achieving a single currency before the end of the century (Scharpf 1996a, 1997; Sinn 1990). The European Union is capable of effective action in the area of negative integration (i.e. removing barriers to the single market), but is much less effective in taking decisions in the area of positive integration (i.e. the capability to Europeanise the conditions under which markets work, including welfare regimes). The result could be a degree of tax competition for attracting mobile factors – induced by positive integration – which would erode revenue resources that currently sustain welfare policies at the national level, without any accompanying measure of positive integration at the European level. In this scenario, a degree of tax co-ordination in the European Union, instead of being a mere complement to the single market, could become a key policy in the attempt to bridge the gap between positive and negative integration (Scharpf 1996a, 1997: 34). Will tax harmonisation ‘rescue’ the welfare state in Europe?

The questions raised above can sustain a long-term research agenda in which many contributions are needed before the politics of tax globalisation could be clarified and explained. At the same time, a strong case can be made for introducing political science into this new field of international taxation. Accordingly, one of the objectives of this book is to take the risk of pioneering into a new area and set the train of political science reflection on tax complexity in motion. The analysis of international taxation offered here proceeds along three different lines of enquiry. To begin with, the main empirical object of analysis is corporate tax co-ordination in the European Union (EU). The EU dimension of corporate tax policy is not considered in isolation but within the contexts of domestic tax policy and tax globalisation. The investigation of the EU corporate tax policy process is therefore supplemented by two further levels of analysis: first, the Europeanisation of domestic tax policy in Italy and the UK and, second, the wider context of tax globalisation in which the European policy regime represents a case of regional policy integration. Indeed, any analysis of EU corporate tax policy cannot be limited to European tax directives or other EU tax measures, but may be assessed only in conjunction with the consideration of domestic tax designs: to what extent have they become ‘Europeanised’?

Symmetrically, the political litmus of EU tax initiatives revolves around the embedment of European policy within the global tax order. This leads to three fundamental questions tackled by the research presented in this book: how did the European dimension of corporate taxation emerge? Using the UK and Italy as case studies, what impact did this EU dimension have on domestic tax policy? And finally, is EU corporate tax policy part of a major drive towards a global tax order, or, alternatively, is it part of a poorly institutionalised and essentially entropic tax policy world?

The conclusions will provide answers to these three questions. At this stage it is useful instead to focus upon the theoretical background employed for tackling questions and reaching conclusions. In the case of this study, the theoretical underpinnings are to be found in the literature on the cognitive dimension of politics. The literature on the politics of tax reform and the literature on European integration provide additional useful hypotheses for empirical research. Consequently, Part I of the book considers the intersections between these three bodies of literature which are usually considered somewhat independent and distinct. The organisation of the theoretical underpinnings proceeds as follows: Chapter 2 examines the literature on the role of knowledge in the policy process; Chapter 3 considers the politics of policy-making in the European Union and Chapter 4 the politics of tax reform. The critical examination of the three literatures has two aims: one, as previously mentioned, is to illustrate the theoretical underpinnings of this research, and the other is to build hypotheses for empirical research. Indeed, the reader can consider Part I of this book as a hypothesis-building exercise.

Part II of the book contains the empirical research. Chapter 5 has a preliminary and interlocutory role, to explain the politics of problem definition ...

Table of contents

• Cover Page
• Half Title Page
• Series Page
• Title Page
• Copyright Page
• Contents
• List of illustrations
• Series editor’s preface
• Acknowledgements
• 1 Introduction: International tax complexity as a political problem
• Part I Theoretical underpinnings
• 2 The role of knowledge in the policy process
• 3 Policy-making in the European Union
• 4 The politics of tax reform
• Part II Empirical research
• 5 Problem definition in EU direct corporate tax policy
• 6 Corporate direct taxation in the European Union
• 7 Europeanisation and policy change Italy and the UK
• 8 International tax complexity
• Part III Conclusions and perspectives
• 9 Conclusion Knowledge, institutions and policy change
• 10 Corporate tax policy development in the EU The ‘fiscal federalism' argument
• Appendix A: Chronology: corporate tax harmonisation in the EU
• Appendix B: EU corporate tax law and proposed directives
• Appendix C: Interviews (1994–1996)appendix3
• Notes
• Bibliography
• Index