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August 10, 2003
Knut Wicksell and the dilemma of tax harmonization in a globalized world
A speech held by Waldemar Ingdahl at the Danish Markedscentret think tank's "Conference on Tax Harmonization, financial privacy, and other attacks on our liberty" in Copenhagen, August 9th 2003.
Waldemar Ingdahl also participated in a panel discussion with Daniel J. Mitchell from The Heritage Foundation and Jacob Bræstrup from The Danish Taxpayers' Association.
The speech has been revised by Lene Johansen.
In 2001 the Swedish Postal Service, incorporated by still fully owned by the government, sold one of its subsidiary companies. It did so through one of its Dutch subsidiaries in order reduce taxation. It stirred up quite a bit of debate in Sweden, since tax planning of any sort is viewed upon with a great deal of suspicion and scorn. But it accurately shows the degree of the burden of European taxes; even the governments try to avoid them. The both historically and globally high taxes of the EU have made taxation and financial policy a risky act of balance where even small policy mistakes could have big, or even dramatic, consequences for society.
In the 1990's we actually experienced a trend break, with falling levels of taxation in many countries. Especially corporate taxes were lowered. Why, one might ask? The reason was that globalisation increased fiscal competition and the European Union facilitated capital movement between member states. The adoption of the Euro clearly exposed the differences and facilitated the move of capital.
Particularly the Republic of Ireland, Luxembourg, the United Kingdom and to some degree The Netherlands have benefited from this through the lower taxation of capital and have seen massive amounts of capital moving towards them from the Scandinavian countries, Germany and France. The so called "Celtic Tiger" of Irish growth wouldn't have been possible without the differences between the EU countries levels of taxation when companies and citizens moved themselves and their capital.
Many EU countries have experienced that they are loosing companies and highly educated taxpayers, and thus also experiencing difficulties financing their vast public sectors. Already in 1997 the German Minister of Finance Theo Waigel noted: "all member countries are experiencing an erosion of their tax basis and the problem needs to be solved in concert". Since then the issue of tax harmonisation has been on the EU's agenda.
Actually, there might be some benefits to the idea of tax harmonization. In my native Sweden, taxes for regular incomes often reach above 60% and harmonization will probably force Sweden to lower certain taxes to a EU level. But the fact that Sweden is a "tax hell" doesn't make France a "tax haven" and harmonization will probably result in quite small compromises from countries with a high level of taxation, since their level of taxation is often seen as a sunk cost in their societal structures. The EU Commission has on several occasions admonished Sweden to lower its income taxes to a more European level, not to avail. I also think that the general level of taxation would probably end up on a German or French level, which is also too high. This could "insure" the governments that they wouldn't need to go lower than this rather elevated level. In order to finance the existing welfare provisions in the high tax EU countries, this level of taxation is necessary, the officials say. After all the citizens are said to want them, and thus they should pay for them.
In the EU, Germany has led the issue of tax harmonization for a long time. It is Europe's biggest economy, with a high tax regime and with many Germans moving their funds to Luxembourg, Switzerland and Liechtenstein. Some time ago, it even got to the point where German border police were stationed to search for drivers they suspected of concealing their savings in their cars in order to take them outside Germany. Germany was instrumental in devising the Tax Savings Directive, a withholding tax regime on savings abroad. On interest earned, there is a 10% tax across the EU- or information on these accounts will be passed back to the taxpayer's tax authorities back home.
They also helped to instrument the harmonization of Value Added Taxes (to a lowest level of 15%). Mainly this situation has risen from former Chancellor Helmut Kohl's failed reform attempt in the early 1990's. The United Kingdom has often opposed these attempts at tax harmonization.
Germany has received good help in their quest for tax harmonization from the EU Commission itself. This is because monetary policy cannot be separated from financial policy in general. The European Central Bank will gradually increase its influence on general economic policy. The Commission, with dimmer areas of interest, cannot just work with environmental and equality questions. Without a direct influence over economic policy its position would be undermined. Through pushing for tax harmonization it would naturally be responsible for organizing and monitoring it. If the tax commissioner would be the one to report to the ECB in this issue, they would still have a say in general economic policy, and competing institutions in the ECB wouldn't be a threat. Thus public choice theory shows one of the reasons behind the Commission's support for tax harmonization.
A question that is seldom raised in the debate, is whose view of taxes we should adopt? Is it the governments' or the citizen's?
This is a very relevant question, since it is almost always a given that tax policies should follow a view of tax maximization in which the government's demand for resources is always placed above the individual's need for the same resources. The more taxes the government collects, all the better.
"Governments just do what people want them to", this indirect consideration is often the only one that citizens get in the present view that governments should maximize its tax revenues. The discussion in economics about "optimal taxation" follows this logic; what is the highest level of taxation a government can extract without hurting its tax revenues? Even corporations and politicians that argue for tax reductions cannot distance themselves from this point of view. Calls for decreases are uniformly justified by saying that they will in the long run increase tax revenues through "dynamic effects". It is not surprising that these attempts fail and the politicians that use this argument lose elections.
The Swedish economist Knut Wicksell (1851-1926) argued from a very different point of view in his book "A new principle of just taxation" (1896). In it he analysed how to finance the public sector in a developed market economy from the citizen's perspective, and it is unfortunate that his work isn't mentioned more in the political debate. In these days when a view opposed to governments maximizing taxation is viewed as the epitome of neo-liberalism it is often a shock for many to learn that he was an early 20th century social democrat. His views on how his contemporary antiquated, unequal system of taxation would hurt society are well applicable to the present.
Wicksell stated that a tax system should finance public expenditure, and for a rational citizen the payment of taxes should be a good deal, as an insurance premium. Citizens could over- and underpay to the system during their entire cycle of life. They could be overtaxed some year, if they were certain that they would be able to overconsume another year. A balance had to be achieved between paid taxes and what the citizen received back in public services.
Wicksell stressed the importance of well-informed citizens, but today this isn't possible. The sheer size, and involvement of the government in so many areas, makes it impossible for the common citizen to see what his or her tax money is financing. The decisions regarding public expenditures and taxation are so divorced from each other. In this vacuum of uncertainty, there is much to be won by organizing into special interest groups. By rent-seeking, these special interest groups may make a big profit for themselves from government grants and subsidies, all while other citizens just make a small loss through extra taxes to finance the government's expenditures. In themselves these losses are not big enough for the others to counter-organize against the special interest. But the proliferation of large amounts of special interest groups certainly put a dent into the taxpayer's wallet.
The concentrated political clout of the special interest groups also sees to ensure the victory of the "big spender" fractions in the political parties, in exchange for the votes they are able to supply. Wicksell pointed out that through this power special interest groups appropriate and formulate the political agenda for the whole of society and also deprive the political system of its ability to make long-range decisions. Tax policies are forced into the short cycles of day-to-day politics. There is a danger that many governments in the EU are seriously undermining their legitimacy in the eyes of the general public, since they (often rightly) are perceived as just the agent of certain special interest groups, with their decisions in conflict with the interests of the common European. The high taxes often seem impossible to repeal since they become perceived as sunk costs, in which extensive renegotiations of the whole state would be necessary to reduce taxes by even minute amounts. The political costs of raising taxes are comparatively small in regard to that.
So, if people are so unhappy with high taxes and the power of special interest groups, wouldn't they just make their discontent known at the general elections and vote for parties that promise to reduce taxes? Wicksell showed us that this isn't probable. General elections are, in fact, too general. The issues in elections are phrased in very general ideological terms that rarely go into specific budget issues. In this environment it is very easy to frame the issues in order to gain votes both from the special interest groups, by promising subsidies and benefits- while still winning the general voter by vague notions of high taxes equalling "solidarity" and "common good", since voters have very little knowledge of how public expenditures actually are made just by the sheer complexity of the high tax state. The voters are unable to make the connection between the high tax agenda they have supported with their vote on extremely general terms, and the actual tax payments they have to do.
This situation doesn't enforce the two important criteria Wicksell had for taxation, namely "consent" and "legitimacy". For taxpayers to be treated equally by the government wasn't enough for Wicksell. He pointed out that a criterion of unity also was necessary. If a new tax was to be implemented it needed the consent of all citizens, or at least a qualified majority. All taxes should also be repealed automatically every five years, if they weren't passed again unanimously. From this we can see that the high levels of taxation today are not passed unanimously since they are generally punitive of high levels of education, ambition and success. In fact, they are even punitive of just potential for success- this can be seen in Sweden were the high taxes make ¼ of all newly graduated civil engineers move abroad, among graduates of the Stockholm School of Economics half leave the country. Less and less of them return. Both capital and labour are so highly taxed that they move.
So what would a "fair" level of taxation be? Note that Wicksell meant "fair" in the objective, juridical sense not the highly moralistic sense used today. It should be about 10% of the income in order to maintain the democratic institutions of society, an additional 10% of the income in order to provide a social insurance. Even if considering other demanded expenditures for the government, the will to pay barely reaches 25% of the income. Today, most EU citizens pay about 50% of their income in taxes, in Sweden reaching as much as 65%! Far above what people consider a fair level of taxation. This is because when real wages rise, the part that is willingly contributed to public services diminishes in line with the consumption and economic improvements. This is comparable with the part of food of household budgets falling over the course of time. Taxes' part of GDP should also fall over time, not the reverse. This creates a tax gap between expected and perceived taxes. The often used "helping the poor" argument used to justify high taxes is without basis. Economist Stefan Fölster showed in 1998, that only 24% of social transfers were between individuals. This is because today's tax system doesn't redistribute money between individuals, but generally it redistributes incomes between various periods of a taxpayer's life. The lowering of taxes would create the opportunity for more attractive alternatives for social insurances, instead of the present's uniform and low qualitative social security.
This can be seen in the fact that people try to correct their taxation down to a Wicksell consistent degree by massive tax planning and tax evasion.
All legal possibilities for tax deductions are strained to their limits, and this trial and error process by the citizens crowds the European courts of justice with tax cases. This creates huge consequences for the governments' finances, even if just small groups in society excel in it. This because when the government tries to "close the loopholes" and increase controls by not allowing cost deductions fully there is a serious loss of rationality in the tax system that hurts the requirement for equality in taxation, which further harms its legitimacy.
The so-called "informal" sector now compasses 12-25% of the EU countries' economies. In fact, if we could include the GDP growth of the "informal" sector in the EU economies general GDP growth, Europe's growth rate would be on par of the Asian tiger economies. This shows the dismal scale of tax evasion today, that the tax maximizing system forces.
How the proposed tax harmonisations in the EU will be handled also creates considerable technical problems. In Germany and France taxes are collected through compulsory social insurance fees, but in the United Kingdom and Sweden through income taxes on wages (this because the labour market reacts less directly on rises in income taxes). In Denmark and Sweden taxes are mostly collected by the local government, but in France and the United Kingdom by the central government (because of their more centralized imperial past). In EU countries with a high level of income and a stable level of employment, income taxes are the main source of revenues for the government, as this achieves stable revenues for the government. But in the three poorest EU members: Spain, Portugal and Greece it is indirect taxes on consumption that provide the governments with most of their revenues. This is also because the Spanish, Portuguese and Greek governments have tried to promote savings.
Thus, I think that the projection that it will be simple to for the EU to harmonize taxes by just raising the level of taxation is a bit more complicated. The various forms of taxation reflect different political and societal values, in which some countries will have to enforce their values on the tax systems of other nations. History teaches us that taxation without representation is hardly a way to ensure peace and friendship between peoples.
Besides, the harmonization of taxes between EU members will just make the advanced production, people and capital move beyond to the US, East Asia, the Caribbean and those parts of Europe that are not members of the EU, even more so since a "dash to the top" to German levels of taxation will probably increase the penchant of people for "voting with their feet", facilitated by globalisation and informatics. It is important to keep in mind, that today we are not just talking about a few couple of millionaires or cosmocrats, but about quite regular average taxpayers too. This would lead to falling tax revenues, the reverse that it was supposed to do, leading to even higher raises of taxes in order to compensate the losses (in accordance to "von Mises' law").
The citizens "voting with their feet" actually provide governments with valuable information. It gives a message that the politician so far have avoided: "we need an extensive tax reform". This is contrary to the common assumption that tax evasion and tax planning would force a "race to the bottom" where people are not willing to pay any taxes at all, and force an erosion of government finances through increasing tax competition. This view to regard the citizens as "naughty" is unproductive, and as Wicksell pointed out, we don't have any general experience that most taxpayers would like to be free riders. Taxpayers are willing to pay for the services they ask for and consume, but not more. Not the subsidies to special interest groups, not the Common Agricultural Policy, not the subventions to failing industries and regions far away, nor to punish certain lifestyles the current political majority doesn't approve of, not the huge scale systems for redistribution of income.
Taxpayers don't just compare levels of taxation between countries, they also compare how and on what governments are spending the their tax revenues. Are they providing stability, rule of law, freedom in pursuit of happiness, and protection of property? Tax maximizing governments seldom do. It could be possible in this respect for a government to have a relatively high rate of taxation and still be competitive, if it does what the citizen asks. If the citizen wishes to pay for more, he should get more services from the government, not just simply pay more into a system he cannot possibly overlook. In this system the citizen doesn't try to correct his tax payments down to Wicksell consistency, because he gives his consent to the taxes.
Thus tax competition is really a competition about which government uses the tax money in a legitimate way in which competition forces it to be economically rational. Tax competition on the market for governments is as beneficial to society as competition on goods and services.
And this is, why I think the best way to attack the discussion about tax harmonization is to start a discussion of "good government" and the pointing out the fact that these high taxes obviously don't provide what the citizens ask for, and that more taxes in all EU countries will only aggravate the problems. It is of no use, as liberals often do today, to get into extremely complicated technical discussions, because the average citizen has so little knowledge of how the tax system actually works. Promises to "lower taxes by 20 billion euro" or promoting "dynamic effects" bears no meaning to him, because in the tax maximizing society his income is such a small and uncertain part of his revenues, compared to government subsidies and grants.
The approach of putting the citizen in the forefront, and demanding a Wicksell consistent tax system will be a more forceful argument, since it attacks the philosophy behind the tax maximizing state in a way that also builds new alliances in society.
Posted by Waldemar at August 10, 2003 12:29 PM