Research Essay

Considering the diversity of European tax policies and the risk of tax competition between them, what are the

consequences on foreign investment and public services?

Ixchel Falaize Bachelor of Business Administration

IT Sligo, Ireland

Research tutor: Nicolas Barbaroux

Methodology tutors: Evelyne Downs & Sandrine Le Pontois

THANKS

I would like to express my gratitude to Mr. Nicolas Barbaroux, Associate Professor in Economics at the University of Saint-Étienne, and my teacher tutor for my research paper.

Both present and available, he guided me in my work, helped me to find ways to move forward, provided tools and its intellectual and moral support throughout my research and work. I thank him for coaching me and giving me advice.

TABLE OF CONTENTS

Introduction

p. 1

I/ The issues of tax competition within the European Union

p. 5

A/ Divergent national taxation systems within the European Union

p. 5

B/ what is tax competition and what are its foundations?

p. 10

C/ Tax harmonization versus tax competition: the issue of the European federalism

p. 14

II/ the consequences of a “fiscal war” on foreign investments and public services within the European Union

p. 17

A/ what happens when European countries compete on taxation between themselves?

p. 17

B/What are the differences between France and Ireland from their respective tax systems? Should the European Union converge to a tax harmonization?

p. 20

III/ The fiscal policy dilemma: tax heaven or the domestic economy.

p. 21

Conclusion

p. 23

Annexes

p. 25

Bibliography and sources

p. 30

1

INTRODUCTION

Following the Great Financial Crisis (GFC), the increasing necessity to find an economic recovery pre-empted the macro agenda of the European Union economy. In this search of growth, the burning topic of taxation became a leading subject in a context in which the EU rules (notably the ones on budgetary deficit) prevent the States to be free to choose the appropriate instrument. The convergence of taxation systems in Europe is a problematic which arises from the birth of the European Community in 1957. Since 1960 a specific Commission was established at the initiative of the European Commission to consider the advisability of bringing closer the different taxation systems and to make them converge. This problem is still not solved nowadays, because in Europe we observe completely contradictory evolutions: on one side there is a strong opposition to the convergence of systems, especially as taxation remains governed by the unanimity system, that is to say, by the principle of respect for national sovereignty. On the other side, we can see the opposite trend emerge to support convergence; for instance, the initiative that comes from the European Commission to establish a common consolidated tax base with regard to corporate taxes: These are initiatives that demonstrate a political will to bring the tax systems closer by harmonizing the corporate tax base . Thus, taxation is a structural problem meaning that it necessitates a thorough changing of economic reasoning while the States are in context in which economic selfishness seems to prevail (for growth purposes). Given the changes that seem to be contradictory and complex how to find one’s way? To answer this question one must kept in mind some simple ideas. Different voices emerge in Europe when the convergence of taxation arises. The first idea is that Europe is a space where different cultures coexist and it’s right that it should remain that way. There is in Europe different tax cultures, as much as, its global cultural diversity. And if a reconciliation of these tax systems doesn’t appear to be necessary for the European members, then it is not easy to make it happen. The second idea is that Europe is a free market, i.e. it is a market which works to facilitate the fluidity and flexibility of the economic relations between companies at an European level, thus, we must eliminate taxes that represent barriers to this market’s achievement: That is why VAT has been harmonized, that’s why there is no customs duties within the European Union, that’s why there are directives that eliminate some tax frictions about cross-border flows, dividends distribution matters, among others.

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The third idea is that we must kept in mind that the European Union is a mutual-help area based on common values , which means that all the Members States must work together to discuss and to fight against fraud and tax evasion. This also means that the tax legislation across the European Union must respect certain fundamental values such as human rights, and by extension, therefore, the taxpayer’s rights. The last idea that is, without doubt, the opposite of the three first points, is that the European Union is a competition and competitiveness area. Tax competition still exists in Europe; the European countries’ interests are clearly in conflict: large states don’t have the same interests with regard to tax policies than the smaller states. The small states tend to compete more or less fairly with large states to attract foreign investment in their territories. This competition area is probably the most ambiguous and problematic issue that affects the progress of a European harmonization. The discussion on tax competition can be illustrated by a duel between the advocates of harmonization who fear the “race to the bottom”, and thus the gradual disappearance of the taxation of the most mobile tax bases; and the advocates of tax competition, for whom harmonization is a conspiracy of high-tax countries to force their European partners to align with this model. This led to a downward convergence of corporate tax rates in Europe. (See annex 1: Top corporate income tax rates 1995-2009)

This convergence can be problematic since it brings about other issues to consider such as the financing of public services which comes from taxes revenue (corporate taxes, but also income and savings that are less mobile). Infrastructure spending, workforce training, and the justice administration contribute to the efficient functioning of businesses. Some of them also benefit from the direct or indirect impact of public research efforts. While tax competition exerted on the overall tax burden is considered as fair, the European Union has been very clear that when tax competition is characterized by the desire to attract foreign tax bases (thanks to different tax measures for foreign investment), this form of competition is harmful. Therefore, this form of competition cannot be accepted because the advantages for a handful of smaller geographic areas, especially small states as previously mentioned, is significantly lower than the loss recorded by the majority of countries that it may affect . Furthermore this type of tax competition may also lead to higher taxes on relatively immobile bases (savings or income) instead off the more mobile bases (capital). In the current institutional and legal context of the European Union, the Member States have the choice to offer to their domestic and foreign investors the best opportunities according to the level of their taxes, and to set the tax systems that they prefer. This way, they can choose to offer a wide range of public goods and services or leave more room for the private sector.

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The problem is more complex if we keep in mind that a higher overall tax burden does not necessarily discourage investment. For example, if a country has developed in return an excellent educational system and provides high quality infrastructure and public services. Similarly, a low overall tax burden does not necessarily attract investment if education, infrastructure and public services are poorly developed. Thus, states face a fiscal policy dilemma: to reduce corporate tax burden so as to improve their price competitiveness or encourage capital inflows; or to maintain a high level of public expenses (particularly social insurances and pensions systems) which implied to maintain or increase the level of taxes so as to finance them (in a context of public debt burden). In addition, each country must also deal with national and European requirements in terms of public expenditure commitments because of the post-crisis austerity measures focused more on cutting public spending rather than on higher tax levies. Indeed, the corporate income tax rate has decrease between 1986 and 2009 about 36 points in Ireland ( from 48% to 12%) and about 3 points in France (from 36% to 33%) when the average for the OECD countries is a decrease of 10 points. (See annex 1: Top corporate income tax rates 1995-2009)

The general trend in the European Union is a slight decrease in taxation; there are countries with high tax levies that are linked with generous social systems like France but also Denmark and Sweden, and countries which are characterized by a low tax system such as Ireland. However we must keep in mind that comparisons between countries, even within an area such as the European Union are tricky because the corporate tax rates depend on the method of financing the social protection, the size of their territory (less tax competition for the larger countries because they have a larger market that make them attractive regardless taxation) . Thus France has an advantage over Ireland whose territory is smaller. In addition, each country must also deal with national and European requirements in terms of public expenditure commitments because of the post-crisis austerity measures focused more on cutting public spending rather than on higher tax levies. However, in the long run, it seems unlikely that such tax diversity is tenable even if this problem has been emphasized for a long time. As the E.U integration is at a turning point in its history, states have to choose between federalism (meaning more integration and a necessary tax harmonization for all of them) and independence, meaning that E.U construction stucked at that level. Considering the diversity of European tax policies and the risk of tax

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competition between them, what are the consequences on foreign investment and public services?

We will answer this question in three parts: first we will be interested by the issues of tax competition within de European Union, then about the consequences of a “Fiscal war” on foreign investments and the public services to finally ask ourselves if a country absolutely needs to have an attractive tax system to develop its domestic economy.

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I/ THE ISSUES OF TAX COMPETITION WITHIN THE EROPEAN UNION

A/ DIVERGENT NATIONAL TAXATION SYSTEMS WITHIN THE EUROPEAN UNION

The evaluation of taxation differentials between countries within the European Union is relatively complex, especially because every business is a particular case. The companies being taxed in the country, in which they are established, are subject to the ordinary taxation system, which in practice, applies to most businesses in this country, or to special rules according to their activity. For businesses operating in several Member States it’s necessary to take into account the parent company countries rules, but also those of the country of establishment of the subsidiary. As things stand currently, there is a great heterogeneity of taxation systems among the Members States of the European Union. The rates vary from 12 % in Ireland to 33% in France and Belgium. The European Union is still a high tax area. Indeed, in 2012 the overall tax ratio, that is to say, the total of taxes and social contributions in the twenty-eight Member States amounted to 39.4 % in the European GDP average: this is fifteen points over the United States and approximately ten points over Japan. Nowadays the taxation level in the European Union is high compared to other developed countries: for instance Russia with an average of 36%, or Canada and Australia that are below 30%. Regarding the other less developed economies, they are most of the time characterized by quite low taxation rates. High European Union tax levels are not new, since the last 50 years the role of the public sector became more and more important, generating a growth of the tax ratios in the 70’s, 80’s and 90’s. When the Maastricht Treaty was adopted and after the Stability and Growth Pact the European Union Members began to adopt some fiscal consolidation packages. Some countries chose the reduction of public spending; others chose to increase the taxation rates. But some countries took advantage of buoyant tax revenues to reduce the tax burden, through cuts in the personal and corporate income tax as well as in social contributions. After the 2008 global economic crisis some effects on growth and then on income began to appear, even though in the European Union the economic growth became negative only the following year. The main measures taken by States were on the reduction of public expenditure. Countries that have chosen to implement cuts in taxes did it on labor income taxes and, to a smaller extend, on capital.

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There are deep variations in tax levels in the European Union: the ratio of 2012 tax revenue to GDP was highest in Denmark, Belgium and France (between 45% and 48%); the lowest were recorded in Bulgaria (27.9 % of GDP), Lithuania (27.2 % of GDP), and Latvia (27.9 % of GDP). The European Union average top rate of tax on corporate income has remained more or less stable since 2010. This follows a trend of continual fall rates from 1995 to 2009. The 28 European Union average in 2014 is 22.9 %, compared with 35.0 % in 1995. (See annex 2: Corporate income tax revenues, 1995–2012) Let’s approach some French and Irish taxation system specifications: Regarding the French taxation system some specification need to be clarified. Indeed, in 2012 the tax to GDP ratio in France was 45%, the third highest in 28 European Union and 6% points above the European Union average (39%). Of total taxes collected in France 54% go to the Social Security Funds, the highest level in Europe. The Finance Bill was adopted in December 2013 and the essential changes are, regarding the corporate taxation, the rate of the notable surcharge which applies to companies with a high turnover (over 250 million) which has augmented from 5% to 10.7%. As well, a temporary tax of 50% on high wages paid in 2013 and 2014 has been introduced. The French tax system is defined by two main characteristics: high nominal rates of tax and narrow tax bases, due to a large range of tax loopholes. The level of tax and social security contributions are higher in France than in other European Union Member States. Also, taxes are concentrated on the most dynamic and most mobile factors, and these high tax rates on narrow tax bases are generating a very restricted tax yield. To illustrate our main point we can rely on the comparison between French and Irish example. Important differences exist between both countries regarding their taxation system, but also some differences exist in employment, infrastructure and education that are key points to answer our issue. At 28.7% in 2012, the total tax to GDP ratio in Ireland is the sixth lowest in the Union and the second lowest in the euro area. These rates have been constant in past years. The taxation structure is characterized by a strong reliance on taxes rather than social contributions. The structure of taxation differs considerably from the typical structure: in Ireland the proportion of social contributions is comparatively low, while the proportion of direct taxes (particularly income tax) is quite high. As in the majority of Member States, the largest share of indirect taxes is constituted by VAT receipts,

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(approximately 56% of total indirect taxes of GPD); taxation of labor has increased by over 25%, while taxation of consumption and capital has fallen. Companies resident in Ireland and non-resident companies which carry out a trade in Ireland through a branch or agency, are, with a small number of specific exceptions, liable to corporation tax on their taxable profits. The corporation tax rate of 12.5% is applied to trading profits in all sectors since 1 January 2003. A 25% rate applies to other passive (non-trading) income. Ireland was one of the first countries in the world to adopt an FDI-based development model "As a result of its interaction with the market place for foreign direct investment IDA-Ireland regularly adjusts its targeting of sectors and companies while fine-tuning the range of financial incentives on offer to attract inward investment". (The Celtic Tiger by former Irish Finance Minister and EU Commissioner Ray Mac Sharry) Foreign direct investment (FDI) is defined as a business investment aiming at a long-term relationship, and reflecting a lasting interest and (partial) control by an entity resident in one economy (foreign direct investor or parent enterprise) in an enterprise resident in another economy (FDI enterprise or foreign affiliate). FDI statistics include both the initial investment and all subsequent investment by the parent enterprise, which can be either in the form of equity capital, reinvested earnings or intra-company loans. (Eurostat) The importance of the corporation tax regime in attracting Foreign Direct Investments inflows to Ireland has led the Irish government to block moves towards tax harmonization within the EU. Several studies have attempted to evaluate the implications of such tax harmonization. Moreover, Irish economists (in particular Patrick Honohan) disagree as to the importance of the increased FDl flows to the Irish boom of the 90s. Two opposing theories have emerged in analyzing the "Celtic Tiger" phenomenon. The first of these (the "delayed convergence" hypothesis), tends to downplay the role of FDI, while the other, (the "regional boom" perspective) views it as crucial. Another factor operating in Ireland's favor in the international battle to attract FDI is that the country remains a relatively low labor cost economy compared to European Union standards. The Irish development have been due in part, at least, to an innovation in the system of wage determination introduced in 1987 which saw wage moderation purchased via the promise of future cuts in income taxes. This new "social partnership" approach played a large role in the successful resolution of the fiscal crisis that had troubled the country throughout much of the

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80’s. The decision to harmonize at the low 12.5% rate means that Ireland will remain the state with the lowest effective corporate tax rate in the EU. The European Union has lost its leading position as the world’s most important recipient of foreign direct investment (FDI). While the countries of the European Union accounted for 50% of global FDI inflows in the early 2000s, the share has fallen to less than 20%. By contrast, the BRIC countries have more than doubled their share in global FDI inflows since 2007. In 2013, China alone received more FDI inflows than all European Union countries together. According to a 2014 Deutsch Bank research “The evolution of FDI activity across the euro area is very uneven. The highest inflows during the previous two years were recorded for Spain and Ireland. While Germany and Italy experienced an increase in FDI activity in 2013, it decreased strongly in France” Indeed, in 2013, the top FDI destinations in the European Union were Spain, UK and Ireland, which all received around 15% of the total 240 billion euro inflows. (See annex 3: The European FDI inflows in 2013)

However, we know that foreign investors are very cautious when entering a national economy; the macroeconomic stability is a precondition of the arrival and generally creates an interest in investing in a country. Therefore, the macroeconomic stability is one of the important determinants of foreign direct investment. It can be traced through a series of relevant macroeconomic indicators: inflation rate, unemployment rate, GDP level per capita, external debt, workforce skills, as well as many other indicators. The important thing to remember is that the foreign investors take into account several criteria before investing in a foreign market and not only its taxation system. As a result, it’s important to admit that there is a real competition between State Members even if they’re part of the same united economic community. The European Union is made up of States Members with different characteristics which, as a whole, have developed production factors as labor or capital. In the case we are analyzing, France and Ireland, we must realize that taxation becomes a major issue in the foreign investor’s choice because Europe is more or less homogeneous regarding the macroeconomic factors we were talking about such as inflation and unemployment rate, external debt or workforce skills. Some countries make a difference to attract foreign investors or subsidiaries of multinational companies with the tax advantages they can offer. Tax harmonization and tax competition become a European puzzle whose pieces are the Member States. This issue will continue to be problematic for the European Union to move towards the European Federalism desired since the creation of the European Coal and Steel Community.

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B/ WHAT IS TAX COMPETITION AND WHAT ARE ITS FOUNDATIONS?

Tax competition cannot obviously be reduced simply to the tax burden (See

annex 5: Tax burden in 2011) that may be exerted on businesses in a country or another, because tax extent is quite complex; because taxes may have as counterpart public goods such as infrastructure, education or insurance that enhance the business efficiency and the attractiveness of the territory; and because the decisive tax parameters vary depending on the type of business or its operations. However, tax burden is not neutral in the medium to long term on the share of value added particularly because governments have lost the currency control in the Eurozone. Taxation is therefore a decisive weapon to increase the competitiveness and attractiveness of a territory, or to divert the tax base thanks to a growing tax competition. According to Jacques Le Cacheux "Tax competition can be defined as a situation in which the tax decisions of individual states are interdependent and generate fiscal externalities, source of distortions”. Tax competition is the interactive governments’ determination of a taxation system in a strategic and uncooperative manner. In this research paper, we will focus on tax competition between states, but we must not forget that such competition may apply between regions of the same nation, or between communities. Indeed, tax competition is a phenomenon that has existed between all public entities. Globalization has had a positive effect on the development of tax systems. Globalization has, however, also had the negative effects of opening up new ways by which companies and individuals can minimize and avoid taxes and in which countries can exploit these new opportunities by developing tax policies aimed primarily at diverting financial and other geographically mobile capital. The economy mutations have made the countries more open, nowadays we evolve in a more interdependent and unified world, and above all, we evolve in a world where the economic agents have greater decision-making spheres and are more mobile. These actions induce potential distortions in the patterns of trade and investment and reduce global welfare. Obviously there are economic agents that are "naturally” mobile such as large multinational business that will maximize their investments, optimize the location of its production depending on the taxation conditions offered to them. The main argument put forward by advocates of tax competition in Europe is the state autonomy. The autonomy in the sense that each state has the right to influence the decisions that affect them. Autonomy, in a tax context, is the freedom to determine their own public budget and their own level of social redistribution: as

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we have explained so far, regarding this political autonomy, preferences are very different from one country to another. This autonomy is somehow protected by the Members State sovereignty to set its own taxation rules. More generally, taxation rules in one economy are now more likely to have repercussions on other economies. The key point that emerges within the European Union is that this tax competition, which falls within a liberal framework, will eventually attain fiscal autonomy because Member States should be forced to agree in a harmonized taxation system based against each other interests and not only based in their own domestic interests, as in the Irish case who gave preferential rates to foreign firms that allowed more, than to Irish businesses before it was changed by European directives. Then, the economic theory provides that such competition becomes a “race to the bottom”, that is to say, taxes on mobile bases in particular will rapidly decrease. This reflection leads us to our main issue: whether taxes go down, state revenues will decrease and, by extension, the public good will too. However, this statement must be qualified: some countries have moved the tax burden on capital, which is mobile, on factors that are less mobile like work, consumption or savings. In other words, these countries were able to protect their income level at the cost of a potential increased inequality. So, there are other countries that do not have the financial and administrative capacity to have an income or VTA tax that pays enough to offset the loss of earnings due to lower taxation of mobile bases: the result is an income decrease and, forward, a social redistribution issue. Why do we tax? Three key goals of taxation have been identified (by Richard A. and Peggy B. Musgrave, Public Finance in Theory and Practice). First, taxes raise revenue to finance government spending. Taxing and spending serve a social distribution function focused on those areas where the market can’t do it as effectively as the government, including the provision of public goods, competition policy, etc. Of course, it will often be controversial in how far government intervention actually serves those purposes. Second, taxes represent an instrument to redistribute income and wealth to promote the conception of social justice that has been chosen through the democratic process. Third, taxation rules are traditionally used to stabilize and smooth the business cycle by tightening or expansionary policies as the case may. The context of the 2008 crisis has changed the situation. Because the European integration, the monetary policy is no longer the short-term policy. The European treaties as the TSCG (Treaty on Stability, Coordination and Governance) also called "budget deal” restricts the governments’ flexibility because countries must

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submit to the European Union and the European Commission their budgetary policies in order to have their approval. Since the governments no longer have as many flexibility as before (currency devaluation for example) to become more attractive and be more competitive, tax policies remains a solution that can enable Member States to control more or less their budgetary balance. According to the OECD there are two types of tax competition: The “poaching” is a term that has been introduced by the OECD. The difference between “poaching” and “luring” is the separation between the landlord of the capital and the capital itself. In that case the owner remains in the country (where the activity is established) and the money flowing through another account in a tax haven for example. There is therefore a “poaching” of the tax base from the residence country to the tax haven where the money flows. Likewise multinationals send their profits elsewhere while the economic activity takes place in the country of residence. The tax base “goes for a walk” and is poached by another Member State. The first example of this type of tax competition are the private (approximately 5800 billion euros hidden in tax heavens) and business investments which flow through tax heavens such as Switzerland and Luxembourg (Tax ruling)considered as classic tax heavens. The second example are the "paper profits" between subsidiaries of the same company based in countries with more or less advantageous tax systems, in order to charge for services between the group subsidiaries and shift profits from one subsidiary to another ( “transfer price”) . It is very hard to verify and is a genuine grey zone. Paper profits are profits which has been made but not yet realized through a transaction, such as a stock which has risen in value but is still being held. For instance Apple takes advantage of the differences between the American and Irish tax system thanks to a subsidiary registered in Ireland but which is not, for tax purposes, Irish. This has allowed them to save billions of dollars. Similarly Google whose profits are diverted to tax havens where they are taxed at really low percentages. To explain this with significant numbers, in 2012 imports of Netherlands and Bermuda accounted about 20 % of services imports of Ireland (20% of Ireland services imports come from the Netherlands and Bermuda) The “luring” is employed to defined when a government tries to attract the production base in its territory as they did before in Ireland in the 70's and 80's.

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Companies and their headquarters move to other countries that can offer to them taxation benefits. This is particularly the case of the FDI. To conclude this chapter, I quote the European Commission for whom "tax competition may strengthen budgetary discipline to the extent that it encourages the Member States to reduce their public spending and thus helps to sustainably reduce the overall tax burden” The introduction of a common tax base wouldn’t be intended to reduce the taxation level but rather a way to create a corporate taxation method in the European Union more efficient, more competitive and neutral in budgetary terms.

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C/ TAX HARMONIZATION VERSUS TAX COMPETITION: THE ISSUE OF THE EUROPEAN FEDERALISM

As we previously mentioned it, European integration evolves since its creation in 1957. The latest evolution was the TSCG (Treaty on Stability, Coordination and Governance) ratified in 2012 and which represents the next step towards a "budgetary federalism" of European Member States. The term was launched by Jean-Claude Trichet in an interview to Le Monde in May 31 2010: "We now need to have the equivalent of a budgetary federation in terms of control and monitoring the implementation of public finance policies” However, in the actual European Union, the redistributive policies of national governments are threatened by the fiscal competition between them, and this raise the issue of the interest of an intervention of a supranational government to fight against the harmful effects of fiscal competition beyond the budgetary federalism. A few decades ago (in the 90's context of the European Single Market) the objective of the European Commission was to harmonize national tax policies to reduce the distortions of competition between Member States. Since the monetary union has become widespread, the tax competition risk is perceived as a threat to the States’ budgetary and fiscal sovereignty, because the single currency, which facilitates the mobility of capital and businesses, may also enhance the risk of tax competition between States. Today an uncontrolled tax competition represents a risk for the public finances of Member States: the State has not only renounced to their monetary sovereignty to give it to the ECB, but also their public finances are under great pressure because of the Stability and Growth Pact and or “budget deal” (TSCG). That is why States, unable to devalue their currencies, could be tempted to take their tax policies as a weapon to improve their competitive advantage and attract the mobile bases we mentioned: companies that have subsidiaries or high skilled labor. To fight against the "harmful” effects of tax competition, several solutions are possible. These include centralize the fiscal policies, which is the most radical solution to harmonize taxation rules within the European Union. However, given the diversity of social models in the European Union, such a solution seems difficult to achieve as it would imply that rates rise in some regions and decrease in others. On the one hand, this would have repercussions on the attractiveness and competitiveness of some territories, and on the other hand, it would have repercussions on revenues that are needed to finance the public good. Furthermore, European Union Member States are far from ready to abandon the last instrument of economic policy available to them, namely the budgetary instrument as we mentioned it previously.

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There is already a form of tax harmonization in Europe regarding the VAT. Europeans have agreed on harmonized rules in the area of indirect taxation. Indeed, the VAT is part of the acquis communautaire, and two directives (1977 and 2006) closely codify the VAT regime in European Union Member States, with a minimum standard rate. The second area of tax harmonization concerns capital income. In 1990, the Parent-subsidiary directive tackled the issue of double taxation of repatriated profits by a mother company from its subsidiaries. Member States are requested either to exempt repatriated profits, or to deduct taxes already paid by the subsidiaries from the mother’s tax bill: the objective was to avoid discriminating against foreign subsidiaries (taxed twice) in relation to domestic firms (taxed only once). Because tax competition has drawbacks that have been mentioned in the previous chapter (basically less income and thus degradation of public property among others), we can imagine that the solution is the European tax harmonization whose primary purpose would be to limit or eliminate the phenomena of competition. This suggests that tax harmonization will have the opposite advantages and disadvantages to those of tax competition. Obviously tax harmonization would limit the "race to the bottom" and thus it should increase budgets to afford to provide more goods and services; but it can also, on the other hand skew how agents make their decisions Critics of tax harmonization argument that such tax harmonization would increase overall tax rates throughout Europe; they also argue that the absence of competition would undermine countries’ opportunities for creative economic reform and reduce individual freedom. Finally they argue that tax harmonization is not the only way to fight against tax evasion. One of the prerogatives of national sovereignty is that tax policies must be a political decision and from this point of view, the European Union does not yet have this budget and fiscal sovereignty, and we can legitimately ask if taxpayers would accept an European tax harmonization. The concern for national sovereignty that has so far been the heart of the European project regarding fiscal and budgetary matters seems to be a topic that is currently discussed and it is likely to increase the years to come, especially after the economic crisis of 2008. First of all, because Member States are much more vigilant than before concerning their public finances in the aim to have effective tax revenues. That is where the growing concern of tax competition comes. Secondly, the crisis has revealed the need for a greater fiscal integration and European states have realized the need for greater European integration. Then thirdly, we are evolving more and more towards a digital economy where information and information

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transfers are inexpensive and fast; it becomes almost impossible to implement tax exemption systems through opacity or discretion. For instance, revelation of fraud and tax evasion make the news. Finally, the question that arises on both sides of tax harmonization and tax competition within the European Union is a much larger issue which is the strengthening of the European integration, and beyond, the question of national sovereignty of each Member State. Move towards a European tax harmonization implies that Member States are willing to concede an important part of their decision-making on tax matters, which is ultimately a sensitive area given the social implications that this entails, as we have previously showed it. Thus one may wonders if the outcome of the European integration could take place without going through a number of reforms which must affect the sovereignty of States: can we really move towards a federal Europe without conceding a share of decisions from national level to the supranational level?

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II/ THE CONSEQUENCES OF A “FISCAL WAR” ON FOREIGN

INVESTMENTS AND PUBLIC SERVICES WITHIN THE EUROPEAN UNION

A/ WHAT HAPPENS WHEN EUROPEAN COUNTRIES COMPETE ON TAXATION BETWEEN THEMSELVES? When examining the European fiscal systems it is helpful to pose a number of questions as to its economic effects. It should be recognized, however, that it may be difficult to gather the information necessary to answer these question. Also, although tax is only one of the factors which may influence investment decisions, governments may find them in a “prisoner’s dilemma” where they collectively would be better off by not offering incentives but each feels compelled to offer the incentive to maintain a competitive business environment. If the preferential tax system is the primary motivation as to where to locate an activity, this may indicate that the taxation rules in question are potentially harmful. It is recognized that in practice it is not always easy for the governments to evaluate the motivation of investors and that non-tax factors, such as the quality of the infrastructure, the legal and regulatory framework, labor costs, etc., may also influence location decisions. First of all the State autonomy mentioned in the chapter II. B involves to respect the principles which impose certain constraints on tax competition within the European Union: each person, capital owner or company is a member of the geographical zone in which it resides so that everyone must pay taxes in the State to which they belong. This principle is not respected because the source taxation rules for companies are not respected due to the competition and the differences between the tax regulations between states that allow them to escape. Tax evasion and tax cuts through these arrangements represent a kind of “free riding” (Cf. Mancur Olson The Logic of Collective Action: Public Goods and the Theory of Groups) as these agents are established in a place where they can benefit from public good, but they’re not paying in return the corresponding levies to benefit from this public good as the profit is circulating in other geographical areas in order not to be taxed. (See annex 4: highest and lowest tax rates in Europe)

Such arrangements takes shape with the multinational companies’ "transfer pricing" thanks to their subsidiaries in several countries. When these subsidiaries are working together the goods or services’ transaction price is determined between the two subsidiaries. The transfer pricing between multinational subsidiaries is an

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Irish subsidiary

(Negociation of a

2% tax rate)

Tax heaven

Apple product

sold in the USA

(35% of taxation on average)

important issue in our modern economy; it represents 60% of the world trade. This is one of the best tools available to large groups to avoid paying taxes or to reduce them in the country where they are based. Profits are finally taxed in the country where the subsidiary is established, often in a tax heaven with an attractive taxation system. These subsidiaries “buy” goods or services (e.g royalties paid) to a subsidiary A at very low price and sell them to a subsidiary B at a very high price. So the profit is made by the subsidiary based in a tax heaven (e.g Luxembourg). Thus, multinationals contribute less and less to Member States’ tax revenues where they are economically active thanks to systems such as the transfer pricing. If tax rates were harmonized such procedures would not be so easy to implement. The corresponding challenge is that the tax burden necessary to finance the public good, education, infrastructure, etc., is finally carried by middle class and small businesses and does not concern large multinational groups that take advantage of tax competition between European Union countries to minimize their contribution to the country they belong to. The most difficult to measure is to know how FDI are diverted from one country to another according to its specific taxation characteristics in terms of taxation on one side, and in terms of supply of public goods on the other side. We can speculate that in Europe taxation plays a more fundamental role than elsewhere because the European Union Member States are, on the whole, homogeneous; especially if we compare what we are talking about from the beginning: the countries with a large territory, and therefore, a potential great market such as France and

Payement

of Royalties

Profits transfer:

Ireland doesn’t tax

money transfers if the

owner is established

abroad

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Germany, and smaller countries with a comparable level of development who emphasize on their tax system such as Ireland, Luxembourg and Switzerland. According to Jacques Le Cacheux whose ideas and documents I have drawn from for this research paper, tax competition can have damaging consequences. First, tax competition could lead to a “pricing” of public goods and services, i.e make pay the different beneficiaries of the public good and services provided by each government. This argument refers to another argument often heard in tax competition debates, in which it’s argue that the choice of business location would be influenced not only by the lower tax burden, but also by the attractiveness of the public services which this "contribution" confer. The heart of problem is social redistribution. But the increasing market integration and the greater mobility of tax bases make redistribution both more necessary and more difficult to implement. Indeed, capital flight and mobile tax bases including large multinationals companies inevitably tend to create a gap in the redistribution mechanisms, distinguishing clearly those who benefit from public good, from those who finance it. Let us recall that the tax exile of the highest income is nothing new and is indirectly attributable to the increase of the European integration: Switzerland, Monaco, etc., have a tradition of receiving “tax exiles". However, it’s also true that European directives foster the people and capital mobility within the European Union, including the most qualified people. Furthermore, a possible increase in the mobility within the European Union could therefore generate two types of migration: first, those without resources might be tempted to take up residence in countries where the social benefits are the most generous, while high-income people would settle in countries offering the best conditions corporate and income taxation. This is an even greater risk since, contrary to the public opinion, the European Union welfare systems are in reality very different particularly in terms of funding, and the changing demographic structures just as well the aging population , if similar, are in fact different enough to create funding problems at different moment and under different conditions. If, in response to these trends, such mobility behavior of the most mobile bases became more frequent, thanks to tax competition increasingly enhanced, and without the control of the European Commission, they inevitably would put into question the financial solidarity mechanisms that define the financing of public spending and social protection in all European Union Members Sates.

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Next, we will examine this “fiscal war” a little deeper through more concrete examples by comparing the French and Irish cases.

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B/WHAT ARE THE DIFFERENCES BETWEEN FRANCE AND IRELAND FROM THEIR RESPECTIVE TAX SYSTEMS? SHOULD THE EUROPEAN UNION CONVERGE TO A TAX HARMONIZATION?

Three European countries were under the microscope of the European Commission which has launched in June 2014 an investigation about unfair state aid to three multinationals. These apply to favorable tax arrangements with Apple in Ireland, Starbucks in Netherlands and Fiat in Luxembourg. Joaquim Almunia, EU Competition Commissionaire said "When public budgets are tight and efforts are required from citizens to solve the crisis, it is unacceptable that multinational groups remain untaxed” This proves that states are as responsible as multinational companies in the race for tax competition. Regarding Ireland, reforms are designed to change its fiscal policy because Ireland does not want to be seen as a tax haven anymore. Indeed, in the new financing bill of 2015, Ireland introduced changes and ends the budget austerity imposed by the European Union. Thus, from early 2015 Ireland definitively bury a tax system that has allowed so far to multinationals like Google and Apple to withdraw billions of dollars of corporate tax. The Minister of Finance Michael Noonan announced the Irish legislation on corporate taxation reform. This corporation taxation system was criticized since months by the European Union and the United States. Residence rules will change by forcing all companies established in the country to become tax resident in Ireland. As explained in the previous diagram, until now a company could create a subsidiary on Irish territory while establishing its tax residence in a tax haven. The new budget also signs the decision to cut taxes on the income of Irish who have been hit hard by the crisis. In France, tax evasion would have a cost between 40 and 50 billion in tax revenue, that is to say, a little more than the corporate tax and almost as much as the income tax for a year. Similarly the CAC 40 companies pay a lower tax rate than craftsmen, SMEs, etc. (8 % against 33%) In December 2013 the Prime Minister launched a major review of tax reform: it has put in place the foundations of corporate taxation, a working group on households’ taxation. The government's goal is to make the territory attractive for businesses, and therefore for capital in the context of uncontrolled liberalization without control capital flows which have led to a strong tax competition and a “race to the bottom”: The rate of corporate tax applicable during 1986 was 50% and now it is about 33 %. Thus, although the corporate tax in France is higher than in Ireland, it is not enough to create the necessary tax revenues to public spending.

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III/ THE FISCAL POLICY DILEMMA: TAX HEAVEN OR THE DOMESTIC

ECONOMY

The effects of the current tax competition between European Union countries existing since the 2008 crisis have already been seen. This is especially true when considering multinationals’ tax optimization that went less out of the headlines. In their case it is not only about establish the profit, but also the headquarters and even activity in the most attractive countries. In other words this tax optimization results, in addition to tax losses, a loss of employment. Some companies did not hesitate a long time to enjoy the benefits offered by some countries like the United Kingdom or Ireland. A first example of this is the case of the Italian Fiat Industrial, a former division of Fiat Group specialized in trucks and industrial vehicles: its leaders openly assume they moved the headquarters from Turin to the UK attracted by the promise of a corporate tax lowered to 20 % by 2015. Similarly, Ireland takes advantage of its tax attractiveness with a rate of 12.5%. Until now, the country persisted in this policy despite pressure from other Member States. Another example is American firm Eaton, a giant in electrical equipment, which moves from Cleveland, Ohio to Ireland in 2012 by buying its competitor Cooper. Thus the acquirer group has chosen the city of the group they bought as their headquarters, considering that Cooper had taken up residence in Ireland in 2009. Relocate its headquarters in the target company for an acquisition is not a very common decision, but it is also the case of our third example: the American pharmaceutical giant Actavis with the acquisition of the Irish Warner Chilcott. Furthermore, the pharmaceutical industry is a good example because, thanks to its taxation system, Ireland has become a stronghold in Europe. It became in 20 years a heavyweight in the pharmaceutical industry with 25,000 employees, major R&D centers, and one of the largest pharmaceutical productions in Europe. Those are pretty substantial number for a country with a 5 million inhabitants, without chemistry or medicine tradition. This fiscal dumping creates a real shortfall for states. With regard to France, governments chose different measures than its neighboring countries. One may legitimately ask whether France is losing the “fiscal war” in terms of tax competitiveness, especially as its neighbors take action for a long time to increase their attractiveness.

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In France, the taxation system is complex: the corporate tax base is relatively small, with many tax loopholes and tax credits which complete it. Thus, despite all, the corporate taxes in France are not extremely high compared to its European neighbors, but the posted rates are quite high which may deter potential investors. Thus, 90% of CAC 40 companies are established in countries with favorable tax system that allow them a significant tax optimization. Indeed, if we only take into account tax rates, France will struggle to emerge as a competitive country, nowadays and probably also later. Given the French’s preference for public spending and redistribution, rates could remain high compared to many countries, especially new European Union members. To reinforce its attractiveness, France has an interest to maintain and enhance the quality of public services directly or indirectly used by businesses. In this respect, the real France’s competitors are not eastern or central Europe but around, in the most advanced countries of Europe. It would be hard to deny that all the conditions are met to implement the changes needed in Europe, between the countries that will take advantage on low rates but with a relatively degraded public good, and those who will apply highest tax rates but with quality services, infrastructure, etc . France can only be part of the second kind of countries, but if public services do not resist the comparison with the best, its mobile bases will seek better fiscal conditions elsewhere.

The introduction of a harmonized tax base is not intended to reduce any level of taxation but rather a way to create a corporate taxation method in the European Union more efficient, more competitive and neutral in budgetary terms.

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CONCLUSION

While the completion of the monetary union in Europe will likely raise to an increase of tax competition between Member States, particularly on the most mobile bases that are financial capital and businesses, the available institutional arrangements in the European Union are obviously insufficient to limit the negative consequences. Competitive pressure strengthens, in France and in most European countries, a movement in favor of reducing the tax burden on the most mobile bases. If this competition would be developed without common rules and constraints as it has been the case in recent years, it inevitably would lead to reduced redistributive systems of compulsory levies, to a reduction in social protection and the impoverishment of national public sectors. To counter such developments, we should, at least, avoid the harmful tax competition, by introducing rules that govern and limit the actions of states: we must go beyond the "code of good conduct" established in 1997. The Stiglitz-Sen report in 2009 raise, among others, the need to "strengthen institutional arrangements to improve harmonization and transparency in tax matters, including the Committee of Experts on International Cooperation in Tax Matters". Indeed, these organizations cooperate, but they are also competing, a new question arises: the role of international organizations in the field of taxation is enough to face the problems arising from international economic integration and globalization? Do we need a World Tax Organization? The debates initiated in the United Nations have highlighted the need to develop policy standards of tax administration and supervision of fiscal matters, the renunciation of tax havens to harmful tax competition, the role of international arbitrations, multilateral information exchange procedures, and finally the search for an international agreement on a mechanism for sharing the profits of multinational companies between countries. Tax base harmonization would make tax competition more transparent in that only tax rates would matter. It would not necessarily lead to an harmonization of corporate income tax rates since taxes are not the only relevant factor for the location of companies. Therefore, the European Commission proposed to consolidate the profit of multinationals within the European Union and apportion it to the different governments according to a single apportionment formula that would depend on a combination of turnover, wage bill, number of employees and physical capital. Each member country would then have the ability to tax its apportioned share at its own corporate income tax rate.

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In addition, there are deep philosophy differences between Member States: France raises its tax rates decreasing the size of the relevant tax bases, continues to create tax loopholes in several areas that make the fiscal system hard to understand. Indeed, France is a country that takes incentive measures for businesses such as tax credits for research and development, or competitiveness tax credit to stimulate the hiring of new employees, while in other European countries taxation is more "neutral" and leaves more freedom to businesses after they have paid their taxes.

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ANNEXES

Annex 1: Top corporate income tax rates 1995-2009

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Annex 2: Corporate income tax revenues, 1995–2012 (% of GDP, GDP-weighted

average)

Annex 3: The European FDI inflows in 2013

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Annex 4: The highest and the lowest tax rates in Europe

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Annex 5: Tax burden in 2011

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