TAX MISERY 2008

Forbes recently published 2008's Tax Misery Index (link).

INCOME TAX RATES ARE FALLING, BUT NOT IN SLOVENIA

The newest study by the KPMG surveyed tax rates on individual income around the world (link). The study finds that average top rate on individual income is less than 29 percent. In Slovenia, it is 41 percent (link).

TAX CUTS IN EUROPE

Forbes reports (link) that Hungarian Prime Minister announced the abolition of 4 percent solidarity tax, a unique layer of tax on company profits that used to finance government's welfare expenditures. In addition, the government announced a decrease in corporate tax rate from 18 percent to 16 percent and payroll tax rate by 10 percentage points. However, after Slovenia and Croatia, Hungary is among the last remaining economies in Central-Eastern Europe without flat-rated income tax (link) that would boost economic growth, investment and job creation. Surprisingly, Greece introduced a gradual reduction in corporate and individual income tax by 5 percentage points over the next five years (link).

THERE IS NOTHING WRONG WITH TAX HAVENS

One of the most interesting discussions among the economists and policy experts is a debate about the role of tax havens and offshore destinations that compete with other nations in the areas of taxes, regulation and investor protection. The opponents of tax havens believe that tax havens cause an enormous damage to the economies on the other side of the world since (in their opinion), tax havens are the fundamental reason for the lack of reinvestment and capital flight in onshore economies. The real reason why tax havens are prosecuted by governments is that governement agents seek the highest possible utility from tax revenues in the form of rent-seeking that would yield more power and revenue.

Taxes and Regulation

There are two reasons for high tax rates. One is that in case of high government spending, the structure of tax rates must be high enough to avoid excessive deficit spending that could impair domestic macroeconomic stability. First, the real threat to macroeconomic stability is not deficit but the size of government spending. Also, excessive deficit spending is a threat to domestic macroeconomic stability because of the so called crowding-out effect where high government spending crowds out investment in the private sector. The net outcome is higher interest rate that arises from an increased scarcity of investment that is caused by budget deficit and high government spending. Second, the basic assertion of the Laffer curve is that high tax rates produce a bulk of negative effect. For example, when Sweden had the highest marginal tax rate in the world excessing 80 percent, the net result had been a decreasing tax revenue and when marginal tax rate were reduced, tax revenue soared. However, the real aim of tax rate reduction is not the growth of government revenue but welfare and the right of taxpayers to use the disposable income they earn. Empirical evidence suggests that prudent macroeconomic discipline such as principles of low tax burden, limited spending and adherence of price stability by the central bank result in the improvement of conditions for economic growth and stabilization process regardless of asymmetric shocks. What about regulation? Government regulate for two reasons. First, to remove the negative effects of market imperfections and second, to insure public goods. However, predatory tax rates, the growth of tax burden and the regulation of the private sector are designed seek monopoly rents in an unregulated way. While sound regulation can certainly offset the sideblocks of negative externalities such as free-riding, excessive regulation is hampering the growth of real productivity which is essential to the standard of living and the quality of life.

Tax Havens

Dan Mitchell recently explained (link) the positive role of tax havens in a global economy. From a basic perspective, minimal tax burden in tax havens is a liberalizing force in the world economy since, given capital mobility and the fluidity of knowledge, destinations with higher corporate and personal income tax burden have no choice but to reduce tax rates on productive behavior. Flat tax revolution, that was initiated by Estonia in early 1990s, also helped reduce corporate tax rates in continental Europe and Scandinavia. Given the lack of data, there are hardly any empirical studies researching the impact of tax rate reductions on tax revenue. When Swedish economy faced an onerous macroeconomic instability marred by high inflation, low output growth, declining productivity growth and a sudden dramatic increase in the interest rate (to 500 percent overnight) by Riksbank, top marginal tax rate was 84 percent. Consequently, economic growth decline and public spending grew and shrank into deficit, pushing the real interest rate up, as explained by crowding-out effect (link). When the economy is on the line of potential output, expansionary fiscal policy boosted money demand which, in turn, induced the increase in the real and nominal interest rate. As a consequence, Swedish economy faced a declining investment. Firstly, because corporate tax rate was excessive and secondly, because crowding-out effect took place. Regarding tax havens, supply-side economic and tax policies induced the trend of lowering tax rates on all sources of productivity ranging from investment, savings and entrepreneurship to labor supply. Concerning regulation, high corporate tax rate and excessive regulation usually go hand in hand since the regulation of the private sector is mostly an implicit insurance against the loss of control and - hence - the loss of tax revenue that is needed to finance government spending.
Empirical observation

I took a closer view on the comparative analysis of tax havens and onshore jurisdictions that impose higher mandatory tax rates on corporate and personal income tax as well as more excessive regulation. I downloaded the data from World Bank's Governance (link) and used a correlation analysis tool to analyze related motions of corporate tax rate, the rule of law and regulatory quality on each of these variables. An important note is that it depends on what is meant by 'regulatory quality' since World Bank oftenly criticizes tax havens. Concerning governance, tax havens scored lower than Germany and Austria - countries with high and almost punitive corporate tax rate. Despite a shaddy and imperialist fiscal agression on Liechtenstein, Germany still enjoys an enormously high score on the rule of law and regulation. However, I did not take a detailed look at methodological details even though I can say that there are extreme bias towards what regulatory quality really is.

This chart, for instance, shows a log-linear relationship between corporate income tax and regulatory quality. Considering trend line - estimated by a polynomial of second degree, countries with higher corporate income tax also have sounder regulation. But, if you take a closer look, it can be seen that trend line declines slightly in the area where there is a high concentration of countries (France, Spain, Belgium, Germany...). From WB's data, a curious reasearcher would conclude that higher taxes are good and tax havens have a tighter regulatory quality. However, the relationship in the chart is intuitive since R-square is 0,0436 which means that the variation of the independent variable explains only 4,36 of the variation of the dependent variable.


This chart(log-linearization of the relationship between corporate tax rate and the rule of law) shows that countries with high corporate income tax rate also have comparatively decreased rule of law. Again, it all depends on what is meant under the rule of law. For example, if offshore services are legally recognized in Cayman Islands, and if World Bank's governance methodology treats that as irresponsible, then Caymans will receive a lower score on the rule of law. As you can see, Iceland has the highest rule of law and a modest corporate tax rate (16 percent down from 18 percent). Interestingly, Netherlands Antilles are a tax haven more in terms of regulation and information disclosure than in terms of taxes since 34 percent corporate tax rate seems to be highly sensitive to the rule of law. In fact, many so-called tax havens have a higher rule of law than continental countries. For instance, Cayman Islands have a higher rule of law than Spain, Singapore has a higher rule of law than Germany, Belgium and France etc.

As a conclusion, tax havens are the force of liberalization in the global economy and when surveys (such as WB's) are conducted, it's good to review the methodology and measurement of particular indicators. There are bias everywhere.

Rok Spruk is an economist.

WILL CANADA, POLAND AND FINLAND JOIN THE FLAT TAX CLUB?

The proposition to move towards flat-rated income tax has been suggested in Canada (link), Finland (link) and Poland (link).

FISCAL FEDERALISM AND TAX COMPETITION: THE CASE OF SWITZERLAND

Financial Times recently published an article (link) describing how fiscal federalism works in Switzerland. Contrary to conventional belief, Swiss constitution gives a significant degree of decision-making and fiscal responsibilities to cantons and municipalities. In economic perspective, one of the key advantages of fiscal federalism is tax competition among jurisdictions within Switzerland. Cities such as Zurich and Lucerne charge notably higher taxes while a growing number of cantons and municipalities use low-tax policies to attract entrepreneurship, savings and investment and stimulate economic growth. Empirically, the sources of productive behavior are favorable to seeking low-tax shelters, generating greater efficiency and welfare.

Although fiscal federalism is perceived as an expensive experiment that does not yield required incentive to maximise efficiency, personal income tax rates are modest compared to continental Europe and Nordic countries. Switzerland might offer a lessons to high-tax jurisdictions in the rest of Europe. Politicians and (surprisingly) even some economists often state that low tax rates on personal income lead to the loss of tax revenue. Contrary to static assumptions, low tax rates on personal income, given favorable conditions such as low and upward limited public spending, generate higher tax revenue. In fact, expatriates in Switzerland contribute SFr 390 million to federal, cantonal and local tax budgets.

AUSTRIA: ALPINE TAX HAVEN DEFENDS FINANCIAL PRIVACY LAW

Austria firmly rejected the initiative from the European Union to ease and possibly remove the legislation that aims at client data privacy and banking quality (link). The EU tries to impose sanctions on jurisdictions known for sound financial privacy, competitive tax policy and bank secrecy laws (link).

GERMANY'S FISCAL AGGRESSION

In a continuing and overpowering war against low-tax jurisdictions (link), German government hit out a tax attack on the Principality of Liechtenstein (link) by sending intelligence spies into Liechtenstein and bribing former bank employee to alledgly obtation bank client data. Angela Merkel, Germany's chancellor, has endorsed threats to isolate Liechtenstein if the latter does not ease bank secrecy rules (link).

Liechtenstein's GDP per capita equals 84,300 € ($125,000) per capita, which is about three times higher than Germany's GDP per capita. Principality's banking legislation is based on financial privacy. German government has continually forced Liechtenstein to sign information-sharing agreements that would enable German tax authorities to tax capital income of German entrepreneurs whose company is headquartered from Liechtenstein. Also, information-sharing agreements might impose sanctions and tax prosecution of German companies situated in Liechtenstein. The aggression on behalf of German government indisputably violates territorial sovereignity and financial privacy. Nevertheless, the latter is one of the most fundemental human rights.

FLAT TAX IN POLAND?

Poland, the biggest economy in central Europe might introduce a low and single-rated flat tax (link)

HUNGARY'S LOW GROWTH DISEASE

When studying and/or doing a job in macroeconomics, it is important to keep an eye on three key features: economic growth, inflation and unemployment. Macroeconomic analysis also emphasized the stability of macroeconomic aggregates such as GDP, public spending and budget consumption. An article Tax tinkering won't fix Hungary's growth problem published by The Guardian briefly outlined Hungary's macroeconomic turbulence in terms of low growth, high government spending and pretty high unemployment rate. Hungary's economy is facing significant macroeconomic problems. In third quarter of the year, Hungary's output grew by as little as one percent (link). In addition, fiscal issues accelerated the fragility of macroeconomic stability.

Tax reform: evidence from Sweden and Iceland

From previous decade onwards, tax reforms have become the guideline of macroeconomic policy. Significant tax cuts on labor supply, entrepreneurship and savings boosted the competitiveness and growth performance in those countries that implemented rigorous economic reforms. In Iceland, the combination of the lower government spending and tax cuts on personal and corporate income generated the Laffer Curve effect, when tax revenues were higher (in the share of the GDP) while tax rate on corporate income was lower (link). Sweden imposed substantial marginal tax cuts and tax revenues grew substantially in the share of the GDP (link).

Don't expect significant Laffer Curve effect in case if public spending is not reduced substantially

As a successful "case-study" of macroeconomic and microeconomic transformation into a market economy, Hungary (link) welcomed foreign investment by slashing the corporate tax rate to the lowest level in Europe, after Ireland and Cyprus. However, Hungary's policymakers decided to build a model of economic policy based on high government spending (link) and resumed budget deficit. The main source of the issue is not budget deficit itself, but the size of government spending in the share of the GDP. Including transfer payments and consumption, Hungary's government spending is extremely high. In recent year it equaled 49,5 percent of the GDP.

High marginal tax rates lead to tax evasion and underground economy

Hoping to restore revenue increases after imposing tax cuts on productive activity in the absence of lower government spending is hopeless nevertheless. Discretionary fiscal policy, high marginal and overall tax rates and highly volatile public finance besides high public expenditures are the main reasons why tax evasion occurs. Tax evasion is nothing else but the consequence of the fact that investors and individuals perceive the opportunity cost of high tax rates as significant. The usual effect of high and marginally progressive tax rates is that tax evasion accelerates the establishment of informal sector known as grey or underground economy. In Hungary, grey economy equals an estimated 17-18 percent of the GDP (link).

Hungary in regional competition

Slovakia (link), Hungary's neighbor went through a period of pro-growth economic and tax reforms. Tax rate on personal and corporate was slashed to flat 19 percent and government spending, including consumption and transfer payments, was reduced substantially. As a result, Slovakia became the Monaco on Danube, a high-growing Eastern European economy known as investment haven. A significant number of international companies such as Peugeot, Citroen and Volkswagen set their production establishments in Slovakia. Also, Slovakia's economy experienced a robust, non-inflationary output growth while Slovakia's macroeconomic institutions streamlined competitive, non-discretionary and stable macroeconomic policy based on expenditure cuts and growth agenda. Hungary has been losing its investment potential subject to abovementioned reasons. Recently, two companies - Audi AG and Servier - have taken alternative consideration of their operations location because of Hungary's statist tax system (link) and discretionary macroeconomic policy.

Reform or die slowly

In 2007, Hungary imposed the 3rd highest tax hike on labor supply in OECD. This could be a substantial incentive for tax evasion. Consequently, productivity growth would definitely stagnate. Timid initiatives to impose tax reform are completely useless unless government spending is cut radically. As a consequence, there would be much less pressure on budget deficit which is estimated to drop from 9,2 percent of the GDP to 4 percent of the GDP. However, deficit is often the wrong number. Also, social security contributions present a persistent barrier to employment and job growth. Long and generous unemployment periods do not create a job-seeking. Nonetheless, the combination of high unemployment and low growth is a deadly situation where the risk of stagnation is huge in case if substantial pro-growth reforms are not implemented. As an economy in transition, Hungary's macroeconomic policy will have to cut spending radically or it will quickly become the France of Eastern Europe (link).

Rok SPRUK is an economist.

Copyright 2008 by Rok SPRUK

BULGARIA IS NOW AN OFFICIAL MEMBER OF FLAT TAX CLUB

Sofia News Agency reports that Bulgarian lawmakers passed flat tax reform. Bulgaria is now an official member of the flat tax club.

OBWALDEN APPROVES 1,8 PERCENT FLAT INCOME TAX RATE

Obwalden is a Swiss canton situated in central Switzerland. SwissInfo reports that Obwalden has recently become the first Swiss canton to adopt 1,8 percent flat income tax rate on all categories. In December 2005, Obwalden decided to slash the corporate tax rate to 6,6 percent. The canton also decided to impose degressive tax system which was later declared as unconstitutional. In the first six months of this year, the canton saw an astonishing 230 percent growth of company registration. In addition, 90,7 percent of voters approved changes in tax regime.

HIGH TAX JURISDICTIONS ARE AS BAD AS MONOPOLIES AND OIL CARTELS

LAFFER CURVE IN MONTENEGRO

Last year, Montenegro's parliament adopted a 15 percent flat tax on personal income. Tax rate on corporate profits was set at 9 percent and by 2010 Montenegro will have a 9 percent flat tax rate on corporate and individual income (link).

As a result of an expanded tax base and lower tax rate on productive behavior, Montenegro's Tax Administration has collected 36 percent more from annual taxes than in 2006 (here and here).

SWITZERLAND VS. EU

The EU recently persecuted Switzerland because because bureaucrats in Brussels believe that Swiss market-friendly model of cantonal tax competition is a form of state-aid.

Here is a report by Tax-news.com:

"The European Commission is basing its legal argument against Switzerland on the latter's alleged breach of state aid rules, which, in the EU, are in place to prevent member states from favouring certain companies and industries with beneficial tax rules and subsidies. But the Swiss say that the EC's arguments rest on shaky very legal ground, pointing out that the country is neither an EU member or part of the Single European Market, nor party to the competition regulations of the EC Treaty, including those on state aid. Moreover, Bern insists that even if the tax laws in question were covered by the 1972 Free Trade Agreement, they would not fall under the EU's definition of state aid, because they do not favour certain companies or industries."

Swiss Federal Council issued a report on state-aid to companies (link). Claiming that regional (cantonal) tax competition is a government aid is a myth. In fact, EU countries such as Germany and France maintain a bulk of government-owned enterprises.

An example of government intervention into the course of market forces is EU's Common Agricultural Policy (CAP) massively endorses income redistribution from European taxpayers into the hands of agricultural lobbies. Another obscure example of statism is EU are subsidies as a "third-party" payer problem.

The majority of EU's budgetary means and fiscal expenditures are funded directly into farming in the form of subsidies. 65 percent of all EU subsidies go to manufacturing, causing disallocation and the distortions in output and productivity. In addition, there're vast sub-funds whereby subsidies and handouts are granted to enterprises in the EU.

On the other hand, there is no such thing in Switzerland. Even more, Swiss government does not penalize businesses competing in low-tax jurisdictions compared to EU's expanding of the power of government such as efforts to establish tax harmonization.

WILL GUAM BE THE NEXT FLAT TAX JURISDICTION?

As a territory outside the U.S., Guam has an ability to choose and design its own tax system. However, the jurisdiction's current tax legislation is subject to the Internal Revenue Service code. The U.S. tax code which Guam uses is marred by complexities, convoluted and heavily complicated. There's a growing probability that Guam will de-link from U.S. tax code. In fact, the latter maintains some regressive provisions which are inapplicable to Guam.

In case of the separation from U.S. tax code Guam would get an opportunity to adopt flat tax. The tax base would increase, there would be less avoidance, double taxation of income would disappear. The simplification of the tax law would also reduce the costs of tax bureaucracy and administrative costs of tax collection. And most importantly, lower taxes would stimulate the growth of output nevertheless.

Source: De-linking from the U.S. tax code makes sense for Guam, Pacific Daily News, November 18, 2007 (link)

FLAT TAX EXPANDS INTO GEORGIA

Alvin Rabushka of the Hoover Institution briefly outlines the adoption of the flat tax in Georgia as well as the implications of the tax reform on growth and revenue. Here is some remarkable data: by January 2005 Georgia adopted 12 percent flat tax, replacing previously imposed four-bracket system. The tax reform lower the rate of taxation on productive behavior which, in turn, had dramatic effects on economic growth, averaging 10 percent in the past three years. Tax revenue increased from 14.5 percent of gross domestic product in 2003 to 22 percent in 2006, and should reach 24 percent in 2007.

PRO-GROWTH TAX REFORM IN NEW ZEALAND

New Zealand officially moves toward a rigorous tax reform by removing the impediments to businesses and companies expanding abroad and competing internationally. As explained by the ministers, the income of controlled foreign firms located in New Zealand is about to be made exempt to cut tax costs and promote offshore operations and an oversea expansion. (link)

CANADA: CUTTING TAXES TO BOOST ECONOMIC SOVEREIGNITY

There is a good news coming from Canada. When Liberal Party was in power, it slashed the federal corporate tax rate from 28 percent to 19 percent. Stephane Dion, party's leader, seemingly understands the benefits of lower corporate tax rate for Canada's international competitiveness (link):

"A lower corporate tax rate is a powerful weapon in the federal government's arsenal to generate more investment, higher living standards and better jobs. If you lower the corporate tax rate, you lower the cost of capital for Canadian companies. Therefore, these companies are induced to spend more on capital equipment. As for foreign investment, we need a big hook to snare investment, including Canadian investment, that might otherwise go south of the border."

Delivering the speech on Tuesday, Canada0s Governor general, Michaelle Jean outline government's future intention to implement tax reform and re-enforce the intellectual property rights (link)

AUSTRALIA - TAX HAVEN?

Here is an article from The Age describing the systemic intentions to turn Australia into fund management tax haven. As a jurisdiction with the enforcement of tax competition, Australia could attract a singificant inflow of foreign direct investment into various investment funds, depending on the legal requirements set-up by the legislation.

The negative comments on international and intranational tax competition include distorting views hardly matched by contemporary findings and conclusions from research on these particular issues. Lower public expenditure are not inefficient. In fact, numerous empirical and evident studies have confirmed the positive correlation between lower spending and higher growth of output.

On the revenue side, lower tax rates on corporate income significantly affect the amount of collected tax revenue. The evidence has shown, that lower tax rate on corporate income as a source of productive behavior, leads to higher tax revenue in the share of the GDP. In addition, many members of the OECD have significantly lowered tax rates on corporate and also individual income and none of the negatively asserted consequences occured. Ireland lower the corporate tax to 12,5 percent, and tax revenue jumped to record highs. It also had a positive implication on the inflow of foreign direct investment.

A research by US economists Mihit Desai, Fritz Foley, and James Hines (here, here and here) has shown that the relocation of investment capital into low-tax jursidictions actively stimulates the investment level in nearby high-tax jurisdictions. As firms located into tax havens retain higher relative after-tax return, they can maintain a significantly higher level of direct investment than otherwise.