CORPORATE TAXES AND ECONOMIC INEFFICIENCY IN EUROPE
Michael P. Devereux Warwick University Institute for Fiscal Studies, London CEPR, London Lothar Lammersen Christoph Spengel University of Mannheim and Centre for European Economic Research GmbH (ZEW), Mannheim
November, 2002
Abstract This paper presents evidence on the effective levels of corporate taxation in the EU. It presents evidence on the distribution of the cost of capital and the effective average tax rate across forms of investment and countries. By simulating alternative forms of harmonisation, it then highlights the main sources of differences across countries. In contrast to earlier work, based only on the cost of capital and on earlier tax regimes, the single most important source of divergence across countries is the statutory tax rate. Acknowledgements This paper has been prepared for the NTA meetings in Orlando, Florida in November 2002. It is based on earlier work prepared for the Taxation and Customs Union Directorate General of the European Commission. Correspondence Professor Michael P Devereux, Department of Economics, University of Warwick, Coventry, CV4 AL, UK;
[email protected]; this paper is available at http://www.warwick.ac.uk/fac/soc/Economics/devereux/.
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1
Introduction
An important current source of concern about corporation tax regimes within the European Union is the extent to which differences in regimes between member states generate production inefficiency in economic decisions. This paper analyses the existing tax regimes in the 15 EU member states. It identifies the extent to which they differ by presenting two summary measures: the cost of capital and the effective average tax rate . It also identifies how these measures would be affected by alternative forms of harmonisation within the EU, such as a common corporation tax rate or tax base. Such simulations serve a dual purpose: they identify the impact of potential policies, but more generally, they show how differences in effective levels of taxation between countries depend on specific aspects of the tax regimes. This paper analyses only corporate level taxes. This is based on the supposition that there is significant international portfolio investment. Each firm can raise funds from the world market, and hence must earn the same (world) rate of return after paying corporate level taxes. Personal taxes may affect the post-tax return to the shareholders, but do not affect the decisions of companies.1 Given this, there are two distinct possible sources of inefficiency from corporate taxes. First, if different companies selling in the same market face different tax regimes, then one firm may gain a competitive advantage over others. This may occur whether or not the firms locate production in the same country. This consideration resembles the typical analysis of capital import neutrality, which is generally supposed to hold if firms producing in the same location face the same tax regime. If they do not, it is generally argued that the post-tax rate of return to the owners of the firms will differ, resulting in what Keen (1993) denotes exchange inefficiency. However, where firms must pay the same post-corporate tax rate of return, then differences in the tax regimes they face may instead generate production inefficiency: a firm with a lower marginal cost may be undersold by a higher cost rival. Further, this may happen if two competing firms each produce in their home country (or any other country) and export to a common market. Second, if a single company faces different tax regimes depending on where it locates its operations, then the location choice may also be affected. This is rather similar to the typical analysis of capital export neutrality, although the relevant tax regime is only at the corporate level.2 We analyse the possible sources of these two inefficiencies using two summary measures of corporate tax regimes. The first is the cost of capital. This is the pre-tax rate of return required from an investment. It is generally assumed that investment projects which earn a rate of return at least as high as the cost of capital will be undertaken. Taxation typically raises the cost of capital: in turn, this is likely to depress investment. The second measure is the effective average tax rate (EATR). This is also relevant for investment decisions, although in a different context: where a company is choosing between two or more mutually exclusive projects. In these circumstances it is reasonable to suppose that the firm will undertake the project with the highest post-tax profit. An 1 2
We analyse cases incorporating personal taxes in Devereux et al (2000). These sources of inefficiency are analysed in more detail in Devereux (2000).
2
obvious example of this is a firm choosing in which country to locate. A higher effective average tax rate in one country may induce the firm to choose a different country.3 Each of these measures are calculated for a series of hypothetical investment projects, which vary according to the type of asset purchased and the source of funds used to finance the investment. The project may take place domestically, or in another member state of the EU. We use data on the structure of existing tax regimes in 1999. However, an exception to this is that we apply the German tax system from 2001, since the German tax reform had been announced in 1999. The basic approach used here is broadly similar to the approach used by OECD (1991), although there are some differences. Measures of the cost of capital for domestic and cross border investment within Europe were also used by the Ruding Committee (1992) and Devereux and Pearson (1995) to identify the impact of alternative forms of harmonisation. Their broad conclusions were that a significant reduction in the dispersion of costs of capital within the EU could be generated by abolishing withholding taxes on the payment of dividends from a subsidiary to its parent (a reform which was subsequently introduced within the EU). By contrast, relatively little was achieved by fundamental harmonisation of either statutory tax rates or tax bases. This paper extends previous work by considering also the role of the EATR. In addition, it also updates the data used in these previous studies by around 10 years – roughly from the beginning to the end of the 1990s. This decade witnessed some significant corporation tax reform within Europe. As a result, it is by no means certain that the earlier results still hold. In fact, as will become clear, they do not. In Section 2, we present evidence of the variation in the cost of capital and the EATR across member states of the EU, both for domestic and cross border investment. In Section 3, we examine the sources of differences across countries in effective tax rates by simulating the impact of various forms of harmonisation. For example, we consider the impact of the dispersion of the cost of capital and the EATR across countries of harmonising the statutory rate at the EU average, and separately of harmonising the definition of the tax base. Section 4 briefly concludes.
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Assessing existing tax systems
Throughout this analysis, we base our measures of the corporation tax regimes on the impact of tax on a hypothetical investment. The approach taken is that of approach of Devereux and Griffith (2002), which is broadly similar to the well-known approach of King and Fullerton (1984). We examine 15 possible forms of investment, consisting of 5 possible assets - intangibles, industrial buildings, machinery, financial assets and inventories – and three sources of finance - retained earnings, new equity and debt. The weights given to each of these for the purposes of constructing an overall mean is shown
Evidence on the effects of variation in the EATR on location choices is presented by Devereux and Griffith (1998).
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in the notes to Table 1, which also shows the assumed economic depreciation rate of each asset.4 Table 1 presents estimates of the cost of capital for each member state. The left hand column shows the overall weighted average across all 15 types of investment. The next 5 columns present the cost of capital for investment in each asset, averaged over the three types of finance. The last three columns show the cost of capital for each source of finance, averaged across the 5 assets. Note that the analysis is based on a required real rate of return of 5%. Hence a cost of capital of, say, 7.5% represents an effective marginal tax rate of 33%.
5.9 5.2 4.2 6.1 5.2 5.4 6.8 5.3 2.9 5.2 5.1 6.7 6.5 5.0 5.5
6.1 7.0 8.1 6.1 8.5 7.1 5.1 6.8 4.6 6.8 6.9 6.2 6.7 6.0 8.2
5.9 5.3 5.4 5.6 8.4 6.1 6.1 5.2 3.8 5.3 5.9 5.2 5.4 5.0 5.6
7.3 8.0 7.1 6.8 8.0 8.2 5.1 5.5 7.7 7.7 7.4 7.7 7.4 6.6 6.9
6.3 6.7 7.1 6.8 7.4 6.9 7.4 5.5 5.0 6.5 6.9 6.5 6.4 6.6 6.9
7.5 8.0 7.5 7.2 9.0 8.0 7.6 5.9 5.5 7.7 7.7 7.9 7.7 6.7 7.7
7.5 8.0 7.5 7.2 9.0 8.0 7.6 5.9 5.5 7.7 7.7 7.9 7.7 6.7 7.7
Debt
New equity
Retained earnings
Inventories
Financial Assets
6.3 6.4 6.4 6.2 7.5 6.8 6.1 5.7 4.8 6.3 6.5 6.5 6.5 5.8 6.6
Machinery
Austria Belgium Denmark Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain Sweden UK
Industrial Buildings
Country
Intangibles
Cost of Capital by Country
Overall mean
Table 1
4.0 3.5 4.4 4.5 4.6 4.4 3.4 5.2 3.6 3.7 4.1 3.9 4.1 4.3 4.8
Notes. 1. The post-tax required real rate of return is assumed to be 5%. Inflation is assumed to be 2% in all countries. Economic depreciation rates are assumed to be: intangibles 15.35%; industrial buildings 3.1%; machinery 17.5%; financial assets 0%; and inventories 0%. 2. Each asset column represents an average across all three types of finance, with weights of 55% retained earnings, 10% new equity and 35% debt. Each finance column represents an unweighted average across all 5 assets. The overall average is an average across all 15 types of investment, with the same weights.
Focussing first on the overall average, it is notable that 8 countries have an average cost of capital between 6.3% and 6.5%. Three others are very close to this range, leaving only four significantly outside: France has an average of 7.5%, and Sweden, Ireland and Italy have averages of 5.8%, 5.7% and 4.6% respectively. However, these averages mask a greater variation within specific types of investment, either by type of asset or by source of finance. In fact, countries with a high average also tend to have a high dispersion – 4
More details are available in Devereux et al (2000).
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this often reflects the fact that a high statutory rate generates a high cost of capital for equity-financed projects, but a low cost of capital for debt-financed projects. By contrast, the dual income tax system of Italy results in a significantly lower dispersion between debt and equity finance. A similar observation can be made for Ireland which applies the by far lowest corporation tax rate (10%) within the EU. In general, low tax rates tend to reduce such dispersions. Table 2 presents a comparable summary of the EATR for each member state. There appears to be rather more dispersion in the overall average EATR for each member state than there is in the equivalent cost of capital. The Irish average rate is only 10.5%. Other values range from 22.9% in Sweden to 37.5% in France. There is also considerable variation across countries for each of the types of investment analysed. However, there are some interesting differences from Table 1. For example, Italy has the lowest average cost of capital, but only the seventh lowest EATR. The UK has the third highest cost of capital, but the fourth lowest EATR. These differences reflect the relative importance the two measures place on allowances. It is well known, for example, that a cash flow tax would generate a EMTR of zero, and hence a cost of capital of 5%. This is because the "normal" return is not taxed. Yet such a tax would generate a positive EATR since any profit above this "normal" return would be taxed. This is closest to the Italian dual income tax system, although Italy taxes the normal return at 19% rather then zero. But this helps to explain why the cost of capital is low in Italy, but the EATR relatively high.
Note. See notes to Table 1.
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29.9 35.3 31.2 27.3 37.1 35.3 37.1 9.8 31.1 32.9 32.5 32.8 30.7 25.7 29.3
33.9 39.1 32.3 28.8 42.1 38.7 34.4 11.7 31.8 36.6 35.1 37.0 35.2 26.0 31.8
Debt
33.2 39.2 31.2 27.3 39.0 39.2 11.6 9.8 36.1 36.6 34.2 36.5 34.2 25.7 29.3
New equity
28.4 31.0 25.3 23.1 40.1 32.9 33.4 8.2 27.4 29.2 29.2 28.6 27.4 19.7 24.7
Retained earnings
29.2 36.1 34.7 24.8 40.6 35.9 30.4 15.8 29.8 33.7 32.4 31.8 31.8 23.4 33.7
Inventories
Machinery
28.6 30.7 21.3 24.8 30.6 30.8 35.5 8.9 24.9 28.6 26.7 33.2 31.1 19.6 24.2
Industrial Buildings
29.8 34.5 28.8 25.5 37.5 34.8 29.6 10.5 29.8 32.2 31.0 32.6 31.0 22.9 28.2
Financial Assets
Austria Belgium Denmark Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain Sweden UK
Intangibles
Country
Effective Average Tax Rate by Country
Overall Mean
Table 2
33.9 39.1 32.3 28.8 42.1 38.7 34.4 11.7 31.8 36.6 35.1 37.0 35.2 26.0 31.8
22.3 25.8 22.1 19.3 28.8 27.6 20.8 8.2 26.1 24.0 23.3 24.5 23.3 17.1 21.6
Tables 1 and 2 focus on domestic investment. However, it is also possible to consider the case in which a company undertakes cross border investment. In this case, we assume that production is undertaken in a different country by a wholly-owned subsidiary of the parent company. The subsidiary can be financed by the parent in one of three ways: retained earnings, new equity and debt. Throughout this paper we assume that the choice between these three is made to minimise taxes. Tables 3 and 4 present a summary of the cost of capital and the EATR respectively, of domestic, inbound and outbound investment for each country. The “domestic” columns is identical to the first columns in Table 1 and 2 respectively, and so represent the weighted average across the 15 different forms of investment. For cross-border investment, we first consider the 15 investments for each possible pair of countries: the home country of a parent company, and the host country where the subsidiary is located. We compute a weighted average cost of capital and a weighted average EATR for each pair. The second column shows, for each host country, the mean of this weighted average cost of capital across the 14 possible home countries; column 4 shows the standard deviation of this distribution. The third column shows, for each home country, the mean of the weighted average across the 14 possible locations of the subsidiary; and column 5 shows the comparable standard deviation. "Tax Efficient" Average Cost of Capital by Country EU Average
EU Standard Deviation
Inbound
Outbound
Austria Belgium Denmark Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain Sweden United Kingdom
6.3 6.4 6.4 6.2 7.5 6.8 6.1 5.7 4.8 6.3 6.5 6.5 6.5 5.8 6.6
6.0 5.9 6.1 5.9 7.0 6.5 5.7 5.0 4.3 5.9 6.1 6.1 6.1 5.5 6.3
6.2 5.9 5.9 5.7 5.9 6.0 5.8 4.8 6.2 6.0 6.3 6.0 6.0 5.7 5.8
0.6 0.4 0.4 0.4 0.5 0.4 0.3 0.4 0.6 0.5 0.4 0.4 0.4 0.4 0.4
0.4 0.8 0.6 0.6 0.7 0.8 0.9 0.4 0.5 0.8 0.4 0.8 0.7 0.5 0.6
EU Mean
6.3
5.9
5.9
0.4
0.6
EU Standard Deviation
0.6
0.6
0.3
%
Inbound
Domestic
Cost of Capital
Outbound
Table 3
Note. These figures are based on the most tax-efficient means of financing the subsidiary - that is retained earnings, new equity or debt. This is found by taking the minimum cost of capital relating to each possible form of finance.
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There is not space here to give a detailed review of the results summarised in Tables 3 and 4. But the main aim here is to cast some light on the possible inefficiencies generated by differences in taxation. To illustrate this, consider the case of France in Table 3. The domestic cost of capital is 7.5%; the average cost of capital for outbound investment to the rest of the EU is only 5.9%. This creates a significant incentive for French companies to locate activity abroad (an incentive generated by the combination of a high French statutory tax rate and largely exempting income earned abroad). However, this average of 5.9% hides a further significant variation across potential host countries: the standard deviation across the 14 other countries is 0.7. The average cost of capital for France as a host country is 7.0% - implying that, on average, foreign-owned companies operating in France face an advantage over domestic companies. Again, however, this figure masks substantial variation across potential home countries, with a standard deviation of 0.7.
"Tax Efficient" Effective Average Tax Rate by Country EU Average
EU Standard Deviation
Inbound
Outbound
Austria Belgium Denmark Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain Sweden United Kingdom
29.8 34.5 28.8 25.5 37.5 34.8 29.6 10.5 29.8 32.2 31.0 32.6 31.0 22.9 28.2
28.7 32.6 27.8 24.8 35.6 34.2 28.4 9.9 27.9 30.7 29.8 31.2 29.8 22.3 27.4
29.3 28.8 28.2 27.9 28.2 28.9 32.7 26.0 29.4 28.2 29.5 29.1 28.3 27.8 29.4
3.0 2.2 3.0 3.6 2.4 1.3 1.5 7.4 3.1 2.7 2.8 2.5 2.8 4.0 3.3
5.7 7.0 6.6 6.1 6.8 7.0 2.6 3.2 7.0 7.1 5.7 7.0 6.9 5.9 3.3
EU Mean
29.2
28.7
28.7
2.0
5.8
EU Standard Deviation
6.1
5.7
1.4
%
Inbound
Domestic
Cost of Capital
Outbound
Table 4
A similar picture applies to the EATR. However, there is one noticeable difference: the variation shown in the last column of Table 4 is typically rather higher than in column 4. This implies that – on average - there is more variation facing a single parent company choosing where to locate than compared with the variation across potential parent companies each investing in the same host country. This would imply a loss of efficiency
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due more to affecting location decisions than in creating a competitive disadvantage to highly taxed firms. This is because the EU system is closer to host country taxation than home country taxation. The bottom of each column in Tables 3 and 4 shows the means (and standard deviations) of the figures in that column. Hence, for example, the bottom of column 2 shows the average and standard deviation of the mean costs of capital for each host country. The bottom of column 4 shows the mean of the standard deviations. They therefore summarise the effects discussed above. They are used in the next section to identify the impact of alternative forms of tax harmonisation. Specifically, we consider the impact of various forms of European harmonisation on the variation across countries in these summary measures of the cost of capital and the EATR, taking into account both domestic and cross border investment.
3
The Impact of Hypothetical Tax Reforms
We now consider how the cost of capital and effective tax rates presented above would be different in the event of various hypothetical tax reforms. The analysis of each hypothetical reform is based on a particular element of tax regimes being harmonised across the EU. This process is useful for two reasons. First, of course, it is useful if a particular reform is proposed, so that the impact of the reform on the distribution of the costs of capital and effective tax rates can be discovered. More fundamentally, the analysis helps to identify the importance of specific features of tax regimes. Simulations based on 6 hypothetical reforms to the existing tax system are considered. They are listed in Box 1. They include changes to the "domestic" corporation tax regime BOX 1
DEFINITION OF SIMULATIONS
1. Common corporation tax rate, including surcharges and local taxes. Rate is EU average of 33.84%. 2. Common tax base , based on true economic depreciation. 3. Abolition of withholding taxes on interest paid by subsidiary to parent within EU. 4. Limited credit system for foreign source dividends received by parent from EU subsidiary. No discrimination in imputation systems against foreign source income originating in the EU. 5. Exemption for foreign source dividends received by parent from EU subsidiary. No discrimination in imputation systems against foreign source income originating in the EU. 6. Home State Taxation. Subsidiary taxed using the tax base of the home country, but the tax rate of the host country. No interest deductibility by the subsidiary; No taxation of foreign source income received by parent. No discrimination in imputation systems against foreign source income originating in the EU
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(specifically the statutory tax rate and the value of capital allowances) and to the "international" corporation tax regime (withholding taxes on payments from one member state to another, and the taxation of income received in the home country). We present the results of this analysis in Table 5, which is based on the last two rows of Tables 3 and 4. The first row of Table 5 summarises the EU tax regime in 1999 (and 2001 for Germany) as shown in Tables 3 and 4; this is denoted the Base Case. As noted above, the existing set of tax regimes clearly falls short of achieving production efficiency. We now discuss the hypothetical reforms in turn. 1
Common corporation tax rate, including surcharges and local taxes; EU average (33.8%) chosen as the common rate.5
The principal effects can be seen for domestic investment. On average the cost of capital for domestic investment rises very slightly from 6.3% to 6.4%; however, the standard deviation across countries falls by half - from 0.6 to 0.3. A similar pattern is true of the EATR – the average rises slightly from 29.2% to 30.0%, while the standard deviation falls from dramatically from 6.1 to only 1.2. Underlying these changes are large changes in a few countries. For example, the average cost of capital falls by 0.6 percentage points in Germany, but rises by 1.2 percentage points in Ireland and by 1.1 percentage points in Italy. Hence, those countries with the more extreme average costs of capital move towards the middle of the distribution, with a consequent reduction in the standard deviation. A similar pattern emerges for the EATR, with a considerable reduction in the standard deviation. (The Irish EATR rises from 10.5% to 31.5%). However, since the EATR measures the effect of tax on a profitable investment, the importance of allowances is rather lower than for the cost of capital, and so the impact of the statutory tax rate is correspondingly greater – this explains the more dramatic fall in the standard deviation of EATRs. Now consider cross border investment. Note first that with harmonisation of tax rates the distinction between taxing foreign source dividends income with a limited credit system as opposed to an exemption system disappears. In the absence of personal taxes, this is therefore close to introducing source country taxation for equity-financed investment - with each source (ie. host) country having the same rate of tax.6 This is also effectively true for debt-financed investment: the rate at which the subsidiary receives relief for paying interest to the parent is the same as the rate at which the parent pays tax on the interest receipt.7 The overall effect on cross border investment of the hypothetical reform is to increase the average cost of capital and the average EATR. However, while the average impact of taxation increases, in all cases there is a reduction in dispersion of effective tax rates both between home countries and between host countries, as reflected in dramatically lower For countries applying special tax regimes the tax rate is set equal to the new tax rate. The lower tax rate applying in the DIT system in Italy is abolished. Hence, in all countries, all income is taxed at the same rate. 6 Home country taxation still matters in some cases. For example, several countries disallow interest payments made by the parent if the loan is used to finance outbound investment. Also, some home countries impose local taxes on interest receipts from the subsidiary. Finally, several countries do not operate a pure exemption system. 7 Although there may be withholding taxes on interest, in practice, all such taxes would be creditable against the home country corporation tax. 5
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standard deviations. The impact of near-host country taxation is reflected in effectively a zero standard deviation in costs of capital across home countries for inbound investment, and a near-zero standard deviation for the equivalent EATRs (falling from 2.0 to 0.3).8 In addition, lowering the tax rate in high tax host countries will reduce both the cost of capital and the EATR, irrespective of whether the residence country operates a limited credit system. This generates a reduction in the dispersion in outbound investment. Summary of Simulation Results: reforms to corporation tax no personal taxes
Inbound
Outbound
Domestic
Inbound
Outbound
Inbound
Outbound
1 Common CT rate at EU mean 2 Common tax base, with economic depreciation 3 No withholding taxes on interest 4 Limited credit system for dividend income 5 Exemption system for dividend income 6 Home State taxation
Stand. Dev.
Outbound
Base Case
EATR Average
Inbound
Mean Standard Deviation
Cost of Capital Average Stand. Dev. Domestic
Table 5
6.3 0.6 6.4 0.3 6.9 0.6 6.3 0.6 6.3 0.6 6.3 0.6 6.3 0.6
5.9 0.6 6.4 0.3 6.5 0.7 5.9 0.6 5.9 0.6 5.9 0.6 6.7 0.9
5.9 0.3 6.4 0.0 6.5 0.3 5.9 0.4 5.9 0.3 5.9 0.3 6.7 0.8
0.4
0.6
29.2 6.1 30.0 1.2 31.1 6.7 29.2 6.1 29.2 6.1 29.2 6.1 29.2 6.1
28.7 5.7 30.1 1.2 30.6 6.3 28.7 5.7 30.9 2.4 28.3 6.3 30.5 7.6
28.7 1.4 30.1 0.3 30.6 1.3 28.7 1.4 30.9 1.8 28.3 0.8 30.5 2.8
2.0
5.8
0.0
0.3
0.4
0.7
0.4
0.6
0.4
0.7
0.4
0.6
0.8
0.9
0.3
1.2
2.0
6.4
2.1
5.8
2.1
2.7
1.4
6.3
2.7
7.5
Notes: 1. Each number in italics are the standard deviations across the 15 member states for the same case as the mean immediately above it. 2. In each case, the effective tax rates for cross-border investment are based on the most taxfavoured means of financing the subsidiary. Distributions by the parent are assumed to be from domestic earnings.
2
Common tax base, based on true economic depreciation
We now examine the impact of harmonising the tax base - specifically here the rules for capital allowances. Capital allowances are assumed to be equal to the true economic depreciation rate (the assumed values for each asset are given in notes to Table 1). All other aspects of EU tax regimes - including the statutory rate and other aspects of the tax base - are unchanged.9 A significant part of this fall can be traced to Ireland, where there is currently a large disparity between potential residence countries depending on whether or not they tax the income generated in Ireland (and taxed at only 10%). 9 Note that this falls short of a consolidated EU tax base, where any individual company would need to calculate its taxable profits only once. 8
10
The results of this simulation are profoundly different from the previous case. The average costs of capital rise by around half of a percentage point, but the variation as measured by the various standard deviations hardly changes. A similar pattern arises with the EATR, although here the relative rise in the average is rather smaller. (This again reflects the fact that the EATR is less closely related to allowances). These similarities occur not just because the table shows only the average result for the EU as a whole. This reform has only small effects in any member state. For example, the very low EATR in Ireland and the very high EATR in France both remain. Costs of capital do change, but only slightly. The broad conclusion from this simulation is therefore that there would be no discernible gain in economic efficiency from harmonising the tax base - even if capital allowances were set equal to true economic depreciation. Part of the reason for these results is that allowance rates are already broadly similar throughout the EU. Partly it reflects that governments set tax bases and tax rates jointly, so harmonisation of only tax bases does not improve efficiency. Of course, as we have seen above, though this does not apply to the case of harmonising tax rates. 3
Abolition of withholding taxes on interest for payments from subsidiary to parent within EU
We now consider the abolition of withholding taxes on the payment of interest from a subsidiary to its EU parent. This is currently one of the proposals being considered within the EU. But it has almost no effect on any of the measures presented in this paper. The reason for this lies in the tax treatment of the parent in the home country. All EU member states tax interest receipts from EU subsidiaries in the hands of the parent. All member states use a limited credit system, so that taxes paid in the host country are credited against home country taxation. However, all member states also permit interest payments to be deductible from corporation tax. So the only tax which the interest payments10 may face in the host country is a withholding tax when the interest is paid to the parent. But in virtually all cases, the rate of withholding tax is lower than the home country tax rate. As a result, the withholding tax does not increase the overall tax liability; it merely shifts revenue from the home country to the host country.11 4
Foreign dividend received by the parent from an EU subsidiary taxed by a limited credit system
Currently, only 3 EU member states tax dividends received by a parent from an EU subsidiary on the basis of a limited credit system (Greece, Ireland and the UK). The other 12 member states all use some form of an exemption system (there are small differences between them). The hypothetical reform analysed here is to change the system in each of these 12 countries to a limited credit system. Where the home country tax rate is lower than the host country tax rate, a limited credit system will not result in any further tax in the home country. The main effects of this reform are therefore to In Germany, however, half of interest payments are subject to trade tax. This clearly limits the advantages of debt financing of a German subsidiary. 11 The only exception to this is for parent companies in Ireland, with a 10% corporation tax rate, receiving interest from Belgium, Greece or Portugal, where the withholding tax rate exceeds 10%. 10
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increase the tax liability on the receipt of dividends from EU subsidiaries of parents in home countries with high statutory tax rates. This reform therefore narrows the gap in the impact of tax between domestic and outbound investment for such parents. This is not a strong enough effect to show up in the cost of capital results in Table 1, however. Partly this reflects that these results are based on the most tax efficient form of financing the subsidiary – before and after the reform – so that one response to the reform may be use an alternative method of finance (neither retained earnings- or debtfinanced investment by the subsidiary is affected by this reform). However the reform does substantially reduce the average standard deviation of the EATRs for outbound investment, albeit at the cost of also raising the average EATR for such investment. Overall, then, this reform has two effects. It tends to increase the cost of capital and the EATR for specific forms of cross-border investment. But these effects do not combine to generate a very strong movement towards efficiency. In fact, this remains the case even if countries introduce a full credit system: that is, even this case would not generate a significant movement towards efficiency. 5
Foreign source dividend income received by the parent from an EU subsidiary exempt from tax
Next we impose that each member state exempts foreign source dividends from tax. At first sight, this may seem to imply that, for equity-financed investments, the EU tax system should become entirely source-based. However, some countries do not permit the deductibility of costs borne by the parent against the parent's tax liability where the costs support outbound investment. And where the subsidiary uses debt finance, then the home country would still tax the interest received by the parent. Given that 9 EU member states already use some form of an exemption system, it is not surprising that this reform contributes little movement in the direction of efficiency. There is virtually no effect on the measures of the cost of capital. There is some effect on EATRs: notably, as would be expected, the overall system moves closer to source-based taxation and away from residence-based taxation. However, this effect is considerably smaller than, for example, the impact of harmonising tax rates. 6
Home State Taxation
We finally also investigate one further proposed reform in the area of international taxation, known as Home State Taxation.12 This proposal is for any parent company within the EU to compute its EU taxable profit once only, applying the definition of the home country tax base to its EU-wide profits. Having computed the tax base for each company, it would then be allocated to different countries on the basis of a formula (possibly value-added). Each country would apply its own tax rates to its allocated tax base. The proposal would avoid practical problems in identifying the location (within the EU) in which profit is located. This advantage of the proposal is not captured by the model used here, since it makes no allowance for the compliance and administrative costs of implementing taxes.
12
See Gammie (1998a) and Gammie and Lodin (1999).
12
However, we can assess how such a reform would affect efficiency as measured here. Essentially, to assess the effective tax rate for any cross border investment, we simply apply the host country tax rate to the tax base as defined by the home country. Interest and dividend payments from the subsidiary to the parent are not taxable (or deductible). As Table 3 makes clear, the resulting tax regime represents a move away from efficiency. This is true on every measure. This suggests a connection between the tax base and tax rates in individual countries: if a high tax rate is applied to a low tax base, then the average cost of capital or EATR may not appear to be particularly high. For example, a parent in a home country with, say a low tax base may invest in another country which has a high tax base but low tax rate. But, under the Home State taxation proposal, the parent would apply the low tax rate in the host country to the low tax base in the home country.
4
Conclusions
We have examined the dispersion in effective tax rates relevant for investment in the European Union. Specifically, we have aimed to consider two forms of inefficiency which may be generated by differences in corporation taxes between countries: distortion to the choices among locations for production; and distortions due to some market participants facing different tax rates from others. We have analysed these using measures of the cost of capital and the EATR. We have provided evidence of the range of dispersion which exists across the EU. We have also investigated the role of specific features of the tax regimes in the EU, by simulating the impact of hypothetical reforms on our measures. By considering, say, the impact of introducing a single corporation tax rate in the EU, it is possible not only to analyse the impact which such a reform would have, but also to analyse the role that differences in statutory tax rates play in the differences in effective tax rates across countries. A vast range of different investments underlie the results presented here; only a summary picture can be provided of the effect of any hypothetical reform. Nonetheless, the results of considering hypothetical reforms are striking.
• Introducing a common statutory tax rate in the EU has a significant impact on the
dispersion of effective tax rates across countries. There is a significant fall in the average dispersion of both the cost of capital and the EATR facing parent companies choosing locations between alternative member states. There is also a fall in the dispersion between subsidiaries located in a given country which are owned by parents located in other members states. In short, such a reform would be likely to have a considerable impact on the prevalence of tax-induced inefficiencies within the EU. • By contrast, no other reform had such a significant effect. For example, introducing a common tax base tends, if anything, to increase the dispersion in effective tax rates. • Since withholding taxes on dividends between subsidiaries and their parents have been abolished within the EU, the international features of corporation taxes do not play a significant role in increasing distortions. Introducing a common means of taxing foreign source income, for example, has little impact on the dispersion of effective tax rates.
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