Tax policies in the new EU member states: A shot in the foot?

Central and Eastern Europe is suddenly rethinking taxes. The Czech Republic is dropping its relatively recent flat-rate personal income tax, as is neighbouring Slovakia, which used to be the poster boy of the “flat-tax revolution”. Slovakia has also announced its intention to raise the corporate tax rate for higher-earning companies to 23% (from the current flat-rate 19%). The same government wants to introduce special surcharge taxes for banks and network industries, taking its cues from Hungary. Does this mean a departure from the long-standing consensus in the region that these countries need to attract investment (domestic and foreign) through aggressive tax competition? Don’t hold your breath.


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A low-tax, low-investment equilibrium

The countries that joined the EU in 2004 and 2007 continue to be a very specific group within the Union. Not only are they generally less wealthy than the rest, but they spend proportionately less than the “old” EU on social policies, education, and research and development.

Conversely, they tend to collect much less in taxes. While the average rate of redistribution of income as measured against gross domestic product (GDP) in the EU is 40%, in all of the new member states it is less. In fact, in half of them it is even below 30%.

Thus, for illustrative purposes, if we rank tax revenue from the highest to the smallest ratio, we see a long tail of low-tax countries populated by several new member states (in ascending order): Bulgaria (27.4%), Lithuania (27.5%), Latvia (27.5%), Romania (28.1%), Slovakia (28.3%). Other post-communist CEE members are not much higher up the ladder, as the figure below shows.

Source: Eurostat

Of course, expenditure-ratio measures need to be taken with a pinch of salt. They tell us the gross, not the net, rate of redistribution. They also hide the true motivation of the government. For instance, in some countries cash advances towards mortgage payments might be taken to primarily serve as a subsidy for the banking sector.

In general, however, with such low levels of tax revenue, it is no surprise that these countries do not have enough funding for social cohesion policies and for investing in innovation and long-term growth.

The reasons for the fairly minimal state prevailing in CEE are not well-known. Some authors highlight simple lack of competence, which is reflected in very high rates of tax evasion in the region. This can be calculated as the difference between estimated income based on current rules and the state of the economy on the one hand, and real revenue on the other hand. However, the tax rules (tax rates and tax base) themselves point to an interest in a low tax burden. This is also reflected in the “flat tax revolution”. Most new member states have chosen to implement a flat-rate income tax system, often officially parting with the notion of vertical tax equity, a concept so well-ingrained in the Western system of progressive taxation. Explanations include the notion that the state has been hijacked by transformational elites, weak democratisation, and generally individualistic cultures.

How much does a millionaire really pay?                                                 

The new measures announced to increase state revenue in a seemingly equitable manner do not, however, constitute a break from the past. In order to become more egalitarian, these countries need to implement a robust system of wealth taxes. This is not happening. For example, the Czechs’ imminent return to a mildly progressive (two income brackets) income tax can be seen as a smokescreen for the public, who will have to contribute to fiscal consolidation via a significantly higher value-added tax (VAT).

The Slovaks are more fair-minded. There are no plans for a VAT increase and Slovakia is planning to introduce a significantly progressive property tax. Nevertheless, none of the countries in Central Europe, or in the wider CEE region, has announced a truly significant overhaul of wealth taxes, which would include proper taxation of financial assets and a more thorough inspection of individuals’ tax obligations. Currently, Eastern multimillionaires can relatively easily escape taxes and the not-so-prying eyes of local authorities by declaring themselves tax residents of Switzerland, Monaco, or, more easily, one of the Caribbean tax havens.

The collective dilemma of corporate taxation

Corporate taxes are a more complicated case than personal taxes. First, there is the complexity of such taxes. Any corporate tax system is a fairly idiosyncratic maze of exceptions and ad hoc tax cuts (e.g., to attract a particular company to invest). Statutory rates rarely converge with effective ones. Secondly, while personal taxes are a matter of local political economies, in the matters of corporate taxation countries might be locked in a collective dilemma that would prevent them from acting individually.

The popular 1990s’ thesis that globalisation will bring a collective ‘race to the bottom’ in which countries would try to undercut each other in tax rates has generally not been realized in the West. However, in the new member states, tax competition is very much the order of the day. Countries in the region have come to rely on foreign direct investment (FDI) as their main engine of growth. In order to attract more FDI, they strive to offer competitive tax rates and special tax treatment to investors. This effect is compounded by the use of offshore jurisdictions for channelling investments and transfer pricing techniques to artificially move value into low-tax locations. But to what extent do these developments impede economic convergence across the EU?

Would EU tax harmonisation help?

Two EU-level developments are significant in this regard. The EU’s ‘fiscal compact’ (the Treaty on Stability, Coordination and Governance in the EMU, also known as the Fiscal Stability Treaty), which member states plan to ratify by the end of 2012, will put pressure on countries to collect more taxes, as the pact puts everybody in a significant fiscal straitjacket. Secondly, the Euro Plus Pact, agreed upon in spring 2011, explicitly creates a framework for tax harmonisation, albeit through Open Method of Coordination (OMC), rather than hard law.

Counter to these developments, there is a growing appetite in the region by investors (including domestic ones) to invest via offshore jurisdictions, which provide tax and investment protection advantages. Similarly, countries in the region continue to provide significant levels of company-specific tax subsidies. EU law (Art. 87 and 88 of EC Treaty) is very strict about state aid, which is banned in principle, although many exceptions are allowed. These exceptions, however, mostly allow horizontal, not sector- or company specific subsidies. The members of the European Community discontinued many forms of state aid throughout 1980s, partly as a spillover from measures taken to implement the Single Market programme. Given evidence of large tax cuts that FDI receives in CEE, the question is whether the European Commission should not start to exercise its competition policy powers more vigorously.

Some tweaks in current rules are also needed. For example, under the current reporting system, a member state government can avoid the Commission’s scrutiny by a not-so-complicated application of de minimis rules. This allows them to avoid reporting subsidies by parcelling a single project into many parts, each under the threshold required for reporting.

The key question: who will act?

Central and Eastern European countries are notoriously ineffective at cooperation. When these countries were complaining that ESA-95 budget rules did not allow them to exclude their mandatory pension saving pillars from public deficit, they failed to press the issue in concert. It took Sweden, which also has a small pillar of mandatory funded pensions, to organize these countries into a lobbying group and to win some exceptions to budget reporting rules.

Lobbying to break collective dilemmas in tax matters would be even tougher. However, by missing out on tax revenue, these countries simply cannot accumulate enough funding for long-term development. Part of the shortfall can be offset by increasing personal taxes. But in order to raise proper tax revenues, the group also needs to address the issue of effective corporate taxation.

In the end, however, the issue might be raised as part of the package of ongoing efforts to get Europe back to growth. Ironically, the Western electorates might press their governments to finally include some degree of tax harmonisation, which would also benefit the East.

Juraj Draxler

Juraj Draxler

is Associate Research Fellow at the Brussels-based think-thank CEPS, and lecturer at the Anglo-American University, Prague. He has authored and co-authored several reports contracted by the European Commission on social policy and labour market regulation.