WHAT IS TAX CO-ORDINATION?

51. When we started this enquiry, the British public had recently been seeing newspaper headlines like "Germany sets collision course with UK on tax"[6] and "Is Lafontaine half-baked?"[7], and some even pithier tabloid headlines. As Lord Taverne says: "When Oskar Lafontaine, then Finance Minister in Germany, was in full flow calling for the harmonisation of taxes in Europe, he presented the Europhobe press with the ideal bogeyman to frighten the children"[8]. Dr Hans Ulrich Kieschke, for the German Government, said delicately: "There had been some irritations in November, December last year between the United Kingdom and Germany. My feeling is … that the atmosphere has been cleared, and we have got the common declaration of Tony Blair and Gerhard Schröder" (Q 195)[9]. This has taken some of the heat out of the terminological arguments, but we nevertheless need to start by defining the terms which we shall be using.

52. We also need to emphasise that the firm proposals—and even future ideas—on tax harmonisation or co-ordination in the European Union cover only certain types of tax. In particular, there are no thoughts of including personal taxation of earned income or social security systems, and the present proposals relate only to Value Added Tax; the taxation of royalties, interest and dividends; and the possible application of a Code of Conduct on business taxation[10]. As Peter Wilmott pointed out, "clearly most taxes are national in that the revenue is raised domestically on domestic taxpayers who really have very little to do personally, economically, socially, with other countries or other taxpayers in other jurisdictions in the European Union" (Q 388).

53. Where taxation is being considered at an EU level, "co-ordination" rather than "harmonisation" is now the Commission's favoured word to describe its policy - perhaps, as Richard Baron of the Institute of Directors suggested to us, to "take the sting out" of what it is saying (Q 279). Nevertheless, many of our witnesses referred to "harmonisation", so we explored the potential differences in meaning.

54. We found the definitions suggested by the Ruding Committee[11] useful, viewing co-ordination in terms of "action or measures taken" by the Community or individual Member States to influence the tax practices of Member States, and harmonisation as the occurrence of greater convergence as a result of action at the Community level. This was echoed by Commissioner Monti when he described co-ordination as less ambitious than harmonisation, implying a coming together of Member States rather than a Directive from above (Q 233). On behalf of the Government of the Federal Republic of Germany, Heinz-Jurgen Selling suggested that "tax co-ordination is the procedure by which EU Member States co-operate in order to overcome tax obstacles for cross-border activities without giving away sovereignty … By contrast, tax harmonisation has some common rules for the tax structure" (Q 199).

55. The Paymaster General told us categorically that "tax harmonisation is not on the agenda … in the European Union. It is not being taken forward in discussion. The Government are quite clear that tax harmonisation in the field of direct and corporate tax is not the way forward" (Q 425)[12]. But, as Peter Wilmott said:

"The basis on which the European Union was founded was one of co-operation in determining common goals and then agreement on methods for attaining those goals, which implies some pooling of sovereignty and some co-ordination and co-operation and, if it is a matter of agreement between governments that certain effects of certain taxes are felt beyond domestic frontiers, it seems to me to be quite legitimate for them then to talk about common action to deal with those effects if they decide that those effects are undesirable" (Q 388).

56. Looking at the terms used in relation to taxation policy in the European Union, we understand "co-ordination" as having fewer connotations of compulsion and imposition from above than "harmonisation", and as leaving more room for variations as between Member States. But, whatever terminology is used, in our view the crucial point is that it is no longer practicable for Member States to establish some elements of their tax régimes in isolation, without recognising their interdependence with other Member States. In our Report, we shall refer to the results of this approach as "co-ordination". We note from the outset, however, that despite all the attention which it is receiving we believe that there are more important issues currently facing the European Union.

WHAT IS TAX COMPETITION? WHEN IS IT HARMFUL ?

57. According to Colin Mowl (Deputy Director, Budget and Public Finance Directorate, HM Treasury): "Tax competition is where countries use low taxes to attract internationally mobile capital and business. There is no completely precise definition of 'harmful' or 'unfair' tax competition [but] … the international community has come to some consensus that … preferential or discriminatory tax measures are potentially harmful", as opposed to measures that are available to all the taxpayers in a particular jurisdiction (Q 134). "Harmful" measures could lead to the erosion of Government revenue, distort the allocation of resources, or be unfair in that not every individual or company had access to them (Q 135). "Fair" tax competition, on the other hand, had benefits: it left governments with freedom to set tax rates consistent with the level of social provision and the size of the public sector they wished to finance, and to choose to use taxation for other purposes (for example, health or environmental reasons) (Q 136). We explored these concepts—and the converse right to use lower taxes, for example to encourage equity investment—with our witnesses[13].

58. There is a general presumption that competition (like the Roman Conquest[14]) is a Good Thing in all markets, on the grounds that competition promotes efficiency and reduces prices. Professor Michael Devereux suggested to us that this presumption is not relevant to tax competition between governments, because "price" in this context refers to tax rates, and cuts in tax rates have opportunity costs; as the revenue from one type of tax falls, governments will be obliged either to raise revenue from other sources or to forgo expenditure (Q 397). He concludes from this that "there is no economic justification for distinguishing between different forms of tax competition in the way attempted by the Code of Conduct[15]" (p 138). Because any form of tax competition can be harmful, eliminating the sort of discriminatory measures targeted by the Code of Conduct will not by itself deal with the problem (Q 397). Malcolm Gammie agrees that "there is no satisfactory line between harmful tax competition and tax competition in general" (p 142). Differences in tax rates may generate a "race to the bottom", so it may be seen as appropriate to impose common minimum rates[16].

59. In favour of tax competition, Graham Mather (President of the European Policy Forum) claimed that the USA regarded different tax systems and labour legislation in different states as "an advantage that stimulates innovation, competition and choice and facilitates a dynamic and adaptive economy". He suggested that the Commission preferred a highly centralised approach not only to stop "fiscal dumping", but also to develop its own competence in the tax area (Q 175). He cited Keith Marsden's work[17] as showing that low tax régimes appeared to result in more dynamic and successful economies, although he agreed that they were not the only factor (Q 176).

60. Many of our witnesses took the view that there was a distinction between "fair" (that is, acceptable) tax competition and "harmful"(or "unfair") tax competition. Judith Mayhew, the Chairman of the Policy and Resources Committee of the Corporation of London, said: "I do not think anyone would regard tax competition per se as unfair. Any tax that distorts markets … could perhaps be regarded as unfair[18], particularly if [a government was] trying to distort inward investment through tax policies" (Q 97). According to the German Government, tax competition is harmful if it distorts companies' decisions on where to locate their activities and erodes Member States' tax bases (p 66). German officials argued that "if one [Member] State is lowering taxes, creating loopholes, against another Member State, then [it] will attract business activities not for real economic reasons but just for tax purposes, and that is not good competition" (Q 202). Deutsche Bank shared the view that "in principle, international tax competition is positive"; it is an important factor in attracting investors, and it forces governments to keep taxes as low as possible. But "governments must take action when tax competition is unfair" (p 74), that is if there is "a kind of reverse discrimination against domestic entities with a view to attracting foreign businesses"(Q 227). This echoes Peter Wilmott's view that one can distinguish as harmful "particularly aggressive reductions in tax rates or the introduction of new exemptions which target people in neighbouring Member States … that is a phenomenon which amounts to a beggar thy neighbour policy which I think is fundamentally destructive if allowed to continue" (Q 399). For the OECD, Jeffrey Owens argued that tax competition can be beneficial, for example because it can encourage countries to adopt best practices, rather than using discriminatory régimes. But it becomes harmful "where a country goes out and designs its tax régimes to target the tax base of another country in what I think has been called tax poaching" (Q 259).

61. We do not believe either that tax competition is always harmful or that it never is. In other words, we accept that some types of tax competition may be harmful, though we note that they are not easy to define exactly, and that they may bring benefits to one Member State at the expense of others. We noted a possible analogy between predatory pricing, a recognised concept in competition policy, and what one might term "predatory tax measures".

DOES THE SINGLE MARKET REQUIRE MORE TAX CO-ORDINATION?

62. With increasing economic integration within the Single Market, issues of whether tax co-ordination is preferable to unrestrained competition will arise in many areas of tax policy, because tax bases are mobile - goods are traded, funds are invested and labour moves across borders. Whether tax co-ordination is worth undertaking will depend on the degree of market distortion arising from differences not only in nominal tax rates, but also in definitions of the tax base, in the rigour with which tax legislation is enforced, and in the burdens imposed by the tax bureaucracy. The attitude of Member States towards co-ordination will depend on the extent to which they are losing revenue because their tax base is moving elsewhere, and on whether co-ordination will stop this by covering all relevant markets.

63. Commissioner Monti argued that for the Single Market to function effectively more co-ordination was needed, though to differing degrees in different areas. At one extreme, there were areas (such as personal taxation) where co-ordination was unnecessary. At the other extreme, some taxes impinged considerably on the functions of the Single Market: he instanced excise duties, VAT and energy taxes, where there was a case for "quite extensive harmonisation". Between those two extremes, he saw an intermediate area (the two main examples being business and capital) where tax bases were highly mobile, where a true Single Market implied a need for co-ordination (Q 233)[19]. Deutsche Bank went as far as favouring some increase in harmonisation, for example of the assessment bases for direct business taxation (to increase transparency in competition between investment locations) (p 75), but did not believe that harmonisation of rates was necessary (Q 219).

64. Others disagreed that any action was needed. Graham Mather considered that "at first sight, it appears that very widely varying tax rates are incompatible with a smoothly functioning Single Market because they may distort the position. Decisions may be taken for tax reasons rather than for fundamental reasons of economics" (Q 182). But he argued that in fact other national restrictive practices were far more important, and concluded: "I cannot immediately identify any area in which I believe that the centralised approach [to taxes] has obvious benefits" (Q 186). Instead, he believed that competition would eventually lead to convergence (Q 187)[20]. Similarly, the Chairman of the CBI Tax Committee said: "We see co-ordination as being a convergence of market forces, to which we would have no objection" (Q 313).

65. For Barclays Bank, Ian Menzies-Conacher and Malcolm Levitt said categorically that the Single Market did not require a harmonised tax base: on the contrary, the basis of the Single Market was competition (QQ 4-6). Judith Mayhew, for the Corporation of London, accepted that some degree of tax co-ordination was necessary, but warned that high rates could drive capital outside the EU (Q 113). The CBI did not believe that harmonisation or co-ordination was necessary "as a blanket principle", preferring to focus on "specific issues and distortions that affect the Single Market" (Q 313). The Institute of Directors rejected the notion that some form of tax co-ordination was necessary to make the Single Market work well; what was necessary was that national legislation should not discriminate against citizens or businesses from other Member States (Q 309).

66. The Government agrees that blanket harmonisation is not appropriate. For HM Treasury, Colin Mowl said:

"We do not think that what is known as harmonisation is necessary to complete the Single Market, but we think that there may be, particularly on the indirect tax side, some areas where further approximation stopping short of full harmonisation is necessary … We think there are some aspects of direct tax where collective action would be sensible - in particular tackling harmful tax competition and tax evasion" (Q 132).

67. The stated position of other governments is similar. The Irish Government says:

"Ireland supports a more co-ordinated approach to taxation policy which does not undermine the principle of subsidiarity and which takes account of the respective areas of competence of the Member States and the Community in determining taxation policy as reflected in the Treaty … Improving tax policy co-ordination in the EU, which Ireland supports and which is being actively pursued at present through implementation of the December 1997 tax package, should not be confused with harmonisation of tax rates, which does not form part of the EU's agenda … In Ireland's view, harmonising business tax rates in the EU is not necessary and would not be in the best interests of the EU" (p 176).

68. In the same vein, the German Government believes that "direct taxes should be co-ordinated, but in no circumstances harmonised". It points out that there is no proposal for a uniform European corporate tax system: "instead we want to concentrate on how best to avoid ruinous taxation competition in the field of business taxation". And "there is no thought of introducing measures harmonising personal income tax. This is not necessary within the internal market and is not consistent with the principle of subsidiarity" (p 66). "We, the Germans, do not want tax harmonisation because the development [in EU Member States] is so different. Compare, for example, Germany with Portugal or with Greece: there is [a] totally different social security [system] in Germany, and that makes a need for a higher tax burden" (Q 195).

69. In a press interview[21], the Luxembourg Minister of Justice and the Budget (M Luc Frieden) is quoted as saying:

"It is regrettable that, at European level, no ultimate objective has been clearly agreed by those prompting the idea of tax harmonisation. I sometimes get the impression that certain representatives of other countries want to succeed on a specific aspect that suits them, without discussing the situation as a whole … The term 'tax harmonisation' is ill-worded. Tax harmonisation is not desirable, or desired by many Member States. What is really needed is some co-ordination of tax provisions in order to prevent unfair tax competition".

70. For the French Government, M le Floc'h-Louboutin considered that "one way or another, the tax systems in this European space (which is more and more integrated) must move closer to each other. So in fact the real choice is to know how we shall go about this … the French position, in fact, consists of being in favour of this rapprochement … but only on some questions and certainly not systematically on every single question … We totally approve of competition as being something that is perfectly healthy for the European Union" (Q 244).

71. Asked why taxation could not remain a domestic issue, Peter Wilmott agreed that in many areas it could: "There is a risk with the European tax debate of the tail wagging the dog in that there is a large lump of any tax system which is national … it is very easy to get it out of proportion and consider that the only debate that matters is the European debate" (Q 388). In other areas, Malcolm Gammie argued that "when you have several taxing jurisdictions and a highly mobile tax base, particularly with companies[22] and capital income, then countries have only two options. They must either work together and agree as to how they are going to tax that highly mobile tax base or they must effectively abandon it or at least reduce their reliance on [it] and rely on other elements of the tax base that are rather less mobile". Michael Devereux added: "In a sense it is impossible for an individual country to determine what its tax base is independently of what is going on outside the country … We live in a world in which capital is mobile between countries and in determining our tax system that has to be borne in mind" (Q 387).

72. But even in areas where co-ordination may have benefits, it also has costs. As Peter Wilmott pointed out:

"The Member States of the European Union do not have public finances which are structured in the same way, whether it is the balance between taxation income, borrowing and expenditure or the balance between individual taxes within the tax envelope. If they are unduly constrained in their policy choices on certain taxes because of what is going on elsewhere in Europe, or because of harmonisation for that matter, it is very difficult for them sometimes to take appropriate policy decisions nationally without having some distortion in their own policy framework … Tax policy cannot exist in a vacuum, it reflects choices about the level of social protection which can be expressed in terms of public spending … The tax debate is … linked into other questions about the way in which you would like society to be structured to meet the needs of citizens" (QQ 399-400).

73. We do not think that a general answer can be given to the question of whether the Single Market requires more tax co-ordination. Decisions on taxation (especially direct taxation) are primarily for individual Member States, but they cannot always be taken in isolation. Of its nature the Single Market will tend to lead towards some convergence of tax rates. But it may also lead to pressures to introduce selective tax inducements, and in this regard some positive co-ordination between Member States may be necessary. We would emphasise that there will always be a trade-off between limitations to national freedom of action and gains from co-ordination, which must be considered in relation to each proposal.

WILL PROGRESS ON THE SINGLE MARKET FOR FINANCIAL SERVICES REQUIRE CO-ORDINATION?

74. The Commission has recently issued two Communications about the completion of the Single Market in financial services[23]. Commissioner Monti (Q 229) described these as the third important step in this direction, following the first step of liberalising capital movements and the second step of the series of banking, insurance and investment services directives[24].

75. If the Single Market is to apply to financial services as well as to goods, Commissioner Monti is in no doubt that:

  "It is in the economic logic as well as in the political logic of many Member States that you cannot in the European Union arrive ultimately at a perfect Single Market for financial services while keeping a number of distortions from the tax side that would perhaps inadvertently transform free movement of capital into a vehicle not of efficient allocation of resources but of cross-border tax evasion. In order to avoid that, we do not need full tax harmonisation; we need just some tax co-ordination" (Q 229).

Peter Wilmott agrees that the development of the Single Market in financial services might generate extra pressure for the removal of existing imbalances in taxation (p 145). The Stock Exchange identified stamp duty and stamp duty reserve tax as areas where a more co-ordinated approach would be desirable, as part of the move towards a pan-European stock market (p 179).

76. The Association of British Insurers emphasised that although changes in taxation might be helpful, there was a greater need to remove regulatory barriers (p 167). The German Government considered that the cross-border selling of financial products would be facilitated by removing the existing imbalance in taxation "and other hindrances" (p 68). The Commission Communication on financial services deals mainly with the non-tax obstacles to which these witnesses referred.

77. We attach importance to the completion of the Single Market. Cross-border selling should be easier for financial services than for goods, because there is no need for physical transport. So in the long-term, in the absence of other impediments, the financial services sector would be likely to show a high degree of integration. A non-distortionary tax régime would help to maximise the gains from this integration. We had therefore expected that witnesses might use this argument in support of tax co-ordination. In fact, they did not, other than arguing in favour of some minor tax adjustment measures (for example of stamp duty on share transactions) on condition that they did not damage the competitive position of EU Member States in relation to third countries.

DOES EMU REQUIRE MORE TAX CO-ORDINATION?

78. It has been suggested that EMU will make tax co-ordination inevitable. As companies integrate their business operations in response to the single currency and the Single Market, it will become increasingly difficult to determine in which Member State profits really arise. Even the OECD's "arms length standards"[25] will probably not be adequate to deal with businesses integrated across Europe. This may increase the pressure for a common system of corporate taxation, which we consider later in this Report[26]. Similarly, Brian Cassidy argued[27] that "the introduction of the euro offers a fresh opportunity for the development of financial markets", and that it was therefore important that "savers and investors should be free to invest their assets without encountering legal, administration or information barriers". On the other hand, Graham Mather considered that the Eurozone made it more, rather than less, necessary for individual Member States to be able to adjust their own tax rates, since they could no longer manage their economies through monetary adjustments (Q 175).

79. We addressed this issue in our previous Report on the European Central Bank[28], where we looked at whether observance of the stability pact would leave sufficient room for manoeuvre by Member States to manage their own economies. We concluded:

"Monetary union requires that there will be a single interest rate across the euro zone, leaving each of the 11 nations within that zone to adopt its own fiscal and structural policies. Co-ordination between these three policy elements, while theoretically desirable, is unlikely to be fully achieved, especially between countries in a different economic climate. However, in practice, the lack of such co-ordination in the past does not appear to have had major adverse effects on national economic performance"[29].

80. There is more than one view on this question. One is that EMU increases the pressure for tax co-ordination since the successful management of monetary and tax policies can be achieved only if both are under the same political control. The other is that since national governments can no longer have recourse to monetary policy they have an even greater need to use tax policy to manage their economies in pursuit of legitimate national objectives. This argues against the view that the single currency in itself must lead to greater tax co-ordination.

IS IT SENSIBLE TO CONSIDER TAX CO-ORDINATION LIMITED TO EUROPEAN UNION MEMBER STATES?

81. The CBI pointed out that "the debate on the incidence of tax, its rates and base, particularly in relation to business activities and capital, must be had in the context of the global economy and maintaining Europe's competitiveness" (Q 312). This was particularly true because of the growth of electronic commerce, which they saw as "a force for change in the way that international tax régimes work" (Q 321). Commissioner Monti said that in its June 1998 Communication on electronic commerce and indirect taxation[30] the Commission had "stressed the need to ensure a clear and neutral tax environment which avoids distortions of the market and contributes to the development of electronic trade" (Q 229). As the CBI said, "electronic commerce is just another means of doing business … The key thing is to go for the business and make sure that tax does not get in the way" (Q 321). The Government supported the principles that tax systems should be neutral as between electronic and traditional commerce, that the tax should be charged with some degree of certainty and accrue to the right country, and that the system for achieving this should be simple (Q 364).

82. The work within the OECD is attempting to address these issues on a wider scale, through its own Forum (which has produced Recommendations and Guidelines for dealing with harmful tax practices), and through dialogue with countries which are not members of the OECD[31]. But, as Peter Wilmott asked, "how do you engage the interests of those people whom you would like to be your partners in some co-ordination venture, because their interests are not yours and sometimes they are exactly opposite to yours?". A country like Switzerland, which might wish to become a member of the European Union, "might be more prepared to make gestures of this kind", but what incentive would there be for others? (Q 409).

83. We can see that, particularly in an era of globalisation and increasing electronic commerce, tax co-ordination measures could be genuinely effective only if they applied in third countries as well as in EU Member States. However, although we commend the work of the OECD in this field, we are not optimistic that third countries will soon fall into line with measures adopted in the EU to prevent harmful tax competition, because we cannot see what incentive there is for them to do so. We do not think that this should be used as an excuse for doing nothing within the EU in the meanwhile, but we do underline the need to consider the effect of proposed measures on the position of the EU on the global playing field, when others will be playing by different rules.

WOULD TAX CO-ORDINATION NECESSITATE CENTRALISED CONTROL?

84. At various points in our evidence sessions we addressed the issue of whether proposals or ideas under discussion would require administrative and/or political centralisation.

85. By definition, the approach of "co-ordination" implies that the administration of taxes remains primarily with Member States. Some centralisation of administration would be unavoidable if the EU were to adopt systems involving major redistribution of receipts among Member States, like a home State based corporate tax system or even an optional single European Corporation Tax[32], or a VAT system based on a single place of taxation for businesses, with the proceeds being allocated between Member States by statistical means[33]. There are no firm proposals on the table for measures of this kind, but more generally Richard Baron (for the Institute of Directors) said:

"I think it is very likely that if that route [tax harmonisation or tax co-ordination] is pursued the result will be some sort of central authority that lays down the rules, If not, one will have something that comes to virtually the same thing. One will have a committee, perhaps a committee of the Council of Ministers, that meets to decide what to do about tax systems this year. If that committee did not have a majority voting system there would probably be paralysis … I would not be at all surprised … if in the end some kind of central treasury made the decision, which would be very undesirable" (Q 304).

86. However, Peter Wilmott argued that once agreement had been reached, "the measures you then have to implement to control what you have agreed do not necessarily have to go beyond what you already have in the European Treaties. I do not see this as necessarily going further politically, legally or institutionally than we already have done" (Q 412). Ulrich Wolff, for the German Government, agreed that whereas tax harmonisation would require central legal control, co-ordination "attempts to avoid bureaucracy at the European level ... The autonomy of national parliaments is preserved, which is particularly important for Germany as a confederation" (Q 207). Harmonisation, on the other hand (in the view of Barclays Bank) would not be possible outside a reasonably homogeneous economic, social and accounting framework, from which the EU was far away (p 2).

87. Even without agreement on major new measures, there might be pressure for international monitoring of a co-ordinated tax system because of the fear that Member States would devote inadequate resources to enforcement on international transactions because the benefits would accrue partly to others (or even because they saw poor enforcement as an inducement to business). M le Floc'h-Louboutin, for the French Government, recognised this danger, but pointed out that most of the work would continue to be done by Member States; in any case he argued that separate bureaucracies to enforce separate rules in individual Member States were actually more burdensome for business (Q 247).

88. We also wondered whether any attempt to co-ordinate taxes on a basis wider than the European Union might lead to the need for a world-wide enforcement body on the lines of the World Trade Organisation. Jeffrey Owens considered it unlikely that such a body could be acceptable; he saw the need for new forms of co-operation or co-ordination, but he thought that the existing OECD mechanism would provide a good forum for developing them (Q 264). There had been no discussion in the OECD of a central clearing system of any kind, which in his view would imply centralisation of the authority to tax (Q 276). Without such an authority, the problem of knowing where to tax corporate profits would remain, but this underlined the need for harmonisation not of taxation but of accounting practices (Q 274).

89. Enforcement of current tax legislation can require co­operation between Member States and the Commission; so would enforcement of some of the proposals now on the table. Broader ideas which have been floated in relation to corporate tax and VAT might lead towards more centralisation, which in turn could lead to a loss of political control for Member States. National governments will need to keep a watchful eye on that aspect of proposals which come forward.

WOULD INCREASED TAX CO-ORDINATION LEAD TO A HIGHER TAX BURDEN?

90. Commissioner Monti was adamant that one of the fundamental principles of the Commission's approach to tax co-ordination was that it must not lead to an increase in the tax burden (Q 229). "The purpose is not, and even the side-effect must not be, that of raising taxes"; on the contrary, to the extent that harmonisation implied a broader tax base it would enable tax rates to be reduced (Q 230). For the German Government, Dr Kieschke supported this view: "Nobody, and I think not even my Minister in [his] talks with Gordon Brown, has expressed that he feels a need for a higher tax burden in order to harmonise it, but the reaction of Gordon Brown was that he had understood Mr Lafontaine in this way" (Q 202). Dr Owens took a similar view in relation to the work of the OECD, which could enable countries to reduce tax rates because it would broaden the tax bases by removing "niches", and by reducing the scope for evasion and avoidance (QQ 260-261).

91. On the other hand, UNICE[34] argues that tax competition is the only counterweight against the desire of governments to increase their revenues, "all the more so since certain Member States have already attempted to expand the scope of the Code [of Conduct] to include general low tax systems prevailing in other Member States" rather than just discriminatory régimes. And Graham Mather was in no doubt that harmonisation was bound to lead to higher taxes, because reliefs or low rates would be removed, and because the removal of the competitive stimulus would leave governments with a free hand to raise taxes (Q 185). The CBI feared that "harmonisation driven through the political process will … tend to raise tax burdens" (p 115), and the Institute of Directors claimed that "governments have an insatiable appetite for money. If they find it easier to raise money because they do not have to worry about business moving to the next door country in retaliation I suspect that they will do so" (Q 282). The Luxembourg Minister of Justice and the Budget said that he was disturbed by the fact that "certain parties" wanted upward harmonisation, aligned towards the highest rate of taxation[35].

92. Whether greater co-ordination would lead to a higher tax burden obviously depends on the effect of the actual measures adopted both on tax rates and on tax bases. If the elimination of "tax breaks" enables the base to be broadened, the same total revenue could be derived from lower tax rates. But the most significant point is that while tax decisions remain with Member States, the wish of politicians to be re-elected acts as a restraint. We consider that there would be a danger of upward alignment continuing unchecked if tax decisions were handed over to a supranational body which was not accountable to an electorate.

DOES THE PRESENT TAX SYSTEM CONTRIBUTE TO HIGH LEVELS OF UNEMPLOYMENT?

93. The Commission holds a view[36], shared by some Member States, that increasing taxes on capital income could contribute to a reduction of unemployment. The Bank of England helpfully summarised this argument for us as follows (p 18). Under the present tax system in the EU, the tax burden on capital has decreased because of harmful tax competition; in particular most Member States do not tax the interest income payable to non-residents which is generated within their jurisdiction. Some have also reduced taxes on interest income to residents to reduce the outflow of capital. As a result, in order to generate the required amount of revenue Member States have had to impose higher taxes elsewhere, in particular on labour. High taxation on labour (including social security and similar payments, as well as personal income tax) contributes to high levels of unemployment. If taxes on capital income were increased, taxes on labour could be reduced, so the cost of labour to employers would fall and more would be employed (p 28).

94. In his evidence to our previous enquiry, Commissioner Monti referred[37] to a paper by Professor Tabellini which estimated that "four percentage points of the present unemployment rate in Europe can be explained by the tax burden on labour", and suggested that an alternative to spending public money to promote employment could be "the co-ordination of taxation in a more labour-friendly manner", putting more emphasis on taxation of physical resources and of consumption. In his evidence to the present enquiry, Commissioner Monti argued that there was increasing evidence of a trend towards decreasing taxes on capital (by which he meant income from interest on savings) and increasing taxes on labour (in which he included social security contributions as well as direct taxation) (Q 234). The German Government, which tends to agree with this argument, claims that tax on pay in the EU has risen since 1980 by three times as much as tax on profits, adding that "consideration should be given to responding to this development, as a matter of equitable distribution and fairness" (p 68).

95. There is not general agreement that the relative tax burden on labour has increased across the EU (contributing to unemployment), nor that increasing taxes on capital would help to remedy such a situation if it existed. The Paymaster General said:

"The argument is that international tax competition has eroded revenue on mobile capital and thus forced governments to increase taxes on less mobile factors such as labour. The Government do not take that view and are not convinced of the argument" (Q 431).

She said that the total revenue from corporate taxes within the EU was broadly stable, and there was no clear evidence of whether a shift from taxation of capital to taxation of labour had actually occurred ("there is a dispute about the statistical collation" (Q 431)). There might have been such a shift in Belgium, France and Germany - but even in those countries there was no evidence either that it resulted from tax competition (Peter Curwen, HM Treasury: Q 147), or that it had been the cause of an increase in unemployment (Q 431). If there was a problem in some Member States, they should deal with it themselves (Q 432). Lord Taverne reaches the same conclusion: although "in theory one could envisage a situation where the pressure for lower taxes on a mobile factor like capital would force up taxes on immobile factors like labour … in practice this has not happened [in the EU]"[38].

96. The Corporation of London suggested that the German Government was blaming its high rate of unemployment on high labour taxes, when the real causes might lie in restrictive labour legislation and lack of flexibility in the labour market (Q 109)[39]. The European Policy Forum pointed to the work by Keith Marsden[40] which suggested that high labour and social taxes were caused not by the effects of tax competition but by the scale and structure of the welfare state in the countries affected (Q 181). Jeffrey Owens said that the OECD's work did suggest that there had been some shift of the tax burden from capital to labour, but he added that "it is difficult to see whether there is any positive correlation between the level of tax on labour and the level of unemployment". In his view, reforming tax systems would not solve unemployment problems; the answer lay rather in more flexible labour markets (Q 268).

97. In a supplementary Note (pp 28-29), the Bank of England pointed out "two important provisos" to the Commission's argument. "First, the extent to which higher tax rates on capital income would actually generate more revenue is uncertain". Because capital is internationally mobile, higher taxes are likely to lead to capital flight. And if taxes on capital rise, over time investment will be reduced and the total stock of capital will fall. So "the potential additional revenue generated by a tax on capital income could be much less than calculations based on an unchanged tax base would suggest". The CBI also submitted evidence[41] supporting the view that those businesses in the European Union which currently benefit from low tax rates offered under "harmful" régimes might not remain in their present locations if they were taxed more heavily, and that the tax revenue resulting from an increase in rates would therefore not be large enough to allow a "discernible alleviation" of the tax burden on labour. As the Institute of Directors put it: "If the capital scoots off somewhere else [because of increases in tax] one may end up with more unemployment, fewer earnings from tax and be even worse off than if one had given capital a decent home in the first place" (Q 292).

98. Secondly, the Bank of England argues that "even if higher taxes on capital income did allow a reduction in taxes on labour income, the long-run effect on unemployment is uncertain". A reduction in taxes paid for by an increase in taxation of capital may simply lead to an increase in post-tax pay for those already in employment. Or it "may have a favourable short-term effect on employment because it may increase labour supply without at first reducing labour demand. But in the long run, the demand for labour will fall, which is likely to offset the short-run effect". And in any case, Michael Devereux suggested that the real burden of corporate taxes effectively fell not on the owners of capital, but on consumers in terms of higher product prices or on the labour force in terms of lower wages; this was an inevitable result of the greater mobility of capital (Q 397).

99. Within their domestic tax structures, Member States have tended to reduce taxes on income from capital, in order to reduce capital outflow. The Commission argues that this has caused taxes on labour to rise, which in turn has contributed to high levels of unemployment; it concludes that measures to increase the revenue from taxation of income from capital would reduce unemployment. Other witnesses suggested that, although high labour taxes could well have contributed to unemployment in some Member States, there was insufficient evidence to show either that the measures which the Commission was now proposing in relation to taxes on capital income would lead to a reduction in taxes on labour, or that even if they did this would lead to a reduction of unemployment across the European Union. The possible links between the distribution of the tax burden and unemployment are complex, and we do not consider that there is firm enough evidence to support the causal connection which the Commission suggests. It follows that we do not agree with the Commission that employment promotion is an argument which can be used to support the proposed tax co-ordination measures.

COULD TAX CHANGES BE IMPOSED ON THE UNITED KINGDOM?

100. The Government believes that "EU taxation should continue to be based on the principles of:

National competence, whereby policy is wholly a matter for Member States if the Community does not have competence under the Treaty;

Subsidiarity, whereby action should only be taken at Community level where the objectives cannot be sufficiently achieved by Member States and can be better achieved by the Community;

Unanimity, whereby EU wide taxation matters can only be adopted by a unanimous vote of Member States" (p 37).

101. We were interested to note the approach adopted by the Government on the draft Directive on the taxation of interest and royalty payments between associated companies[42]. In her Explanatory Memorandum on this proposal, Dawn Primarolo (then Financial Secretary to the Treasury) suggested that the Directive did not breach the principle of subsidiarity, "because it would eliminate withholding tax between companies in different Member States and thereby benefit United Kingdom businesses". The Minister reassured the House of Commons European Legislation Committee[43] that accepting this proposal would not create a precedent, because there had already been cases[44] where the United Kingdom had agreed to Community action in particular areas of direct taxation "where such action would be beneficial and the subsidiarity test is satisfied". This pragmatic approach might fuel Graham Mather's fear that "the [Government's] policy appears to be that some further moves on tax harmonisation would be compatible with British interests, that some others (not defined) would not be, but that there is no fundamental point of principle so far adumbrated"[45] (Q 174).

102. Commissioner Monti recognised the fear of some Member States that efforts on tax co-ordination were "trying to take sovereignty away from [national] parliaments" - in effect, breaching the principle of subsidiarity. He claimed that in fact the position was "quite to the contrary": the Commission was trying to enable Member States to "avoid the gradual increasing erosion of sovereignty in favour of the anonymous market place and away from democratically elected decision-making bodies that would occur as markets integrate, unless there were to be some tax co-ordination" (Q 229).

103. As for the issue of unanimity, the Treaty[46] specifies that it shall apply to decisions on indirect tax matters. But as Malcolm Gammie says: "There is no legal framework for advancing Community measures on direct taxation. The EC Treaty contains no requirement that Member States harmonise their corporate taxes or other aspects of their direct tax systems" (p 140) - and thus no provision as how such harmonisation might be achieved.

104. The Government's declared position is that unanimity must be preserved for all decisions on all forms of taxation. In his oral evidence, Colin Mowl of HM Treasury said that the maintenance of unanimity was a Government commitment set out in its election manifesto: that commitment was an absolute one. He added: "Having said that, that is the formal position with the Treaty at the moment, and you quite rightly suggest that other people have different views and they may look for ways to encourage us, force us, to change that situation" (Q 131). However, for decisions on indirect taxation such a move would require a Treaty change which itself would require unanimity, "and the United Kingdom would not agree to such a change". The Paymaster General emphasised that the Government would also apply the same principle to direct taxation: "The Chancellor has made it clear that the United Kingdom will not agree to qualified majority voting in the area of direct tax and corporate tax" (Q 429).

105. Commissioner Monti confirmed that all tax decisions required unanimity "as things presently stand", but noted that "a few Member States have already pronounced in favour of shifting … from the unanimity rule to the qualified majority rule". He suggested that, "should the European Union be unable to finally reach consensus and compromise on the so-called withholding tax, this would considerably increase the pressure on the part of several Member States to shift from the unanimity requirement to the qualified majority requirement … If it were possible to adopt [the withholding tax proposal] … I believe a lot of the pressure will fade away" (Q 238). The Paymaster General confirmed that "in the margins of the ECOFIN meeting in December Germany made some comments in that regard", but there had been no formal proposal (Q 429).

106. For the French Government, M le Floc'h-Louboutin also envisaged the possibility of relaxing the need for unanimity. In relation to VAT, he said: "For some fields we are beginning to wonder, since that tax has now reached more or less full maturity, whether we could not adopt qualified majority voting[47], and … working within [the VAT] committee[48] would be a possibility". He contrasted this with direct taxation, which he said was

 "a field where … [the EC's] competence is subsidiary but at the same time … an extremely important subject for … the good operating mode of the internal market … But if the work that has been done by the Monti Committee … does not reach a successful end … because there is opposition by one single state for instance, well then obviously qualified majority voting would be totally legitimate or become so … French Ministers are in favour of evolving … on certain subjects yet to be determined and upon terms yet to be determined, but that would move towards lifting this possibility of irreducible opposition or a veto that would come from one single state" (Q 245).

107. We noted that the requirement for unanimity was not universally welcomed: for example, Peter Wilmott perceived it as leading to "unwieldy compromises" by giving undue weight to purely national concerns in negotiation, especially as Community membership grew (p 143). But those who do support unanimity fear that departures from the principle could occur "through the back door". We explored how this might happen.

108. First, we have noted an increasing number of Commission proposals where, once a measure had been unanimously agreed, decisions on its implementation would be made by qualified majority voting. These include the decision to withdraw agreement for a Member State to charge a reduced rate of VAT on labour-intensive services, and the proposals for reform of the VAT committee[49]. The Government has taken the view in both these cases that unanimity should be maintained; and if agreement were reached it could hardly be described as being "through the back door" since the provision for qualified majority voting is on the face of the proposal.

109. Secondly, the Economist[50] has drawn attention to an European Court of Justice judgment[51] that the taxation of life assurance in Sweden was illegal because it discriminated against firms from other European countries, and suggested that "the same principle - that the Court can overrule national sovereignty in tax matters, where it clashes with other aspects of European law - could theoretically be applied to other taxes too". It is well-established that although, as Community law presently stands, direct taxation does not as such fall within the purview of the Community, Member States' powers must be exercised consistently with Community law[52].

110. Thirdly, Lord Shore of Stepney has expressed concern "about the possibility under the enhanced co­operation procedures of the Amsterdam Treaty of the other European countries [that is, the members of EMU] coming together to agree on tax harmonisation and then making that a condition of Britain's further move to entry into the single currency" [53]. Since the requirements for entry to EMU are laid down by Treaty[54], it would not be possible to impose any further conditions formally. But of course, it is always possible that the Government might - whether or not in the context of EMU - trade off an undesirable tax proposal against something else[55]. Treasury officials conceded that there could be such pressure, but maintained that the Government would not allow the national interest to be compromised by linkages of this kind (Q 145).

111. Finally, we have concerns about the procedures being used in relation to the Code of Conduct on harmful tax competition, which we consider in our discussion of that proposal[56].

112. We note the commitment of the Government to the principles of national competence, subsidiarity and unanimity in tax matters. We also note that the Government is inclined to adopt a pragmatic view on the issue of subsidiarity when it judges measures to be in the interests of British business; we welcome this.

113. We recognise that the concept of national sovereignty in tax matters is subject to market pressures. When tax bases are highly mobile, governments may be unable to set tax rates that differ to any great extent from the rates ruling elsewhere; because capital is so mobile, this applies particularly to taxes on the income from savings. The effect in practice is to reduce the fiscal sovereignty of individual Member States. We recognise that international co-ordination may be a way for Member States collectively to regain some of the fiscal sovereignty which they have lost at a national level as a result of market integration.

114. We consider that there is no case for any departure from the principle of unanimity unless and until such a departure has been openly and explicitly made by a change to the Treaty; such a departure would itself require unanimous approval. We note that this issue is likely to arise at the next IGC. We agree that the principle of unanimity should be maintained for major issues. But we are also agreed that that principle need not necessarily be extended to cover all minor administrative measures dealing with taxation, especially as the number of Member States increases.

115. We note that, like any other European Union measures, tax proposals are the subject of negotiation. The outcome of such bargaining may involve the pooling of sovereignty, which some may see as a reduction of sovereignty. We do not believe that this possible outcome should influence the Government's position on the present tax co-ordination proposals.

7   Financial Times, 25 November 1998. Back

8   Dick Taverne, Tax and the Euro, Centre for Reform paper no 6, May 1999, p 8; not published with this Report. Back

9   The two leaders said they opposed "a unified European system of corporate taxation" and would not support "measures leading to a higher tax burden and jeopardising competitiveness". Exceptions to initiatives designed to combat unfair tax competition should be granted where a Member State demonstrates that the "competitiveness of Europe" is in jeopardy (Financial Times, 10 December 1998). Back

10   Not involving measures relating to corporate taxation as a whole. Back

11   Report of the committee of independent experts on company taxation, Commission of the European Communities, March 1992. For definitions, see Glossary at Appendix 3. Back

12   The position for indirect taxation is defined in the Treaty: see paragraph 103. Back

13   We also considered the interaction between taxes and State aid. Back

14   Sellar and Yeatman, 1066, and all that. Back

15   Which envisages action against "harmful" tax competition: see paragraph 119. Back

16   Because a Member State which cuts its tax rate imposes costs on others, whereas a Member State which raises its tax rate harms only itself. A "race to the bottom" is not universally regarded as a bad thing: the Institute of Directors said they would welcome it (Q 283). Back

17   Published (and submitted as evidence for the enquiry) by the European Policy Forum as Is tax competition harmful, November 1998: not published with this Report. Back

18   Economists would of course argue that all taxes "distort markets", in that they influence economic behaviour. Back

19   This echoed what he had said in his evidence to our previous enquiry: Tax and Competition Policy in the Single Market, HL Paper 117, 28th Report Session 1997-98, Q 202. Back

20   Compare also the Ruding Committee's definition of "competition", quoted in the Glossary at Appendix 3. Back

21   Given on 21 January 1999 to Luxembourger Wort; submitted as evidence by the Government of Luxembourg; not published with this Report. Back

22   We return to the issue of corporate taxation in paragraphs 221-231. Back

23   12624/98: Financial services: building a framework for action and 8329/99: Implementing the framework for financial markets: action plan. Back

24   On banking: principally the First and Second Banking Directives (Council Directive 77/780/EEC of 12 December 1997 (as amended) and Council Directive 89/646/EEC of 15 December 1989 (as amended)). On insurance: reinsurance and retrocession (Council Directive 64/225/EEC of 25 February 1964); the direct life assurance Directives (Council Directive 79/267/EEC of 5 March 1979 (as amended), Council Directive 90/619/EEC of 8 November 1990 (as amended) and Council Directive 92/96/EEC of 10 November 1992 (as amended)); the direct non-life insurance Directives (Council Directive 73/239/EEC of 24 July 1973 (as amended) and Council Directive 88/357/EEC of 22 June 1988 (as amended)); and the motor insurance Directives (Council Directive 72/166/EEC of 24 April 1972 (as amended), Council Directive 84/5/EEC of 30 December 1983 (as amended), and Council Directive 90/232/EEC of 14 May 1990). On investment services: Council Directive 93/22/EEC of 10 May 1993 (as amended) and the Directive on undertakings for collective investment in transferable securities (UCITS: Council Directive 85/611/EEC of 20 December 1985 (as amended)). Back

25   The principle set out in Article 9 of the OECD Model Tax Convention that, in order to ensure that the tax base of a multinational enterprise is divided fairly, transfers within a group should approximate those which would be negotiated between independent firms (Q 274). Back

26   See paragraphs 221-231. Back

27   In his draft Opinion (as an MEP) for the European Parliament Committee on Economic and Monetary Affairs and Industrial Policy, which he submitted as evidence for this enquiry (not printed with this Report). Back

28   The European Central Bank: will it work? HL Paper 112, 24th Report Session 1997-98; see especially paragraphs 83-94 and 122-124. Back

29   op cit, paragraph 122. Back

30   9742/98. Back

31   See p 96 and paragraph 194. Back

32   See paragraph 227. Back

33   See paragraph 236. Back

34   Company taxation in the Single Market: a business perspective, 4 November 1998 (annexed to the CBI's written evidence, but not printed with this Report). Back

35   loc cit. Back

36   Expounded inter alia by Commissioner Monti when he addressed a European Investment Bank forum on 23 November 1998. Back

37   Tax and Competition Policy in the Single Market, HL Paper 117, 28th Report Session 1997-98, Q 210. Back

38   op cit, p 23. Back

39   Denied by German officials in their oral evidence (Q 204). Back

40   loc cit. Back

41   Comments by UNICE on the proposal for a Council Directive on a common system of taxation applicable to interest and royalty payments between associated companies of different Member States, 5 October 1998 (annexed to the CBI's written evidence, but not printed with this Report).

 Back

42   6615/98, whose substance is discussed at paragraphs 147-150 below. Back

43   See Report of Select Committee on European Legislation: HC 155-xxxvi (1997-98), paragraph 2 (29 July 1998). Back

44   For example, Council Directives of 19 December 1977 concerning mutual assistance in the field of direct taxation (77/779/EEC), and of 23 July 1990 on the common system applicable to mergers, divisions, transfers of assets and exchanges of shares concerning companies of different Member States (90/434/EEC) and on the common system of taxation applicable in the case of parent companies and subsidiaries of different Member States (90/435/EEC). Back

45   Mr Mather used this argument in support of his belief that the Government might accept qualified majority voting on some tax matters. Back

46   Article 93 EC. Back

47   We note that the 1996 Commission Communication on VAT (9466/96: see paragraphs 232ff) suggested (p 19) that "thought will … have to be given to … the decision-making process (unanimity or qualified majority?) for arriving at a system of VAT that is genuinely common and uniformly applied". Back

48   See paragraph 207. Back

49   See paragraphs 205-206 and 207-209.  Back

50   5 December 1998. Back

51   Case C-118/96 Jessica Safir [1998] ECR I-1897. Back

52   Case C-279/93 Schumacker [1995] ECR I-225. Back

53   Hansard, 2 December 1998, col 489. Back

54   Article 121 EC.  Back

55   In the context of EMU, for example, acceptance of unpalatable tax proposals might be made a quid pro quo for failure to adhere strictly to other conditions of entry (for example, prior membership of the ERM).  Back

56   See paragraph 123-128. Back