Occasional Paper

IOverviewGeorge KopitsT perhaps the most significant step toward Euro pean economic integration since the creation of thehe Single European Act of 1987 representsEC three decades earlier. In accordance with andbuilding upon the initial Treaty of Rome, the Actenvisages the removal of remaining barriers to thefree movement of commodities and factor inputs,with a view to enhancing competition and effi ciency within the Community. Under the authorityof the Act. the EC Council of Ministers was ex pected to approve nearly 300 provisions that woulddismantle, by the end of 1992, physical barriers(customs and passport control), technical barriers(regulatory restrictions that aiTect trade. and finan cial and real factor ftows). and fiscal barriers(border controls involving indirect taxation)among member countries.1 Of these, all exceptabout 50 measures have been adopted a year be fore the deadline. In addition. by the end of 1991,agreement was reached in Maastricht on the Eco nomic and Monetary Union (EMU) Amendmentsto the Treaty, mapping out the final stages towardeconomic integration and eventual adoption of asingle currency, largely through fiscal convergenceand monetary coordination.Notwithstanding an early concern with tax har monization,2 the explicit Community-wide man date in this area has been limited to phasing in acommon external tariff, eliminating internal tariffs,and achieving some uniformity in the type and baseof commodity taxes. Although additional steps to ward harmonizing the tax systems of EC membercountries do not follow automatically from eitherthe Treaty of Rome or the Single European Act,such measures must be consistent with them. In deed, the intended removal of border controls andrestrictions is intimately connected to tax harmo nization; arguably, lack of sufficient harmonizationI For a discussion of the major barriers. their economiceffects, and survey results about attitudes toward such barriers,see EC Commission (1988e) and Emerson and others (1988).2[n 1960 the Commission appointed the Fiscal and FinancialCommiuee. under the chairmanship of Frit7 Neumark. to studytax harmonization. The Commiuee's findings are contained inEEC Commission (1963).may even inhibit completion of the single internalmarket. Progress toward formal unification or con vergence of monetary, fiscal (including taxation),or social policy instruments, however, has beengenerally Slower than the removal of regulatory re strictions for two reasons. First, these policies areby nature often politically contentious becausethey may reflect profound differences in social andeconomic philosophy and can be perceived to limitnational sovereignty and discretionary policymak ing.3 Second, unlike most Community-wide regula tory changes. which can be adopted by a qualifiedmajority of member governments, enactment ofprovisions in monetary, fiscal. and certain socialpolicy areas requires unanimous consent.The first section of this chapter addresses thefundamental question of the extent of concertedtax harmonization that is necessary or desirable tosupport the completion of the single market. Har monization of the bases of product and incometaxes contributes to greater transparency for eco nomic decision-making. In addition, tax rate har monization is likely to enhance Community-wideefficiency and welfare. Concerted harmonizationcan be limited. however. to setting common mini mum tax rates to protect the tax revenue of mem ber governments, since, upon removal of bordercontrols and restrictions on factor movements,competitive pressures would induce a spontaneousdownward alignment of effective tax rates withincertain margins.4 Further, consensus on minimumtax rates. accompanied by mutual assistance amongtax authorities for enforcement purposes. is to be1Specifically. the EMU envisages eventual establishment of asupranational monetary authority, building on the EuropeanMonetary System (EMS). which already entails some loss ofindependent monetary control by panicipating member coun tries. Similarly. fiscal policy convergence implies some transferof decision-making to a supranational level.I· Concened" tax harmonization here denotes a formal agree·ment for convergence (not necessarily equalization) of tax struc tures: by contrast. "spontaneous" tax harmonization indicatesconvergence of tax structures in response to competitive pres sures. without a formal agreement. Unle s otherwise qualified.tax harmonization is used to denote concerted tax harmoni7a·tion throughout this paper. International Monetary Fund. Not for Redistribution

I OVERVIEWassigned priority as regards income from financialassets because these assets are the most mobile in ternationally. Similar action can follow in the areasof commodity taxation and, eventually, corporateincome taxation. Harmonization seems least urgentin the taxation of less mobile labor and real assets.An examination of various principles of interna tional taxation in the second section suggests thaLunder a plausible set of assumptions in the EC con text, retention of the destination principle for com modity taxation (through domestic taxation of im ports and exemption of exports) and consistentapplication of the residence principle in capital in come taxation (involving full offset for interna tional tax rate differentials on foreign-source in come) should ensure a more efficient allocation ofresources than alternative principles. However, dif ficulties in enforcing the destination and residenceprinciples without border controls and capitalcontrols-given uneven administrative practices,including anonymity of financial holdings in certaincountries-as well as relaxation of some of the as sumptions underlying the efficiency implications ofthese principles. indicate that tax rate harmoniza tion would lead to greater allocative efficiency.regardless of the principle adopted. Taxharmonization-much like other aspects of creat ing the single market-may have to be qualified byequity considerations. In particular. fairness in thedistribution of tax revenue among countries en gaged in tax harmonization and removal of nontaxbarriers argues for lump-sum transfers from high income to low-income countries.The third section outlines the main proposalsconsidered or adopted i n the EC for approximationof taxes on commodities and income from capitaLsupporting administrative steps, and other relevantmeasures. For commodities, agreement has beenreached on a standard VAT rate. at not less than15 percent on most products other than necessities;one or two reduced VAT rates not lower than5 percent mainly on necessities, with a transitionalarrangement for countries that have a lower re duced rate; and a set of minimum excise rates ontobacco products, alcoholic beverages. and mineraloils. The effective date of these rates coincides withthe elimination of frontier controls, in January1993. Among various administrative proposals, itwas agreed that the destination principle would bemaintained for four years and be replaced by a de finitive system based on the origin principle in1997. Meanwhile, border tax adjustments would beadministered through a postponed accounting sys tem (whereby transactions are reported to tax au thorities in both importing and exporting countries,without border declarations) for the VAT andlinked bonded warehouses for excises. As regards financial investment, an initially proposed 15 per cent minimum withholding tax on interest incomeof EC residents has been virtually abandoned infavor of mutual assistance to combat tax evasion.For corporate income taxation, past proposals forharmonizing statutory rates and bases were eitherwithdrawn or not formally submitted for considera tion: formulation of future proposals awaits the in put from a committee of experts. Nevertheless, sev eral measures were adopted to eliminate thedouble taxation and other tax disadvantages onintra-EC investment income.Although not formally part of tax harmoniza tion, there are a number of measures that are antic ipated to take effect either in tandem with tax har monization or after its implementation. Theremoval of controls on commodity and factormovements within the Community will be largelycompleted by the beginning of 1993. The EMUAmendments envisage convergence of budget defi cits and of government indebtedness to below cer tain limits, as a precondition for monetary unifica tion. Moreover, to compensate for the probableexacerbation of regional disparities resulting fromtax harmonization and further economic integra tion, an increase of disbursements from the ECStructural Funds to less developed regions withinthe Conununity is under way.The fourth section of the chapter examines thelikely economic effects of tax harmonization and ofthe associated financial liberalization and removalof border controls. On the basis of various quan titative simulations, it appears that the static effectswill be modest for the largest member countriesand for the Community as a whole. For certaincountries and sectors. however, the effects, withoutcompensatory fiscal action. can be substantial.Countries that rely on high standard VAT and ex cise rates are likely to experience a shift in con sumption. especially toward goods with relativelyhigh price elasticity of demand; a cut in consump tion may take place in countries with low standardVAT or excise rates, obliged to converge to higherrates. The shift in consumption patteros would,over time. be accompanied by efficiency gains inproduction. From a distributional perspective, rateharmonization involves a moderate reduction inthe progressivity of indirect taxation in countriesthat exhibit a relatively wide dispersion of VATand excise rates.A minimum withholding tax on interest incomewould result i n shifts from newly taxed assets toexempt assets and to tax havens outside the EC.Pressures on capital outflows would be felt par ticularly in countries where certain exchange re strictions are yet to be dismantled or where interestincome is in principle subject to ordinary income International Monetary Fund. Not for Redistribution

The Case for Tax Harmonizationtax but is not reported. Harmonization of effectivecompany income tax rates would probably lead to asignificant reallocation of capital to presently high tax countries from low-tax countries over the longrun. An increase in tax rates on income from capi tal, due to harmonization, could adversely affectlabor and other immobile factors to the extent thatin an open economy the tax burden tends to beshifted to them.The static budgetary impact of harmonization islikely to be concentrated in the VAT and excises ina few high-tax and low-tax countries. Model-basedsimulations suggest that the overall macro economic effects tend to be negligible for mostcountries. especially for the largest ones. The sim ulations, however, understate significantly the con sequences of these structural measures because ofthe exclusion of dynamic repercussions. Tax har monization, together with financial liberalizationand removal of border controls, is likely to have anadverse net static effect on non-EC economies.Trade diversion, in combination with strengthenedexternal competitiveness, would probably morethan offset any increase in import demand vis-a-visnon-EC member countries. However, on balance,the dynamic effects of the enlarged market alongwith the resulting trade flows may outweigh the netnegative static effects. ln any event, the efficiencygains from completion of the internal market ingeneral, and from tax harmonization in particular.should provide increased room for EC membercountries to pursue trade liberalization and Jess re strictive macroeconomic policies, thus benefitingnon-EC economies.In the final section it is argued that harmoniza tion of taxes on commodities and capital incomeand possible competitive pressures to align taxrates on labor income, within the single market,will reduce the scope for EC member governmentsto maintain an independent fiscal stance. More over, the combination of tax harmonization, finan cial integration. and the EMU should be conduciveto convergence of both fiscal structure and perfor mance in the EC. Within narrow limits, however,member governments might still rely on certainbuilt-in stabilizers and tax incentives for domesticpolicy objectives. Overall. concerted as well asspontaneous tax harmonization-insofar as it in volves convergence to relatively low minimumrates-coupled with the other steps toward eco nomic integration, should contribute to greater effi ciency in the public sector in most member coun tries. and, at the same time, may require a furthersubstantial expansion and overhaul of the Struc tural Funds to support low-income regions in theCommunity.A harmonized EC tax system may pave the wayto greater tax coordination between EC and non-EC member countries. In particular. ongoing finan cial liberalization and efforts to harmonize taxationof interest income argue for agreement on a mini mum withholding tax rate or increased administra tive cooperation in a broad international forum.Such an approach would be comparable to existinginternational agreements on minimum interestrates on export credits and a minimum capital ade quacy ratio on international bank lending.The Case for Tax HarmonizationTax harmonization is generally understood as aprocess of adjusting tax systems of different juris dictions in the pursuit of a common policy objec tive. In the context of the Single European Act(EC Commission (l986a)), tax harmonization in volves the removal of tax distortions affecting com modity and factor movements in order to bringabout a more efficient allocation of resourceswithin an integrated market.S Narrowly defined,tax harmonization guided by this policy goalimplies-under simplifying assumptions aboutother policy instruments and economic structure convergence toward a more uniform effective taxburden on commodities or on factors of productionacross EC member countries. Convergence may beattained through the alignment of one or severalelements that enter the determination of effectivetax rates: the statutory tax rate and tax base, andenforcement practices.6Perhaps the most widely accepted argument forharmonization involves convergence in the defini tion of product value or income for tax purposes.Such tax base harmonization would contribute totransparency for economic decision-making and,thus. to improved efficiency in resource allocation.In particular, a common income tax base for multi national companies operating in different jurisdic tions would be instrumental not only in enhancingefficiency, but also in preventing overlaps or gapsin tax claims by different countries.Under various assumptions examined in the nextsection. some of the efficiency effects of rate har monization can be accomplished with taxcoordination-that is. through offsetting com modity or income tax rate differentials among Tax harmonization may serve alternative goals. such as eq uity or stabilization. It also can be subsumed. along with publicexpenditure harmonization, under the broader concept of fiscalharmonization. See Dosser (1967) and Andel (1967).6Conceivably, equalization of only one of these clements mayexacerbatt: tht: variance of effective tax rates. The combmationof a broad base and a low legal rate in a gtven country. however.may yield an effective rate equivalent to that of another countrythat is based on a narrow base and a high legal rate. International Monetary Fund. Not for Redistribution

I OVERVIEWmember countries. As defined here, taxcoordination-distinguished from tax rate harmo nization proper7-consists of specific tax adjust ments on trade or income flows between jurisdic tions that aim to neutralize the effect of tax ratedifferentials on the location of production or in vestments In this regard, the consequences of suchtax coordination on commodity or factor move ments could be close to those of effective tax rateequalization. Nevertheless, the two approachesmay have different effects on the pattern of con sumption and production, on the choice betweenconsumption and leisure, or on the choice betweenconsumption and saving.The basic rationale for tax harmonization or fortax coordination lies in the general proposition thateither approach should lead to a more efficient al location of resources. That is, the decision to con sume imports or domestic products would dependon relative before-tax prices: likewise, the decisionto invest at home or abroad would depend onbefore-tax rates of return-assuming uniform pub Lic service benefits at home and abroad. The rele vance of this rationale diminishes, however, in thepresence of direct or indirect regulatory barriers tointernational trade, investment flows, or labor mi gration. In the extreme case of autarky. intercoun try tax rate differentials play no role in resourceallocation. By contrast. phaseout of physical andregulatory barriers. as envisaged by the Single Eu ropean Act. exposes the distortionary impact oftaxation on trade and factor flows and enhances theelasticity of economic decisions to tax rate differen tials. To the extent that economic agents do re spond to such differentials, the latter will be re flected in relative commodity prices, interest rates,and wages at home and abroad.Furthermore, the abolition of nontax barriersmay result in increased aUocative distortions underprevailing tax rate differentials because possiblesecond-best efficiency arguments-predicated onthe combination of tax and nonrax distortions-forsuch differentials would no longer apply. Given the7ln the early literature in this area, the term tax harmoniza tion was used broadly to include border tax adjustments andbilateral treaties to avoid double taxation of foreign-source in come; see Dosser (1967) and Shibata (1967). In an event, evenunder a narrow definition. tax harmonization may be accom panied by tax coordination."Agreement about source taxation by a group of countries(requiring no offsets) could be viewed as an ahemative form oftax coordination. In contrast to Lhe specialized definition usedthroughout most of the present analysis. liscal or tax coordina tion is ordinarily used to indicate discretionary polic

Tables 1. Value-Added Tax (VAT) Rates. 1990 2. Estimated Revenue from Operation of the Clearinghouse System (CHS), 1986 3. Excise Duty Revenue Other Than from Alcoholic Beverages, Tobacco, and Mineral Oils, 1987 4. Excise Duty Rates on Alcoholic Beverages, 1990 5. Excise Duty Rates on Cigarettes, 1990 6. Excise Duty Rates on Mineral Oils, 1990 7.