Chapter

X Tax Harmonization

Author(s):
International Monetary Fund
Published Date:
December 1990
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With the implementation of free mobility of commodities and factor inputs, the EC Commission has stressed the need for tax harmonization. The Commission has given top priority to harmonizing indirect taxes, since, at present, the administration of these taxes depends crucially on the existence of border controls, which are to be removed with the start-up of the internal market. As no removal of border controls between the EC and the EFTA is currently envisaged, the implication for the EFTA of indirect tax harmonization in the EC is limited. Moreover, the EC countries have tended to postpone decisions relating to tax harmonization. While an alignment of taxes may still result spontaneously through competitive pressure, it would proceed more slowly than a centrally administered harmonization. Harmonization of corporate and capital income taxes is potentially a more urgent problem because these taxes fall on a highly mobile base. However, at this point, the Commission has no plans for a general harmonization of taxes on labor income, reflecting the fact that the psychological and cultural barriers to international mobility of labor remain high.

Indirect Taxes

At present the EC and EFTA countries maintain widely different value-added tax (VAT) rates (Table 9).100 Since the VAT systems are operated according to the “destination principle,” under which goods are taxed in the country of final consumption, adverse effects on any country’s competitiveness or tax base are avoided. Thus, a product carries the domestic tax rate whether it is produced domestically or imported, while exported products leave the country free of any VAT. In order to ensure that the domestic VAT is charged on imported products and that goods for which zero-rating is claimed are being exported, countries rely on tax adjustments at the border. Border controls are also used to monitor cross-border trade, so that consumers making direct purchases abroad are subject to the domestic VAT on purchases in excess of the personal exemption. Thus, the frontier formalities permit a member country to set its own tax rates without imposing adverse externalities on others.

Table 9.EC and EFTA: VAT Rates1(in percent)
CountryLower RateStandard RateHigher Rate
EC
Belgium1–61925–33
Denmark22
France5.518.625
Germany714
Greece3–61636
Ireland2–1025
Italy4–91938
Luxembourg3–612
Netherlands618.5
Portugal81730
Spain61233
United Kingdom15
EFTA
Austria102032
Finland19.5
Iceland21424.5
Norway20
Sweden23.463
Switzerland416
Sources: “Rates of VAT in the EC on January 1, 1989,” European Report, December 14, 1989, p. II, 4; “Value Added Taxation in Europe,” Guides to European Taxation, Vol. IV; and country authorities.

January 1, 1989, unless specified otherwise.

January 1, 1990.

Reduced rates are applied for construction and certain other services. A temporary increase to 25 percent took effect on July 1, 1990; it will expire on December 31, 1991.

No VAT. Turnover tax levied at 6.2 percent on consumers and 9.3 percent on retailers. Imports are taxed at 9.6 percent unless they are imports of a registered enterprise.

Sources: “Rates of VAT in the EC on January 1, 1989,” European Report, December 14, 1989, p. II, 4; “Value Added Taxation in Europe,” Guides to European Taxation, Vol. IV; and country authorities.

January 1, 1989, unless specified otherwise.

January 1, 1990.

Reduced rates are applied for construction and certain other services. A temporary increase to 25 percent took effect on July 1, 1990; it will expire on December 31, 1991.

No VAT. Turnover tax levied at 6.2 percent on consumers and 9.3 percent on retailers. Imports are taxed at 9.6 percent unless they are imports of a registered enterprise.

If the VAT system is to remain neutral after border controls are eliminated, an administrative substitute for fiscal checks at the frontier has to be devised. In addition, member states with higher rates of indirect taxation may have to reduce their tax rates in order to avoid a diversion of retail business (and tax revenue) to lower-tax member states. For the former purpose, the Commission has proposed that the system of zero-rating of exports from one member country to another be ended, that is, transactions between countries be treated as those within countries. Thus, exports would carry the exporting country’s VAT, which would be reimbursed as input VAT to the importer. Such a change would have implications for the international distribution of tax revenue.101 Accordingly, a clearing system would be set up to redistribute VAT revenues, so that they continue to accrue to the country consuming the products. In relation to nonmember countries, the EC would continue to operate a traditional system based on fiscal documentation at the border. Thus, the administrative aspects of the proposed VAT reform would have no consequences for the EFTA as long as border controls are maintained between the two blocks.

The issue of harmonization of tax rates arises primarily in the context of cross-border shopping. There is already a considerable amount of cross-border shopping in the EC (for example, between Denmark and Germany), and it is likely to increase with the removal of border controls. This may lead to competitive downward pressure on tax rates. Instead of such a market-driven alignment of rates, the Commission proposes harmonization by agreement, whereby the burden of adjustment is shared between high-tax and low-tax countries.

At present, all member countries except Denmark apply at least two VAT rates: a reduced rate for such necessities as food and medicine, and a standard rate for other goods. The Commission has proposed retaining a dual rate structure, while leaving the member countries some freedom in setting the tax rates in each category. According to the initial proposal announced in 1987, the standard rate should be set between 14 percent and 20 percent, with the reduced rate between 4 percent and 9 percent. The width of the bands was determined on the basis of the U.S. experience, suggesting that differences of about 5–6 percentage points in tax rates between neighboring states can be sustained without serious border trade problems.

Some countries objected to the Commission’s proposal because of the large changes in tax rates or tax coverage that it would have required. The United Kingdom would have had to eliminate the zero rate it uses on a variety of goods and services, while Denmark would have suffered a sharp cut in revenue from its VAT. In May 1989, therefore, the Commission modified its proposal, adopting a “pragmatic” approach to VAT harmonization. The modified proposal entailed, among other things, rescinding the upper limit on the standard rate. The Commission also accepted a zero rate for a limited number of commodities in countries that already provide for a zero rate. However, it retained the proposed band for the reduced rate.

Along with its proposals to align VAT systems, the Commission has also suggested harmonizing excise taxes. Excise tax systems of the EC countries are even more divergent than VAT systems, for example, in the treatment of manufactured tobaccos, alcoholic beverages, and mineral oils.

The Commission’s initial proposal was quite radical, involving complete harmonization of tax rates as well as of the tax base of excises. Full harmonization was justified on the grounds that the VAT is calculated on a product’s price including excise duty, so that any differences in excise duty rates would magnify the differences in effective VAT rates. Full harmonization was probably also considered essential to reducing the scope for indirect protection of national production of such products as tobacco and alcoholic beverages. On the other hand, the proposal has been criticized for not paying adequate attention to health, environmental, or other legitimate concerns of member countries. In May 1989, the Commission modified its proposal by setting only minimum rates for tobacco products and alcoholic beverages. For the longer run it also defined target rates of taxation; these target rates are 10 percent higher than the rates proposed in 1987. To administer excise taxes after lifting border controls, the Commission has proposed establishing a system of linked bonded warehouses. This involves suspending the excise duty until goods leave a warehouse to be sold on the domestic market.

Assuming that border controls between the EFTA and the EC are maintained, tax harmonization would not have important consequences for the EFTA. However, all the EFTA countries except Switzerland have tax rates in excess of the top rate originally proposed by the Commission. Since harmonization in the EC—whether by prior agreement or by competitive pressure—is bound to lead to a lowering of the higher rates, the incentives for cross-border shopping by EFTA nationals in the EC will increase. Thus, the Danish VAT rate is likely to fall, providing opportunities for profitable cross-border shopping by Swedish nationals. However, the difference in rates between the two countries is unlikely to exceed 5–6 percent, which is considered the maximum sustainable difference in the absence of border controls. On the other hand, Austria’s VAT rate on luxuries (32 percent) is likely to look very high following harmonization in the EC and would probably have to be brought closer to the EC standard rate. Iceland has the highest VAT rate in the EFTA, but the scope for cross-border shopping is limited, given Iceland’s geographic location.

While Switzerland’s dependence on its turnover tax is comparatively modest, most EFTA countries rely heavily on VAT revenue (Table 10). A removal of border controls between the EFTA and the EC and a concomitant harmonization of VAT rates would thus lead to sizable revenue losses for the EFTA countries. The latter may therefore opt to follow Denmark’s approach to harmonization, which is to give priority to the lowering of rates on goods that are important in cross-border trade.

Table 10.EC and EFTA: Revenues from VAT and Excise Taxes1(in percent)
VATExcise Taxes
of Revenueof GDPof Revenueof GDP
EC
Belgium16752
Denmark2310115
France21963
Germany13482
Greece207145
Ireland208104
Italy14573
Luxembourg13694
Netherlands16853
Portugal187166
Spain17562
United Kingdom166124
EFTA
Austria18672
Finland3310144
Iceland34972
Norway2210157
Sweden177104
Switzerland15331
Sources: IMF, International Financial Statistics, March 1990; and IMF, Government Finance Statistics Yearbook, 1989.

The data refer to the most recent year for which data are available. In most cases the year is 1987 or 1988.

Sources: IMF, International Financial Statistics, March 1990; and IMF, Government Finance Statistics Yearbook, 1989.

The data refer to the most recent year for which data are available. In most cases the year is 1987 or 1988.

Capital Income Taxation

The liberalization of capital movements now in progress in the EC raises the issue of harmonization of corporate and portfolio income taxation. With capital liberalization in the EFTA countries also progressing at a rapid pace, the issue is equally important in their case. Indeed, the EFTA countries could be vulnerable to any major changes in EC capital income taxation. In practice, however, although capital income taxation has been on the EC agenda longer than the internal market, consensus has been particularly elusive.

At present, EC countries’ methods of taxing capital income differ widely. Calls for harmonization have been prompted by the fact that with full capital mobility in prospect, these differences are creating considerable scope for tax arbitrage and tax evasion. Moreover, when capital is free to flow to countries with a favorable tax regime or where it can escape taxation altogether, the capital will not necessarily be used to finance the most efficient investments.

The Commission has made a number of proposals in the area of corporate income taxation, with the first back in 1969. The proposals address such issues as harmonization of company tax systems, elimination of double taxation of foreign source company income, and crediting of shareholders for the tax on company profits. Thus, the main features of a directive proposed in 1975 included a single statutory rate of corporate income tax set in an interval between 45 percent and 55 percent; a common imputation system for distributed dividends with a single rate of tax credit to shareholders; and a common approach to the taxation of dividends crossing borders. The proposal was never adopted; it was officially withdrawn in April 1990.

On July 23, 1990, EC finance ministers adopted a package of three corporate tax directives that had been blocked at the Council level for several years. The directives aimed at eliminating most risks of double taxation for firms operating across borders within the Community. The package included a directive to prohibit member states from imposing a withholding tax on profits distributed by a subsidiary in its territory to a parent company located in another member state.

The Commission has formed a special group of experts to review the whole area of corporate taxation. It will analyze such issues as whether the differences in corporate taxation distort investment decisions, whether market forces and competition among national fiscal systems will suffice to eliminate these differences or whether Community legislation will be necessary, and so forth.

Interest income from foreign bank deposits or securities is potentially an easy conduit for tax evasion following removal of capital controls. Thus, a Commission proposal issued in February 1989 calls for a minimum 15 percent withholding tax on interest income of EC residents. In view of the risk of inducing capital outflows to third countries with adverse effects on interest rates in member countries, the proposal provides for numerous exemptions. Nevertheless, it has run into considerable opposition. As a result, the Commission has shifted the emphasis of its proposal from the withholding tax toward agreement on adoption of minimum reporting agreements and exchange of information on EC residents’ interest income.

Progress toward concerted harmonization of capital income taxes in the EC will apparently be slow, which may not give great comfort to the EFTA countries. First, with increasing capital mobility, the EFTA countries may be just as exposed as the EC countries to the risks of tax arbitrage, tax evasion, and distorted investment incentives posed by the current EC system. Second, concerted action may be replaced by harmonization through uncontrolled competitive pressure. The proliferation of tax reforms in both the EC and the EFTA in recent years may be an indication that this process is already under way. One problem with such a process is that the competition may in the long run drive tax rates down to suboptimal levels or create tax systems that are less efficient than if they had been the result of coordinated effort. In any event, the hardships are likely to be particularly great for such high-tax countries as Norway and Sweden, where substitute revenue sources may be difficult to find.

100Switzerland has a turnover tax instead of a VAT.
101Under this proposal, exporting countries with relatively high rates of VAT would gain, as would countries with export surpluses.

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