Letters to the editor

Polls and Opinion

Library - an archive
of speeches

Economists write

Bibliography of EMU

The Euroland Economy



Capital tax cacophony

Mario Monti, the (ex-) EC Commissioner for taxation, is pushing harmony for capital taxes across Europe; his notorious interest withholding tax has however triggered cacophony, as its doctrinal purity has threatened the operations of the City's Eurobond business. Professor Monti is an old friend of mine but alas his enthusiasm is running away with him on this one.

Everybody knows that in today's world of mobile capital you cannot tax capital owned by foreigners; the reason is of course that they will put it somewhere else. That has not stopped some governments trying to do so - for example California tried it a few years back when it produced its idea for taxing the world-wide profits of companies located there. The only effect of such proposals is either to drive the capital away or to cause offsetting falls in local costs (basically wages and land rents) that still enable the foreign investor to get as big a return as elsewhere - but these offsets cause local damage because there is mispricing of capital relative to land and labour, and all for nothing as the tax is paid, not by foreign capitalists but by local workers and rentiers. Better to tax them directly through income or consumption taxes.

So taxing foreign capital is foolish. But taxing home capital returns (our savings income that is) is feasible enough provided you tax it wherever it is invested, home or abroad. Plainly if you let people invest in the Channel Islands tax-free but levy income tax on their deposits in High Street banks, you will get huge capital flight to those happy islands. But the answer is obvious: you let people invest where they like but you tax them on their world-wide income - the basic principle of British income taxation of its residents. You can only avoid this by becoming 'ordinarily non-resident', an irritating business requiring frequent flights abroad to foreign homes and something best suited to globe-trotting tycoons.

So what, you may well wonder, is all this EC withholding tax harmonisation about? Apparently we would all have to levy the same (minimum 20%) rate of tax on interest received anywhere in Europe at source - like our own bank and building society deposit interest today. Why? Because otherwise those cunning German residents of Frankfurt, Munich and the rest will put their money in Luxembourg where it pays no tax. Indeed when the German government a few years back tried to tax interest like we do, that is exactly what happened.

But wait a minute - can't the Germans devise a way of policing their own tax system? Do we all have to rally round and mess up all sorts of arrangements because they cannot? It is fairly baffling. Virtually every other country in Europe has a system for taxing savings income. They have all managed perfectly well to operate them without losing all their tax proceeds to Luxembourg.

The reason that this proposal is so damaging to us, as has been widely explained, is that the City is exempt from withholding taxation, on the grounds that most of its customers are non-resident and therefore exempt from our income taxes. The City of course makes a very successful living out of selling all sorts of financial instruments to foreigners - also to British residents, but they are expected to make their own arrangements to pay tax under the various Inland Revenue Schedules. Now under the Monti proposal they would have to levy this tax on all 'deposit income', regardless of who held them; if they were non-EC citizens, presumably they could claim a rebate- at some cost and trouble ('transactions costs'). But if EC citizens, they could not. Hence all EC business would go say to Switzerland (unless caught by the tax authorities), and all non-EC citizens may well depart also to avoid the extra transactions costs.

All this because the German taxmen cannot do their job? Well, not quite. Enter Signor Monti, public finance economist: tax harmonisation is approved by many such economists because they see the tax base being eroded by tax competition so that 'public goods' (that is, goods the state 'must' provide) cannot be properly afforded and so are underprovided. The more integrated a country, the sharper this tax competition between its regions - ergo unified Europe now requires tax harmonisation between its countries.

There are serious flaws in this argument. First, and most practically, there is great dispute between these countries about what is a public good; in Germany the state devotes some 50% of national income to public spending whereas here we devote less than 40%, even under New Labour. Why should Britain be forced to raise taxes to make it easier for Germany to pursue aims that we do not share?

Second, the effect of tax competition between countries is vastly exaggerated by this argument. Just taking this latest withholding tax issue, most countries have been able to live with competition from Luxembourg, even if Germany has not. Nor do wide discrepancies in income tax cause floods of European citizens to resettle - far from it: labour mobility in Europe is tiny.

Third, there is a strong counter-argument that such competition does not erode tax bases because countries and areas can afford better public services for the taxes they can collect (and there are always some): this is beneficial because it gives people greater choice - the power of 'exit and entry'. They can choose to live in Holland with higher taxes and more public goods, or in Britain with lower and less. This process was identified by Charles Tiebout,  Professor at Seattle's Washington University; and there is plenty of evidence that it is alive and well even in local government where competition is at its sharpest. One may add that even where people do not in practice move, they can threaten to and use this politically to influence their own government - the power of 'voice'.

In sum, this withholding tax charade is practically absurd and intellectually indefensible. Isn't it time our Treasury got to work and said so?

Professor Minford teaches economics at Cardiff Business School

Patrick Minford's home page
Back to the Index of Daily Telegraph articles