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Unformatted text preview: TAXATION POLICY Tax Harmonization Different tax systems and tax rates distort trade and factor movements between the member states of a common market During market integration it becomes necessary to introduce policies aiming at tax coordination and harmonization The EU never had the intention to apply overall tax harmonization However, a high degree of harmonization is desirable in the indirect tax field because indirect taxes may create obstacles to the free movement of goods and services within the single market Tax Harmonization In 1998 the Commission set out a broader vision of tax harmonization and laid down three categories: Income taxes which would never be harmonized VAT and excise duties where more harmonization is desirable Business taxes where the Commission would be willing to act The Problem Abolition of trade barriers among the members of the customs union does not necessarily mean that a common, perfectly competitive market has been completed Differences between the tax systems of the members of the customs union are one of the most important of these impediments and one of the most difficult to alleviate Impediments to the smooth functioning of the competitive markets for commodities, services and factors of production are still many This is the case of the EU The nature of tax harmonization Tax systems may differ between countries in many ways associated with: What is taxed the tax base By how much it is taxed the tax rate What particular sort of tax is levied the tax type Even if the tax base, rate and type are the same, tax compliance and tax enforcement may differ across countries The nature of tax harmonization The process by which the tax systems of different countries are aligned with each other so that tax considerations do not influence the movement of goods, services and factors of production between countries Required when there are fiscal externalities between member states whereby one state's fiscal decisions affect other states Attempts to internalize these effects by making different tax systems compatible with each other and with the objectives of the economic union Tax harmonization The scale of compatibility ranges from nil to perfect and exactly what degree of compatibility / tax harmonization is ideal for a particular economic union will depend on the extent of integration the members aim at In an FTA where only trade barriers between the members are removed, the required tax harmonization is minimal Even fully independent states may choose to coordinate their tax systems to reduce the likelihood of tax avoidance, double taxation and etc. In a regional economic association aimed at economic and political integration some form of tax coordination is inevitable Principles of tax harmonization Significant differences in tax or fiscal systems between different countries can affect trade in : Optimality requires that international trade, factor movments and the location of production should not be guided by tax considerations Commodities and services Capital movements Labor migration The location decision of firms Intercountry fiscal affairs should be based on tax neutrality: the flow of goods, services, persons and capital and the international specialization in production should be the same with and without taxes Trade and taxation Indirect taxes and their changes affect relative prices within an economy and therefore the terms of trade between countries and thus the direction, pattern and volume of trade may be affected Taxinduced chnages in the terms of trade cause income redistributrion between: The effects of tax changes implemented by tax harmonization are similar to those derived from changes in tariff structures and cause trade creation and trade diversion The citizens of the country The country and its partners in the economic union The economic union and the outside world Trade and taxation Indirect taxes are levied on traded commodities according to the origin or destination principles of taxation Under the origin principle taxes are levied at the production stage and the country of production gets the tax revenue Therefore, exports of identical cost products from a low tax country to a high tax country enjoy an artificial comparative advantage, thus distorting the specialization of production and trade Trade and taxation Under the destination principle, which is used worldwide, taxes are levied at the consumption stage and the coutnry of consumption gets the tax revenue Therefore, countries have to make border tax adjustments, levying domestic taxes on imports and removing domestic taxes on exports Countries can gain an unfair advantage by taxing imported products at rates higher than those levied on similar domestic products and by refunding taxes on exports at levels higher than those actually paid This amounts to placing disguised customs duties on imports and subsidizing exports and therefore it is specifically banned by internaitonal agreements (ex. GATT) and forbidden in common markets Trade and taxation The destination principle of taxation, which treats imported and homeproduced good alike, ensures that firms complete on the basis of prices net of taxes It does not distort comparative costs and international competition Under conditions of perfect competition in international trade production will be located in the country with the lowest cost extax Trade and taxation In contrast the origin principle entails taxinduced trade distortions so the pattern of pretax trade is different from posttax trade The origin principle would have effects equivalent to those of the destination principle only if all trading countries apply a single tax rate to an identical tax base Since in practice tax bases differ and tax rates are many the equivalence between the two principles is only a remote theoretical possibility Trade and taxation Countries forming a customs union start with the existing destination system of taxation When they proceed to a common market and remove border controls from the member states, geographically they will be similar to a country and its regions The regions of a country operate a common tax system and tax rates and therefore in interregional trade they apply the origin principle with tax revenues accruing to the national treasury Trade and taxation It is suggested that members of a common market should adopt the restricted origin principle whereby the origin principle applies on internal trade and the destination principle remains in force on trade with the outside world There is an important difference between the regions of a country and the members of a common market The latter apply different tax systems and rates and the proceeds of taxation accrue to different national treasuries The application of the restricted origin principel in a common market is impractical for as long as the tax systems and rates of the member states differ substantially Since the border controls have been removed the only way out of this dilemma is to proceed with tax harmonization until the tax differences between the member states are erased Trade and taxation The change from one principle of taxation to another will have effects on competitiveness and tax revenues (and budgets) It may also affect relative prices and therefore trade, specialization and the location of production: allocation efficiency f the member states of an emerging common market applied different indirect tax rates under the destination principle with national markets separated by tax borders and decide to unify the market by adopting the restricted origin principle, trade flows will be affected by tax considerations n this case optimization would be reached only by forming a tax union and adopting a uniform tax system which would privde the necessary tax neutrality Therefore, in common markets and economic unions indirect tax harmonization becomes a necessity International income taxes For income taxes in an international context there are two polar principles: According to the first principle: The residence of the taxpayer The source of the income The residents of a country are taxed equaly, regardless of whether the source of their income is domestic or foreign f capital can move freely between countries and all countries adopt the residence principle, then capital income taxation does not disturb the optimality rule which requires equality of the marginal product of capital across countries and the international allocation of capital remains optimal International income taxes According to the source principle a country's residents are taxed only on income from domestic sources f the tax rate is not the same in all countries the marginal product of capital will differ between countries and the international allocation of capital will be nonoptimal The residence principle accords with tax neutrality making investors indifferent between domestic and foreign assets if the interest rates are the same f the residence principle is not universally applied within an economic union then capital flows will be governed by tax considerations and therefore tax harmonization will be necessary Tax harmonization There are two approaches to tax harmonization within economic unions:
The equalization approach The differentials approach Two methods of implenting them:
The administrative method The market solution Tax harmonization Equalization approach: Favors standardization by uniformity of tax base and tax rates among the members of the union Standardizaiton can be reachewd with or without unification of the tax system under a single fiscal policy authority Supported mainly for two reasons: Accords with the aim of economic unions to `to enhance competition on equal terms' Favored by those who consider tax harmonization as one of the driving forces for economic and politicalintegration, where equalization of rates and uniformity of taxes are deemed necessary Tax harmonization Problem of tax harmonization under the equalization approach consists of selecting and implementing the set of taxes and tax rates which will direct the economic union to realize its objective of economic integration and maximization of welfare for the economic union as a whole Tax harmonization Differentials or fiscal diversity approach: Based on the principle that the tax system of each country acts as an instrument of policy for attaining major economic objectives The same principle should apply at the scale of the economic union with the prerequisite that the externalities of each country's tax system on other countries should be minimized Based on the presumption that private (members') beneift and social (economic union's) beneift coincide Since the sum of the members welfare adds up to the welfare of the economic union the differentials approach consists of each participant selecting the taxes and tax rates which would optimize its own welfare Achieved by close collaboration among members achieved by a minium degree of tax harmonization implemented administratively Tax harmonization A variant of the differentials approach asserts that administratively imposed tax harmonization is an unnecessary interference with the price system The convergence of tax systems in an economic union should instead be left to market forces and tax competition based on the recognition that states differ in: Preferences for one tax over another Perceptions of the role of taxation Acceptability and feasibility of various taxes Preferences for public sector size Tax harmonization Therefore, taxation should be based on residence, which in an economic union depends on subjective choice Then governments will have to compete for scarce resources tax resources This will restrain the inherent tendency of governmnets to overtax and overspend, promote efficientcy in the public sector and lead to the necessary convergence of tax systems through harmonization by the market process In practice, this is, more often times than not, wishful thinking Tax harmonization... Encompasses both the equalization approach and the differentials approach Ranges from the one extreme of zero change in taxes and tax rates and the other extreme of unification of taxes and complete equalization of rates, with all variations in between Tax harmonization n general tax harmonization is multi dimensional, influencing:
all the functions of the tax system Allocation of resources Economic stabilization Economic growth ncome distribution The balance of payments Tax revenue Tax harmonization The equalization approach gives precedence to the common goals of the economic union, placing them above the goals of the individual members Under the differentials approach the presumption is that the economic association will not move further towards full integration and specifically that fiscal policy will remain in the domain of each member state Therefore, moves towards a uniform tax system, with common tax rates, imply that the members endorse the transfer of fiscal policy power from the national to the union's authority This means taht the members decided that the ultimate objective of the economic union is economic (and political) integration and that a common tax system based on tax neutrality is a direct way towards achieving that goal n this case they will cooperate to overcome tax obstacles to crossborder economic activities by tax coordination, without giving away much of their fiscal sovereignty The state of EU tax harmonization The tax systems of the original six members of the Treaty of Rome were dissimilar, reflecting important differences between the members' economic and social structures and policy objectives Sales taxes were in the form of Value Added Tax (VAT), cumulative turnover tax and taxes on gross value Excise taxes were applied to different goods in different countries, at different rates and means of evaluation Different systems of coproration taxation had differnet implications on capital mobility and investment The personal income tax system differed in rates, allowances, administrative procedures, compliance and enforcement The social security taxes and the social benefits were also diverse All these differences constituted serious obstacles to the integration of markets and were dealt with by the treaties EU tax harmonization The Treaty of Rome specifies that `the harmonization of legislation concerning turnover taxes, excise duties and other forms of indirect taxation' is a principal objective of the Community and that the laws in general should be approximated to the extent necessary for the establishment or functioning of the common market The general aim of tax harmonization was fiscal neutrality defined as equal treatment for domestic production and imports from member countries EU tax harmonization The Commission clarified that tax harmonization `is not an attempt to design an ideal fiscal system for the Community, but a blueprint for abolition of fiscal frontiers' But details about what tax harmonization and coordination involve are not provided in the treaty They are specified by special study committees and submitted to the Council by the Commission as proposals If the Council approves them, then they are issued as directives bindng on the member states EU tax harmonization Tax harmonization in the EU has aimed at two objectives: n practice tax harmonization has proved more difficult than envisaged The complexity of the problem and the widely held democratic principle of no taxation without representation which makes tax sovereignty on eof the fundamental components of national sovereignty meant that little could be achieved and at a slow pace Competition on equal terms among the EU partners, implying abolition of tax frontiers Acceleration of the process of integration and unification of the market EU tax harmonization Taxation in EU countries is based on the principles of: National competence whereby policy is exclusively 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 EUwide taxation matters can only be adopted by a unanimous vote of member states EU tax harmonization There is a difference among the EU states in terms of tax burden Despite many years of economic cooperation and several attempts at tax harmonization, the data reveal significant differences between the EU countries in both the total tax burden and the composition of tax revenues For instance, Ireland has one of the lowest tax burdens, with 33.9% while Denmark and Sweden have two of the highest with 56.8% and 58.6% respectively Both direct and indirect taxes are most important for government revenue in Denmark (17.3% and 29.5%) The highest ratio of social security taxes on GDP is in Germany and France (18.6% and 18.4%) Indirect taxes Indirect taxes enter the final prices of goods and services on which they are levied Under similar production cost conditions different principles and levels of taxation will be reflected in different market prices Tax harmonization in the Community has followed a pragmatic approach The objective of indirect tax harmonization entails a threestage process: Fiscal neutrality in intraCommunity trace Simplification of administrative procedure in this trade Creation of a single market by abolishing fiscal frontiers Sales tax harmonization First attempts: When the first moves towards trade liberalization among the members of the Community had started the Commission appointed a group of experts the Neumark Committee to review the fiscal systems of the member states and to recommend methods for harmonizing them The Committee's report (1963) recommended the introduction of a common sales tax, the VAT and the restricted origin principle which would promote integration by abolishing fiscal frontiers between the member states The Community accepted the VAT proposal t also declared that although it formally adhered to the introduction of the origin principle and the abolition of border controls, for as long as the process of building up the common market was in progress the destination principle of taxation should apply this was considered essential to reassure the member states that the revenues from indirect taxation would continue to accrue to the country of consumption of the good Sales tax harmonization From 1969 six directives have set up VAT as the common sales tax of the Community. Tax harmonization at the going phase of integration in the EU meant adopting only a common structure, but no attempt was made to intrudce a common VAT rate The sixth directive of 1977 aimed at a uniform VAT base by a common list of taxable activites and a common tax threshold a lower limit of exempted transactions An important simplification was also made by replacing an abundance of national customs papers by a single common administrative document for traded commodities Value Added Tax VAT has several advantages over other forms of sales taxes (turnover, single stage, etc.): t provides neutrality about saving, investment and work decisions, especially if the tax base is wide and there is a single tax rate t is neutral between production by vertically integrated enterprises and production by several independent firms Under the destination principle of international taxation it promotes unambiguous border tax adjustments by the exact refunding of taxes on exports and the precise nondiscriminatory levying of taxes on imports therefore, trade taxes are transparent and cannot be used as a disguised subsidy to exports or tariff on imports in support of domestic production But VAT may involve heavy administative costs for both the tax authorities and the taxpayers therefore, exemptions are usually granted to small firms since collection costs may exceed the tax revenue Value Added Tax VAT is a tax on consumer spending t is generally assumed that a general single rate (or a flat rate) consumption tax is regressive and that tax rate differentiation can change it into a progressive one therefore in some countries a variety of sensitive goods with a realtively large share in the budget of lowincome consumers (such as food, clothing, etc.) either are not taxed at all or are taxed at a lower rate, while luxury goods are taxed at a higher rate VAT is made more complicated by exemption of certain kinds of business which are difficult to fit into the scheme of tax, eg banking, insurance and some property transactions Value Added Tax VAT is a method of taxation and not a new type of tax It is a general sales tax, levied on all stages of business activity, from each stage of production through to sales to final consumers f there is a single VAT rate, then the tax is on the value added the difference between the value of inputs and output in each stage of production and distribution Businesses credit tax paid on their purchases of inputs against the tax due on their sales of output Thus the tax payments accumulate at each intermediate transaction and the final tax burden is precisely equal to that which would have been levied under a singlestage sales tax applying only at the retail stage Example of VAT (3 stage production from wool to yarn to pullover) VAT Example Example shows how complicated VAT is t charges one firm in the chian of production only to repay the same tax to the next firm t would b possible and less complicated to charge the tax at the retail stage and collect the same revenue with less fuss but this solution entails the risk that the governemnt amy suffer a high loss if the retailer were to evade the tax By taxing at each stage of production the governemnt introduces a selfpolicing control which helps tax collection VAT Example f a good is VATtaxed and tradd under the destination principle the customs know exactly the amount of tax which they must rebate on export at the border For ex. f yarn is exported the rebate is 140 adn the net export price is 1500 f the yarn is imported the tax charged is 10% on the import price After 1992 the EU has had no border customs controls on internal trade hence the changes in the system introduced by the single market The Single Market The decisive stage for completing indirect tax harmonizaiton in the Community started with the move for unification of the market and the Single European Act (SEA) A single and free internal market without internal frontiers in which the free movement of goods, persons, services and capital is ensured requires the abolition of fiscal frontiers which anyway cannot work without border controls For this reason federal states with a VAT system allocate all control over the definiton of the VAT base and the rates to the central government n contrast outside observers and certain EU states argued that the frontier obstacles can be eliminated without aligning tax rates (for ex like the USA which does not apply the VAT system) This argument expresses more an unwillingness to move to market integration rather than a realistic proposal for creating a single internal market In the USA different states apply different sales taxes without having border controls Evidence suggests that only tax differences of about 5% are as much as can be sustained without causing largescale taxdodging and crossborder shopping The Single Market The Commission proposed market unification from 1993 with tax harmonization under the restricted origin principle of taxation The first step would consist of VAT approximation by squeezing the operational VAT rates in the Community within two bands, a 49 % reduced rate for necessities and a 1420% standard rate for other goods and services The Council, representing the member states, objecte4d that this proposal would cause difficulty for countries with very high (ex. Denmark) or very low (ex. Luxembourg) indirect tax rates or for those that rely for their revenues mostly on indirect taxes (ex. Ireland) Some member states argued that harmonization would impose unwarranted constraints on their fiscal sovereignty This led to a compromise which did not advance the process of tax harmonization and thwarted the realizaiton of benefits from the single market The Single Market On January 1, 1993 the Single Market Transitional System was adopted, including the following points: All member sttes applied a legally binding minimum standard VAT rate of 15% Member sttes had the option of applying upto two reduced rates of not less than 5%, reduced and zero rates of VAT continued in those states which applied them before 1993 The destination system remained in operation but without border controls the taxable event of "importation" was replaced by "acquisition" which means that exporters do not charge tax, as in the old system, but importers from other member states pay the exporting country's tax and claim it as a liability on their VAT returns. Next they charge the domestic VAT rate and deduct inthe same way as if they had purchased the good from domestic producers Tax revenues would be allocated to the country of consumption by setting up a central clearing house for settling tax credits and debits between countries in accordance with the value they added to trqaded goods ndividuals buying goods from another country of the union by post or telephone are charged the VAT of their own coutnry as if the goods are imports. But they have the opportunity to buy them personally in unlimited amounts by crossing the border and paying the VAT of their country of purchase The Single Market The Council decided that the transitional arrangements shall be replaced by a definitve system for the taqation of trade between Member States based in principle on the taxation in the Member State of origin of the goods or services supplied The transitional system for VAT proved to be costly, administratively complex and discriminating between intra and interstate transactions, thus creating barriers to intraUnion trade and distorting the operation of the single market While plans are devised for its replacement, the transitional system still remains in operation VAT rates in some EU states Excise Tax Harmonization First Attempts: Excise taxes are specific taxes levied on certain products which are characterized by their elatively high share in consumers expenditure (up to a 5th) and low price elasticity of demand Excises are levied mainly for revenueraising reasons but sometimes also to discourage the consumption of harmful products for public health reasons, for ex. Tobacco and spirits Excise Duties The systems of operating and enforcing excise duties in EU countries displayed wide diversity Some countries operated controls based on strict production supervision and distirbution through a network of bonded warehouses while others affixed tax stamps on the product itself at the production stage The tax rate varied from country to country but in general was very high three to four times higher than the standard VAT rate High rates mean that excise tqaxes have a high incidence on prices and in genraql a wide economic impact therefore differences among the members in the structure, rates and administrqation of excise taxes have serious effects on competition on equal terms The significant divergence between the excise duty systems was maintained byt strict frontier controls that insulate domestic markets from duty systems abroad Trade is affected by intercommodity and intercountry discrimination Excise duties In assessing the proposals for harmonization of excise taxes the most important consideration is the revenue effect n some members of the Union excise taxes contributed more than 25% of the total receipts from taxes and social contributions n certain countries some commodities, which are subject to excise duties were also traded by state monopolies (ex. Tobacco in France and Italy and alcohol in Finland) and some others (such as mineral oils, tobacco and alcohol) are inputs to further processes whose output is subject to different systems of taxation. Excise duties The harmonization of excise duties in an economic union attempts to remove distortions to competition and fiscal frontiers The first steps for a common policy conerned agreement on the tax base to decide which excise duties were to be retained and harmonized Traditionally three broad groups of commodities are subject to excise taxes in most countries: Hydrocarbon oils Maunufactures tobacco and Alcoholic beverages Excise duties In the EU most of the revenue from excise duties is collected from: Tobacco products, beer, spirits, mineral oils and wine A variety of other commoditeis were subject to excise tax in different countries: Ex. Sugar in Belgium, spices in France, coffee in Germany, matches in Italy, cars in Denmark Besides tax base there is a variation in tax rates: for ex. Denmark, Ireland and the UK had the highest tax rate Excise duties Over the years the Commission put forward many proposals about harmonizing tax structures (rather than tax rates) Progress was slow because of the budgetary impact of excise tax harmonizaiton which for certain countries would have been considerable Another facet of the conflict between national priorities and Community targets Excise Taxes The Single Market: The Commission argued that the single market required uniformity throughout the Community in structure, rates and administration of excise taxes as a precondition for abolishing frontier controls t proposed that only the 3 principal excise taxes should remain after 1992 alcohol, tobacco and mineral oils and that duty rates should be standardized at about the average of national rates Problems resurfaced from the proposed uniformity of excise duties which could affect consumption, social habits, health policy and tax revenues Finally excise tax harmonization was settled by a general and definitive agreement Excise Taxes Since 1993 the EU interstate trade of products subject to excise taxes has gone through interconnected bonded warehouses On leaving the warehouses taxes are levied by the country of consumption which also appropriates the tax revenue according to the destination principle When individuals purchase goods for their own consumption in other EU member states, they pay excise tax in operation at the point of purchase Therefore, significant differences in excise tax rates may give rise to cross border shopping Competitive goods entering the EU from third countries are subject to excise taxatiion at the point of entry The agreed system induced extensive crossborder shopping, particularly between the UK and France, Sweden and Denmark, and Denmark and Germany but without any tendency for tax rate convergence from the operation of tax competition ...
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This note was uploaded on 08/06/2009 for the course INTERNATIO EU306 taught by Professor Itirbagdadi during the Spring '09 term at Izmir University of Economics.
- Spring '09