Tax solidarity as a prerequisite for the survival of the EU

The fundamental values of the European Union, such as the single market, open borders, or the rule of law, should include tax solidarity between Member States. EU countries are losing more and more income due to the transfer of profits by international corporations to tax havens, and some countries within the community are involved in this process—not only the smallest ones, such as Cyprus, Luxembourg, or Malta, but also countries at the very core of the Union: Belgium, the Netherlands, and Ireland.

A game worth billions

Nearly 40% of the profits of multinational corporations are transferred to tax havens, as shown by a study made by three scientists, Thomas Tørsløv, Ludvig Wier, and Gabriel Zucman. This process lowers global CIT revenues by approximately 10%, which amounts to over $200 billion. The most affected countries include France, Germany, and the United Kingdom—which lose between 20% and 30% of CIT revenues—and the United States, with losses estimated at 19%. Poland loses about 3–4 billion PLN annually (5%–10% of CIT revenues).

Although countries are taking steps to reduce this phenomenon, the problem has not diminished: between 2015 and 2017, the value of globally shifted profits increased by as much as 20%, from $616 billion to $741 billion . This growth is clearly faster than the nominal GDP growth in the world at that time.

Bermuda, the Cayman Islands, the Bahamas, the Seychelles—when we hear about tax havens, we usually think of these small island countries. This is only part of the truth. Tax havens are also right next to us—Cyprus, Luxembourg, Malta, Belgium, the Netherlands, Ireland, or Switzerland. By applying specific legal regulations, they attract the profits of global companies. What’s wrong with that? Such actions violate the fundamental principle behind the global tax system: profits should be taxed in the country they were actually made in. If a country encourages corporations to transfer profits artificially, it always does so at the expense of other countries.

How does this work?

Artificial profit shifting takes place mostly by: interest payments, royalty payments, and favourable transfer pricing. Multinational companies use  subsidiary companies that are characterised by low employment and usually have no production activity in the country they are established in. They also play a major role in the entire global capital group, e.g. they own the logo of the entire corporation, and they make other companies from the group pay for the use of this trademark. How much? In principle, any amount; after all, it is very difficult to estimate how companies located in different countries benefit from operating under a specific logo. This way, a special purpose vehicle can attract almost unlimited capital.

It is no coincidence that special purpose vehicles are particularly popular in the Netherlands and Ireland. These countries are the ones that encourage international corporations to create them, using friendly legal regulations and tax preferences for this purpose.

They artificially attract capital which, even if taxed at a low rate, gives them additional budgetary revenue. The aforementioned Tørsløv, Wier, and Zucman reported that approx. 20% of CIT revenues in Belgium, approx. 40% in the Netherlands and Switzerland, approx. 60% in Ireland and Luxembourg, and over 80% in Cyprus and Malta result from artificially transferred profits.

Moreover, international capital very often does not end its journey in these European countries. It is transferred further to traditional tax havens, e.g. in Bermuda, the Cayman Islands, the Bahamas, or the Seychelles. Research shows that European tax havens are often ‘transit countries’ for international capital, a gateway that opens the way for them to traditional havens. A major element is the institutional consent to questionable capital transfers. An international corporation that would like to artificially transfer profits, e.g. from Germany to Bermuda, would be immediately monitored by the local tax administration. The case is similar in Poland and most other EU countries. But not in the Netherlands, Ireland, or Switzerland. Therefore, companies often treat these countries as an intermediary that serves to allocate their capital to a country where the tax burden is minimal.

The consequence of these operations is that, as scientists from the International Monetary Fund estimate, as much as 40% of direct foreign investment in the world is phantom investments. Their primary goal is to avoid paying taxes rather than to allocate capital in another country productively.

Why don’t international companies transfer their profits from Poland or Germany to traditional tax havens directly? In such a case, the Polish or German tax administration could question these operations immediately. On the other hand, when capital is being transferred to another EU country, there is much less room for questioning such a transfer. However, European tax havens do not mind the further transfer of profits to small island nations—after all, the profits were not produced in their country anyway, and they can keep a slice of the pie for themselves.

First of all—tax solidarity!

At the beginning of our discussion about possible solutions to this problem, one thing must be made clear: it is impossible to introduce any of them without a basic sense of solidarity between the EU countries.

The EU treaties state that income taxes are the competence of the Member States, and any solution at the EU level requires unanimity. Unanimity in tax matters will not become a reality unless the interests of the community are placed above the narrowly understood national interest of European tax havens, i.e. what I refer to as tax solidarity.

To expect European tax havens to voluntarily agree to tax solidarity is, of course, utopian thinking. Therefore, perhaps they need to be forced into it. Firstly, there is a need for action at the political level: let’s start openly calling certain EU countries tax havens and start stigmatising the regulations that promote the artificial draining of profits from other countries. It is necessary to create a coalition in the EU, which is losing billions of euros on the artificial transfer of profits.

Secondly, the lack of tax solidarity should have economic consequences. If the allocation of funds from the currently planned European Reconstruction Fund is made partially dependent on the assessment of the rule of law in EU countries, then it would be even more justified to link this process with an assessment of the extent to which a given country acts to the detriment of other EU countries in tax matters.

The position of the Dutch government is hypocritical, as it opposes unconditional aid to the countries most affected by the epidemic, while the Netherlands has been using unfair practices for many years, draining the budgets of other Member States, including those of Southern Europe.

According to the Tax Justice Network, the Netherlands ranks fourth in the world for contributing to tax avoidance by global corporations. The first three are: the Virgin Islands, Bermuda, and the Cayman Islands.

The European Commission regularly creates its own list of tax havens. The problem is that EU countries are not included in the verification process. Wrongly so. Had the EU assessment criteria also been applied to Member States, at least four of them—the Netherlands, Ireland, Luxembourg, and Malta—would have been blacklisted as tax havens. If we wish to force all EU countries into tax solidarity, not only should the Member States be included in the assessment process as a tax haven, but the European Commission should also be able to impose sanctions on those that do not meet the criteria of fair tax jurisdiction.

It’s high time for pan-European taxes

Only after fulfilling the first condition—tax solidarity—will it be possible to move on to the next item, i.e. specific proposals for changes in European taxes. In this context, there are at least a few ideas worth discussing.

Their primary assumption is that some regulations concerning the taxation of international corporations should be moved from the national level to the EU level, not only because attempts to force corporations to pay taxes at the national level are increasingly doomed to fail, but also because the EU needs financial independence to overcome its identity crisis—sources of income other than direct contributions from member states. And taxing multinational corporations is ideal for this end.

The first idea is a digital tax, i.e. creating separate regulations for the taxation of global companies operating in the digital space. In this world, after all, it has become even more difficult to link income to its place of origin. From a corporate perspective, this means that it is even easier to demonstrate income where taxes are very low or non-existent. Work on digital tax has been going on for several years now. The major challenge is to divide the profits of the digital giants among the different tax jurisdictions, or how to put national borders on the Internet. Some countries (e.g. France and Czechia) are becoming impatient with the negotiations dragging on and have decided to introduce a digital tax on their own. There is no doubt, however, that only a supranational solution, at least EU-wide, can be truly effective.

The second issue is the fee for using the common market. This entails introducing a one-off or recurring fee for companies from outside the EU that wish to operate on the EU market. This way, they would contribute to the construction of the EU legal infrastructure proportionately to the benefits they derive from it. Meanwhile, such a solution would improve the competitive position of European companies.

The third proposal is a border carbon tax. The idea is to compensate for the costs related to the climate policy that are incurred by manufacturers in the EU and beyond. Costs to companies in the EU are currently higher than in most other regions of the world. A border carbon tax would be imposed on goods imported from outside the EU. The amount of this tax would depend on the emissions of the production process of a given good and whether the manufacturer incurred appropriate costs in its own country in connection with CO₂ emissions during production. The most problematic issue, however, will be to determine the carbon footprint of goods whose production process involves several countries. However, the European Commission is already working on solutions in this regard.

Uniform rules will seal the system

Two other possible solutions do not constitute new potential sources of EU income, but rather aim to eliminate the problem of tax evasion at the EU level, and thus to increase CIT revenues of each of the Member States (perhaps apart from EU tax havens).

The first is the Common Consolidated Corporate Tax Base (CCTB). The idea behind this solution is to introduce uniform rules for determining taxable income in all Member States. Companies operating in different countries could then determine income at an EU-wide level. The EU institutions would then use the developed formula to divide this income between the countries in which the company operates. Each country would have the right to tax this income at its own rate. This solution is therefore aimed at reaching harmonisation similar to that in the case of VAT: states would be free to determine the rate, but the general principles of taxation would be uniform.

The second possible tool is the compensation tax, something being tested in the United States, for example. In this case, the tax is calculated twice. The first time according to the standard rules. The second time, it is calculated at a reduced rate, but the most frequently used payments for tax avoidance, e.g. the aforementioned costs for using the logo, are excluded from the tax base. The company then transfers the higher of the two values to the tax administration. In this way, companies are limited in their ability to use various questionable financial flows.

Havens are not cool

One of the common reactions I encounter when talking or writing about the problem of tax havens is the question of what is actually wrong with countries like the Netherlands acting as tax havens. After all, other countries can also lower taxes and create preferential regulations for international capital. Let’s make tax havens everywhere!

This process has been going on for over a decade. This is referred to as a race to the bottom. Countries are beginning to compete with one another on tax rates and regulations, gradually reducing the taxes paid by large companies. Between 1997 and 2019, the average CIT rate among the current EU members fell from 35% to 22%. A similar decline was recorded in the effective taxation of corporate income, i.e. taxation taking into account various allowances and exemptions. It is now 16%, while it was 24% at the beginning of the 21st century.

Meanwhile, the demand for state-funded benefits—pensions, quality education, and healthcare—is not decreasing. Consequently, in order to pay for public goods, the state must either incur debt or raise other types of taxes, e.g. on labour or consumption. This is what is happening in many EU countries—ever lower taxes on large companies are being compensated for by increasing public debt and taxation of ordinary citizens. Tax havens are really not the direction in which we should be headed.

Polish version is available here.

Jakub Sawulski – head of the macroeconomics team at the Polish Economic Institute and Assistant Professor at the Warsaw School of Economics, author of the report Tax unfairness in the European Union: Towards greater solidarity in fighting tax evasion.