Henri Sterdyniak

Ofce

Taxation in Europe: towards more competition or more co-ordination?

Introduction

Taxation is high in EU countries. Tax-to-GDP ratios stand at around 40% compared with 25% in Japan and the US. This high level of taxation provides the funding of the European social model characterised by a high level of public expenditure and transfers. Apart from governing powers (armed forces, police, justice), the State provides free services to households (education, health); finances public infrastructures, research, culture; pays significant social transfers (family policy, minimum income) and social insurance (pensions, unemployment). Ageing populations imply higher pensions and health spending; technical progress leads to higher education and research spending; rising social exclusion implies higher assistance benefits. People ask for more public infrastructure and higher security spending. Military spending as well as aid to developing countries seem to be required if countries wish to play a major role internationally. All these elements make the rising trend in public spending difficult to resist. Besides, European countries think that public spending should be on a contributory basis. It makes sense to have people on highest incomes or wealth pay more for collective spending, as they benefit most from the way the social system is organised. Taxes must reduce income inequalities. It is hence crucial for European countries to remain entitled to collect tax revenues, according to democratically agreed rules.

Section 2 discusses how the European social model is at risk in a global world; it discusses several strategies for European taxation: competition, unification, coordination. Section 3 provides a descriptive analysis of tax structures and trends in Europe. Section 4 deals with income tax coordination. Section 5 addresses social contributions coordination. Section 6 deals with corporate taxation. Section 7 concludes with a strategy for tax co-ordination.

The European social model in a global world

In recent years, the European social model has been put under pressure both on political and economic grounds. In the last two decades, economic policy has moved from implementing social-democrat policies to free-market reforms. Priority is now given in many countries to strengthening competitiveness and the attractiveness of the country as a location of productive activities. Saying that working incentives should be increased both at the upper and lower ends of the wage scale governments wish to cut social redistribution and public spending, to cut the highest marginal income tax rates and to lower social benefits in order to make the poorer work. Governments wish to cut 'social contributions' to boost domestic competitiveness. This prevailing model makes it difficult to implement tax co-ordination in Europe.

The European social model is threatened by globalisation that puts tax and social domestic systems into competition. Free capital and products mobility enables companies to choose to locate their production among industrial economies or between industrial and emerging economies. Taxing the more mobile factors (big companies, financial capital, highly skilled workers, wealthy people) is more and more difficult, which undermines domestic redistribution policies. Some countries may choose to offer low public spending and hence need low tax revenues. These countries may thus attract wealthy foreigners, as is the case for the UK, although this is not the result of a deliberate policy. The race to the bottom strategy aiming at attracting the more mobile factors is all the more successful that a country is small (it will be able to attract relatively large capital flows that will raise its tax revenues, albeit lowering its tax rates). It may be worth for small countries to introduce low tax rates that will attract foreign capital flows (like in Luxemburg or Switzerland). Last, very small countries may decide to become a pure 'tax haven'. Competition may oblige countries either to cut their public spending or to tax mainly immobile factors: labour and dwellings. Countries lose the ability to implement satisfactory redistribution: similar incomes will not be taxed similarly. In a world with free factor mobility, taxation measures would necessarily have a similar and immediate counterpart: no redistribution would be possible. Moreover, some economic agents may adopt a free rider's behaviour and benefit from the high level of public spending in a country while being taxed in another country. For instance, a high skilled worker educated in France (owing to the free education system and family allowances) may decide to leave and work in the UK where he will not have to pay for his parents' pensions. Old and rich people may leave the country where they built their wealth to retire and die in a country where property and inheritance are tax exempt. Companies may decide to locate their profits in country different from the country where their production is located. The development of such behaviours would necessarily lead to the expansion of paying schools, private pension funds,… However, taxes and public spending have not significantly been cut as a share of GDP in Europe. The characteristics of the European social model have in no European country been fundamentally put into question. No European country has implemented the 'Big Reform', consisting in cutting strongly taxes and altering their structure. In most cases, reforms have applied to specific areas.

Will European integration, especially the Economic and Monetary Union, the single market and the single currency, add to globalisation to put pressure on European tax and social systems, or will they help securing the European social model?

The treaty establishing the European Community and the treaty establishing a constitution for Europe stress four 'fundamental freedoms': free movement of persons, services, goods and capital. However, the texts do not say anything on the need for countries to remain responsible for domestic taxation. Besides, the logic of European integration is such that the Commission wishes decisions to be taken at its level; it is thus not in favour and may even be against measures guaranteeing domestic taxation autonomy. Member states should therefore pay attention to keep their fiscal autonomy, although they rarely do.

The EU has difficulty in introducing a coherent tax system. Taxation is a symbol of domestic sovereignty and remains in the hands of national governments. Countries, and not the European legislative authorities (Parliament or Council), vote taxes and on decide on how to spend tax revenues. Introducing a taxation system consistent with European Treaties, with the subsidiarity principle and the unanimity principle shows how it is difficult to build an economic Europe without political integration. European Taxation in Europe is a political issue. What should the respective weights of national and European institutions be? Should the Commission and the Council be given a major role in future changes of the tax system or should domestic choices be maintained? What is the final objective: maintaining the social democrat model or moving towards a liberal model? What method should be used: tax competition, co-ordination or unification? European countries will have to live for a long time with contradictory objectives: keeping their domestic autonomy, remaining in charge of domestic tax policy, keeping their freedom of introducing new measures while there is a need for harmonisation. One may for instance consider that countries should be allowed to set on their own the VAT rate to be applied by hairdressers, restaurants, records, alcohol... Conversely, European institutions should check that no change in VAT rates is a protectionist measure. Criteria would need to be defined. For instance, can a country be allowed: to promote the consumption of services that are by definition not imported, to tax heavily imported luxury cars if there is no domestic production, to tax wine less than alcohol in vine-producing countries, to tax heavily alcohol in countries where alcoholism is high?

Europe has to choose between three strategies. The first one would consist in aiming -more or less rapidly-at the unification of taxation in Europe, on the one hand through the introduction of European taxes, on the other hand through the unification of domestic taxes, both in terms of rates and bases. This unification would be made necessary with the completion of the single market, the increasing mobility of goods, people, capital and companies. The elements of taxation remaining domestic would be subject to European rules (as is the case today for local taxation). This strategy currently seems an illusion. First, most countries dismiss it, wishing to keep their autonomy in taxation matters. A single tax system cannot be introduced if there is no legislative European authority entitled to vote taxes. Taxation unification requires political and social unification. But Europe has made no precise choice in terms of Society: the British, Franco-German, Scandinavian, Southern models differ widely. A single European taxation cannot be implemented as long as citizens do not move towards a federal Europe, as long as political and social institutions remain mainly national. In the current state of European integration, each country should remain free to set their level of public spending, degree of redistribution and social protection system.

Decision-making has until now been slow and technocratic at the European level. For instance, European authorities have kept claiming for lower fiscal deficits despite the economic slowdown of 2001. This shows that there is a risk that European institutions do not to account for domestic specificities.

Last, should taxation unification be understood as a single taxation everywhere in Europe, or as uniform rules decided by all: for instance, could countries catching up or being in difficult times be entitled to implement lower tax rates, albeit receiving community funds (as is currently the case at domestic levels), or not? Some think that European institutions are less sensitive to industrial lobbying than Member states, hence can more easily introduce painful reforms. But is this true? Perhaps industrial lobbying is in fact more powerful in Brussels than in Member States, where they be countered by national associations. The European level is more appropriate in some areas, such as environment. Will it be possible to maintain different benefit taxation rules if European companies develop? Europe could move towards a compromise, where some taxes would be set at the European level and some others not, which would raise difficult questions on tax controls and internal coherence of domestic legislations.

The second strategy would consist in letting tax competition play freely. Each country would remain fully responsible for domestic taxation. European citizens and companies would be free to decide where they want to settle, work, save and invest. But there is no guarantee that this strategy will lead to the taxation system European citizens would like to have. States would see their capacity of taxing the more mobile agents (multinational companies, skilled workers, financial capital) strongly constrained and this would force them to either raise taxes on immobile agents or forget about redistribution policies. A neutral liberal model would progressively develop where everyone pays exclusively for the amount of public spending they will benefit from, i.e. a model without redistribution. If taxpayers can also pay taxes in countries different from their live or work (for instance, a company benefits from public infrastructure in a given country, but locates its profits in a tax haven), public infrastructure will lose their funding. Such practices make countries open more widely their frontiers and weaken their ability to resist the impact of globalisation on their tax receipts. Full tax competition would be unenforceable in practice since taxation rules for a company operating in several countries have in any case to be defined (multinational companies, non-residents savings, etc…) In a softer version, the controlled tax competition, countries remain free to implement the taxation of their choice on their residents and companies, but harmful tax competition is forbidden, i.e. measures consisting in applying lower tax rates on non residents or new residents, or foreign companies to attract more profitable tax bases. This is roughly the view of the Commission. Derogatory regimes are forbidden, but there is no control on general regimes. Hence, a country can decide to attract rich people through abolishing wealth taxation provided this applies to all its residents. Unfortunately, controlled tax competition does not prevent the race to the bottom since smaller countries can keep on using this kind of competition, lowering their tax rates to attract more capital and rich people, while losing relatively little in terms of their domestic taxable base.

According to the tax coordination strategy, the subsidiarity principle should still prevail. Taxation systems remain national as much as possible, but are unified when necessary; the coexistence of different national taxation systems is run under codes of good conduct allowing countries to decide on the taxation of their residents. Besides, some measures are more efficient if decided at the European level. However this strategy is difficult to implement. It requires international agreements. Harmonisation, even if agreed with partners, restricts states tax autonomy.

The success of such a strategy depends on how easily countries agree on desirable taxation. Co-ordination will be difficult if some countries are very liberal while others are very sociodemocrats. Institutional reforms are thus required to allow Member States to preserve their tax revenues. The issue should also be politically debated so that each country, each People are aware of the need to protect and improve the European social model. Member States and the European Commission should implement tax co-ordination for each tax, possibly leading to unification, forbiddance of unfair practices (aiming at forbidding tax measures targeted to attract tax bases for no good reason), etc. In some cases, minimum rates could be introduced. What should be done if differences persist after discussion? We think that the countries wishing to remain responsible for domestic taxation should be entitled to it, through refusing to enforce the principles of free movement of people and capital to countries with excessively low taxation and refusing to delegate any power to the ECJ in this respect.

Tax structures: where do we stand?

The 1990's have been characterized by successive tax reforms, more or less ambitious all over Europe. Member States have been confronted with the need to raise their tax revenues in order to halt the rise in public deficits and debts entailed by low economic growth in the early 1980's and the early 1990's. The introduction of the single market in 1993 did not affect these trends: contrary to the effects expected from the opening of frontiers in the absence of tax harmonisation, tax to GDP ratios did not decline in EU countries but rather tended to rise, even if less rapidly in the 1990's than in the 1980's: the EU-15 tax burden rose from 38.9% of GDP in 1990 to 39.6% in 2003. In 2003 tax to GDP ratios were 10 percentage points higher in the EU than in Japan or the US (see table 1). Until now, globalisation and tax competition have not deprived European countries from revenues. Social contributions and taxes on goods and services have a strong weight in the EU as compared to the US, whereas personal income taxes weigh less (see table 3). Income tax is especially high in Scandinavian countries, contrary to Southern countries keeping a relatively « archaic » tax structure (Portugal, Greece, Spain). Corporate taxation is low in Germany and Austria, while it is particularly high in Finland and Luxemburg. Social contributions weigh heavily on wages in Bismarckian countries (Austria, France, Germany, Sweden, Netherlands), whereas they are relatively low in Denmark, Ireland and the UK. Taxes on goods and services are particularly high in Denmark (where their weight offsets the absence of employers' social contributions). Two main factors explain the diversity of tax structures: first, the design of social protection systems -Bismarckian (high public spending funded by contributions on wages), Scandinavian (high spending funded by income taxes), Anglo-Saxon (low public spending); second, the contrast between modern systems (high weight of income tax) and archaic systems (high weight of indirect taxes).

What degree of 'socialisation'?

Primary public spending amounts to 45% of GDP on average in continental European economies, of which 11 percentage points go to pensions, 8 to health, 3 to unemployment allowances, 3 to family/housing/poverty, 6 to education/culture, 3 to economic subsidies; 8 to collective spending; 3 to capital spending. Pension, health, social assistance and education spending are much higher in continental Europe than in Anglo-Saxon countries. Thus, any significant cut in tax-to-GDP ratios implies a similar cut in public expenditure requires privatising and, in a way or another, lower spending directly benefiting households.

Income taxation: the residence principle

According to the subsidiarity principle, each country must decide its level of public spending and degree of redistribution. This requires that the country keeps control of a significant part of its tax revenues. Yet income taxation is one of the taxes that are the less likely to generate direct tax competition, if the residence principle is applied, in other words if each country taxes all its residents' incomes. People are less mobile than capital, companies and products.

An individual may chose to more abroad to escape taxation, but will then change its residence and be taxed as a resident in the country where he lives.

However, tax competition plays more and more for higher earnings people, like stars, executives from multinational companies and wealthy people, who may decide to move abroad for taxation purposes. An executive earning euros 30,000 per month will pay an average tax rate of 38% in Switzerland, 44% in the UK, 62% in France (of which 14% are differed wages). Some countries provide specific privileges that induce unfair tax competition. EU Member States should reaffirm the right of each country to tax their residents. This means that derogatory systems allowing for different taxation on permanent, transitory (or newly arrived) residents and non residents should be forbidden.

Incomes earned and kept abroad by foreign people are tax exempt for 15 years when a foreigner settles in the UK and Ireland (remittance basis system). This allows foreigners to settle in the UK and pay no personal income tax on income earned in their native countries and transferred anywhere abroad. Such a system attracts people with high financial wealth. In Denmark and Finland, foreign executives benefit from a derogatory tax regime, in the form of an income tax rate lower than for national residents. If such unfair tax competition was to develop, some categories of the population would be exempt from paying public expenditure if they change their residence country, while earning high incomes and having in general benefited from free education spending in their native country. The French government has introduced such dangerous measures in 2003, exempting from income tax extra-earnings paid to executives moving back to France. The only acceptable measure is tax exemption on specific expenses generated by moving abroad.

Table 4 shows average tax rates in several EU countries for a two-earner couple with two children. Column a shows income tax as a percentage of disposable income: this is an indicator of the weight of personal income tax as generally felt by individuals. Column b shows total income tax payments net of family benefits as a share of total wage costs: this ratio is more economic and is not affected by the respective shares of social contributions, social benefits and taxes. The first indicator shows a larger dispersion than the second. For a two-earner couple on medium wage earnings, the first indicator varies from 7.9% in Spain to 32.5% in Sweden, while the second indicator varies from 25.2 in the UK to 46.4 in Belgium.

Countries may be split into two groups: countries where income tax is low (Spain, France, Italy, the UK), countries where it is high (Denmark, Sweden, Belgium). In terms of global tax burden, taxes are relatively low on low wage earnings in France and the UK. Taxes are also low for high incomes in Spain and the UK, whereas they are heavy in Belgium, Denmark and Sweden. All in all, the tax burden is small in the UK, but public pensions are low. Conversely, the tax burden is high in Belgium, Sweden, Italy, Denmark and France. Taxation is especially progressive in France and Belgium, but hardly in Spain and Italy. In the future, in a global world, the contradiction between incentive and redistribution policies is likely to grow. It will be easier for the upper classes, who win from globalisation, to choose where to work and pay taxes. The upper classes may refuse to support the part of the population who will be negatively affected by the globalisation process. Governments may have no choice but cut strongly highest marginal income tax rates, and even offer derogatory regimes allowing for tax exemption (like stock options), while at the same time income disparities will grow. One may consider that European countries should resist these changes and agree on a minimum tax rate for high incomes, although this would raise a number of technical issues: should an average or a marginal tax rate be set? How to distinguish taxes and social contributions? What definition for income -including or not financial income and capital gains?

As concerns wealthy people, tax competition applies also to property and inheritance taxation. In 1998, France had introduced an exit tax, i.e. French residents settling abroad had to pay 26% on accrued capital gains on financial assets. In 2004, the ECJ judged this measure not conform to the freedom of establishment.

There is thus a high risk that tax competition to attract wealthy people strengthens in Europe, the principle of freedom of establishment depriving countries with heavy taxation to react. Three strategies may then be considered:

-Race to the bottom: governments will accept not to tax wealth and inheritance, or at least will cut them sufficiently so that it will not be worth moving abroad. This would mean that the less 'tax demanding' countries will design the tax structure in all European countries, which in not very democratic.

-Isolated measures: each country would introduce measures against domestic citizens leaving abroad for tax purposes (deprivation of voting rights, honours,…). However, this may not be accepted by the ECJ.

-Affirmation of the right to tax: the countries wishing to keep on taxing their residents reject the principle of freedom of establishment in countries where taxation is too low for high incomes, wealth and inheritance. This strategy would be set by a group of countries wishing to maintain the principle of the European social model, i.e. in favour a redistributive taxation.

The choice between these strategies is a political one, and should be discussed openly.

Capital income taxation: a model of European taxation?

In most European countries, interest incomes are taxed at a lower rate than other incomes (see table 7). A few countries have maintained personal income taxation on interest income (Denmark, Spain); in the other countries, a withholding tax is levied, at rates ranging from 10 to 30%. This agreement is a model in terms of tax co-ordination.

The future of social contributions

In most European countries, the ageing of populations and the structural rising trend of health spending can be expected to translate in a rising trend in pensions and health social contributions. At the same time, many countries should increase family benefits in order to rise birth rates, that are currently well below the level at which the population would remain constant. Unemployment allowances and social assistance benefits vary according to the unemployment rate, but until now, there have been hardly any signs that continental European countries will rapidly be back to full employment. Despite all the efforts planned to postpone the effective retirement age, an increase in social contributions seems almost certain.

The rise in social contributions could be avoided if people resorted more to private insurance, but the development of private pension funds would be costly for the intermediate generation and pension funds premiums hardly differ from social contributions. The US experience does not give any evidence that private health insurance is more efficient and cheaper than public social insurance. Privatising partly pensions systems would allow for a stabilisation in tax to GDP ratios, but the counterpart would be a rise in pension funds and private insurance premiums that would need to be made compulsory so that all people remain covered under satisfactory conditions. A system combining public insurance for the poorest and private insurance for middle and higher incomes would make it possible to cut the tax to GDP ratio but would not solve the problem, since the middle class would have to pay taxes for the poorest and premiums for themselves.

Do social contributions raise a tax competition issue? Not in principle, as concerns the social security contributions that finance more or social benefits (pensions, unemployment, workplace injuries, and maternity allowances). These systems are not fully contributory since these have a redistributive element (for instance, executives with a low probability of being unemployed pay for workers who have a higher risk of being unemployed; men pay for women, as concerns pensions). But the contributory element is probably high enough for employees to realise that social benefits are part of their earnings. A rise in pension contributions to finance pension benefits will be accepted more easily by contributors than a rise in taxes. However, employees' contributions only should be increased so that company competitiveness is not directly affected. The competitiveness of public pension benefits as compared to private pension funds should be ensured, i.e. public pension rights should be reaffirmed, tax incentives for pension funds should be restricted to a EET type system for the income tax, with no social contributions rebates.

Besides, only contributions financing contributory benefits should be based on the 'wage bill' while other benefits should be financed by taxes. This logic is not always applied in Europe.

Family benefits are financed by social contributions in several countries (Belgium, France, Italy for instance), this can also be the case for health benefits (Germany, Austria, Belgium, France). This way of financing benefits is neither socially fair, nor economically justified in times of mass unemployment.

Two examples show how the issue could be tackled: CSG in France and IRAP in Italy. The CSG was introduced in 1991 and extended in 1997, which has allowed for the abolition of employees' health contributions. The CSG allows for financing part of family and health benefits on the basis of all households' incomes instead of wages only. Hence, employees' social contributions now finance insurance benefits only. Conversely, employers still finance family and health benefits. None of the successive governments have dared introduce the logic reform that would have consisted in basing family and health expenditure on total value added. Governments stepped back due to the huge size of inter-company transfers it would have entailed. They also feared that such a reform would have had a negative impact on the more capitalistic branches, assumed to be the more modern ones.

In 1998, Italy substituted health contributions based on labour only (at the rate of 11.46%, however with many rebates), with IRAP (regional tax on productive activities), taxing all net value added components at the rate of 4.25%. This taxation ensures tax neutrality, whatever production technique is chosen by companies and, relatively to wage-based contributions, should be an incentive for companies to use more labour and fewer machines and to favour labour intensive activities. However, IRAP was forbidden by the ECJ, on the motive that VAT is the only taxation that may be applied to value added. This decision paralyses unfairly tax reforms. It has no justification because a tax that does not hit imports and is not reimbursed on exports has no competitive advantage as compared with social contributions.

VAT weighs on imports but not on exports, contrary to social contributions. Hence tradingoff percentage points of social contributions with percentage points of VAT provides competitiveness gains, similarly with currency devaluation. But these gains will persist only if the rise in imported consumer goods prices generated by the rise in VAT has no impact on wages, i.e. if employees accept purchasing power losses. Let us assume that consumers consume 20 of imported products and 80 of domestic products. Domestic production is 100, 20 is exported. Labour is the only production factor. Initially, prices and wages are worth 1, wages 80, the employers' contribution rate is 25%. These contributions are replaced by a VAT of 25%. The following day, import prices are 1.2; domestic production prices on the domestic market are 1, export prices are 0.8 (since VAT is not paid on exports). The domestic economy has benefited from competitiveness gains (+20%). A tax of 4 has been shifted from production to imports. But these gains have been obtained thanks to a loss of 4% in workers' purchasing power. If workers get a pay rise compensating for this loss, and if this pay rise impacts prices, then wages again, prices and wages will rise until prices have risen by 20%. Competitiveness gains will have been transitory. No tax reform may by miracle provide competitiveness gains without employees losing purchasing power.

In Germany, environmental taxes have been raised (by 0.8% of GDP) in order to finance oldage benefits and to avoid any rise in employers' and employees' contributions (which would have needed to rise by 0.85 percentage point each). The contributory principle has been lost. In Sweden, a similar reform has been introduced, aiming at rising environmental taxation by 1.4% of GDP from 2001 to 2010, in order to cut personal income taxation and employers' contributions.

These measures are part of the 'double dividend' logic: environmental taxes would have two advantages. They would be an incentive for reducing the use of polluting products and the revenues they would generate would allow for lower labour taxation. In fact, three strategies can be considered. The rise in environmental taxation may be counterbalanced by subsidies for the production of each type of products; by a subsidy to each producer depending on its past polluting activity; last at the level of all companies by lower employers' contributions.

The first two reforms have the advantage of not penalising directly polluting companies, but they are difficult to implement. They require an accurate knowledge of production processes.

How would new companies be considered? How to account in permanence for technical progress? If polluting companies are given an incentive for changing their production techniques, households have no incentive for not buying goods produced with polluting techniques. The third strategy hits directly polluting companies, raising their production costs.

The rise in prices is an incentive for households to buy other products. This strategy does not require any microeconomic analysis and allows subsidising labour.

The combination of environmental taxation and of cuts in employers' social contributions may generate, at no cost for public finances, lower pollution and less unemployment. This is more likely to occur if the country concerned is initially far from full employment. However environmental taxation revenues are all the more high that the price elasticity of demand for taxed products is low. A contradiction may thus arise, between ecological aims (strong and targeted taxation will be efficient only if it generates ex post limited revenues) and aims for profitable taxation in terms of tax revenues. Last a fiscal reform affecting significantly the structure of company costs implies costly reallocations of activities: some activities will not be profitable anymore and will have to be stopped. Some other activities will become profitable, but will require new investments. In any case, such reforms should be co-ordinated at the European level in order to avoid some countries becoming the preferred production site of polluting companies.

It does not seem possible, in the current state of European integration to unify or even have a convergence of national social protection systems, while at the same time market unification in Europe makes it more and more difficult for different systems to coexist. A European company located in seven European countries has to handle seven social protection systems. Will this mosaic resist the increase in labour mobility in Europe and the increase in the number of trans-national companies? There is a major risk that tax competition operates through social contributions, i.e. through lower benefits or their privatisation. This would be in opposition with the European social model.

Social protection should remain purely national as long as social life, trade unions and social negotiations are done at the domestic level. The systems today have extremely high disparities across Europe, in terms of pensions, unemployment and health benefits. The risk is that, under the principles of free competition and establishment, private insurance companies become entitled to compete with public pensions and their redistributive element. Hence, countries concerned should clearly state that the principle of free competition should not apply to social insurance regimes, with social or redistributive aims. Each country remains responsible for implementing a sufficiently attractive system at the European level, while remaining sufficiently redistributive. The task would of course be easier if social standards were set at the European level: minimum income, old-age income, family benefits (as a percentage of average income in each country), universal health insurance; minimum pension income (as a percentage of wages in the country). Deciding if such issues are part of the European social model is a political choice. Adopting such standards would reduce the risk of social competition.

Corporate taxation coordination

The company tax burden is not easy to estimate precisely because it is difficult to breakdown accurately taxation affecting companies, workers and households: in which category are employers' social security contributions or the Italian IRAP? For a company deciding to settle in a country or another, all taxation measures may have their importance, including personal income tax to be paid by their executives while public expenditure and transfers benefiting their workers will also need to be taken account.

Let us consider a company aiming at profit rate of π after taxes. Its production cost is thus: c=(1+c c )wn+(rθ+(1-θ) π/(1-s)) k where θ is its borrowing ratio, s: the corporate tax rate, c c : the employers' social contribution rate.

The wage is: w=(1+t)(1+c s )ω where t is the VAT rate, c s : the employers' contribution rate and ω the real disposable wage. So:

c=(1+c c )(1+t)(1+c s ) ω n+(r θ+(1-θ) π /(1-s))k
Thus, the total cost depends on the whole taxation, the ratio between disposable wage and labour productivity, finally on the corporate tax rate. Social security contributions and the VAT play entirely symmetrical roles.

According to a relatively arbitrary definition (corporate taxation + wage tax + property firm tax+ taxes on company capital + local taxes), the company tax burden generally varies from 3 to 5% of GDP in Europe, but is higher in France (6.1%) and Italy (5.7%) and well below in Germany (1.3%, see table 8).

In addition, the analysis of companies' financial situation shows that, almost everywhere in Europe, the wage share in value added was lower in 2004 than in 1990 and 1973, while the profitability index was higher (see table 9). It is thus currently unnecessary to consider introducing tax reforms increasing company profits at the expense or workers or public revenues.

6.1.Local taxes on firms

Companies are subject to local taxation in all European countries, except in Sweden and the UK. Local taxation raises four problems: the tax base must be located, which necessarily implies taxing production factors (labour, fixed assets, buildings) rather than company benefits; local taxation may come in contradiction with national policy orientations, in particular as regards tax relief; it generates inequalities between local administrations due to the discrepancies in tax potential and these inequalities are cumulative; it generates tax competition between local administrations, at the detriment of deprived areas. European countries have tackled these problems in different ways, also varying from time to time, ranging from the abolishment of local company taxation in the UK to autonomous local taxation of productive activities in most countries. In term of tax competition, a choice has to be made between these two models, since maintaining local taxation may require the introduction of a minimum rate at the European level.

All European countries, except Sweden and the United Kingdom, have a taxation of company's property. Seven Member States -Germany, Belgium, Spain, France, Italy, Luxembourg and Portugal -use specific local company taxation, levied on several bases (fixed assets, wage bill or number of employees, profits, value added, etc). Several countries introduced reforms of local company taxation in the 1990's, either to reduce tax competition on these taxes, or to ensure a better adequacy with national taxation policy objectives. Thus, in Germany, the 'professional tax', previously set on fixed assets and wage bills, is now based on profits. In France, the reform of the professional tax, undertaken from 1999, led to the progressive suppression of the wage bill from the base, in order to reduce labour costs. Moreover, the ceiling of the professional tax as a percentage of value added implies that many companies pay local taxes as a proportion of their value added. In Italy, IRAP directly is based on value added. Each of these tax bases has specific advantages or disadvantages (se table 10).

Table 10. The choice of local taxation base

Will corporate taxation survive?

Although corporate taxes amount only to a small share of tax revenues, they are a very sensitive issue for companies. For the last twenty years, governments have convinced themselves that company profitability was crucial for investment and therefore employment. Besides, tax competition has strengthened: with the opening of frontiers implied by globalisation, large companies put domestic tax systems into competition when making their location decisions. So, almost all EU Member States have reduced their corporate tax rates in the 1990's.

Corporation tax revenues are highly volatile since they are based, in a non-linear way and with variable delays, on company profits that fluctuate with the economic cycle (see table 11).

Corporation tax revenues rose from 2.3% of GDP in 1995 to 3% in 2000, following the improvement of companies' accounts (rise in mark-ups, lower interest rates) before falling down to 2.6% in 2002. Corporation tax revenues are relatively similar in all European countries, about 3% of the GDP. However Austrian and even more German revenues are dramatically lower than in the average EU, many entrepreneurs choosing to set individual companies. Revenues are much higher in Finland (since 1997, owing to new technology activities), Netherlands and even more Luxembourg (owing to high profits in the banking sector). Most EU Member States have cut their corporate tax rates in the 1990's (see table 12). Germany had two tax rates: 36 and 50% (for respectively distributed and retained profits, the latter being more heavily taxed because they were exempt from dividend taxation), which were cut down to a single rate of 25% by the reform introduced in 2000. The French rates (42% on distributed profits, 37% on retained earnings, less taxed in order to support investment) were cut down to 34.33%. In Denmark and Sweden, rates declined from 50 to 30%. Taxation is dramatically low in Ireland (12.5% in general, but 10% for industrial sectors). Except Ireland, rates range from 28 to 35%. However, the comparison is made difficult by the existence of local taxation that may be levied on profits (Germany), value added (Italy), capital (France) and even more by substantial differences in the assessment of the tax base (in particular depreciation rules). In the 1990's many countries have widened the tax base while cutting their tax rates, in order to design a more neutral system. New Member States have generally lower rates than the old Member States (see table 13) and they consider cutting further their rates so as to compensate for the abolition of state aid to companies, changes in basis determination rules and to attract foreign direct investment.

In a report on company taxation in Europe, the Commission ( 2002) measured the extent of the divergences between tax systems. It calculated an average effective tax rate, i.e. the tax rate levied on a standard investment with a return of 20% before tax (see table 14). The charges levied on companies for domestic investments are relatively disparate in Europe. However, rates range from 28% to 32% in most countries, except Ireland (10% only) and Sweden 23%, whereas Belgium, France and Germany have tax rates of 35%. Apart from Ireland, these disparities are not likely to generate substantial capital movements. However, the risk exists that the downward trend in tax rates turns into excessive tax competition.

The basic principles for corporate taxation

Corporate taxation can be considered as a tax on companies' shareholders or as a tax on companies themselves, as a counterpart of the advantages companies draw from the infrastructures of the country where they have located their production (from this point of view, taxation should also be levied on borrowed capital). Benefit taxation may rely on two principles. According to the source principle, a country may tax all benefits generated at home, either by residents or non-residents. Thus, in a country applying the source principle, domestic benefits of foreign groups entities will be taxed and national companies will not incorporate their profits earned abroad in their taxable profits (as a counterpart, foreign losses will not be deducted). According to the source principle, corporation tax is a tax on companies, and corporate tax rates may differ between countries to reflect differences in the services provided to companies.

A country applying the residence principle must tax all incomes earned by national residents, whether earned in the country or abroad. Foreign losses can be deducted from profits.

According to this principle, corporate taxation is levied on company owners.

At the international level, the source principle should apply. Residence is an ambiguous concept for companies. The residence principle would allow firms to escape taxation if they locate in a tax haven. So in a given country foreign firms could benefit from an unfair competitiveness advantage by escaping to taxation. With the source principle, all firms operating in a given country are subject to the same tax rate: this ensures neutrality for capital imports. But it may be feared that a company from a given country is encouraged to invest in countries with low tax rates: there is no neutrality for capital exports. This fear is not justified if low rates only compensate for a lack of infrastructure, geographical distance, political risks… The other problem is profit shifting: firms could try to localise their profits in countries with low tax rates by manipulating transfer prices, royalties and interest payments.

Some countries accept that their international companies produce consolidated benefits, in other words, the principle of residence: these companies can consolidate all losses and benefits of their subsidiaries or branches world-wide, deducting the taxes paid abroad from their domestic taxes.

Corporate taxation and the single market

The current system is unsatisfactory. Two kinds of critics can be made. For companies (and for the Commission), the main problem is that countries have different rules for assessing tax bases, which complicates the operating of trans-national companies. Discriminations according to the nationality of parent companies and subsidiaries remain. Some incomes are subject to double taxation. Transfers between parent companies and their subsidiaries are managed under a disparate set of bilateral conventions that must be re-examined when one of the partner countries modifies its legislation.

For Member States, the main problem is tax rates disparities. Large companies are incited to optimise their taxation by carefully choosing the location of their headquarters, of their subsidiaries, of their financial transactions. They can use transfer prices, intra-group borrowing and royalties to locate their profits in the countries where tax rates are the lower. This generates costly surveillance policies for governments and exerts pressure on Member States to decrease their taxation rate. The need to avoid costly tax competition, the European single market, the rising number of European companies (settled in several European countries) make it increasingly necessary to co-ordinate corporate taxation at a European level.

The Commission tries mainly to ensure tax neutrality for trans-national investments: firms should be able to invest anywhere in Europe without taxation being a source of economic distortion. Directives have been implemented in order to avoid double taxation and to limit tax optimisation practices. The Commission has also introduced procedures to fight harmful tax competition among European countries. However, corporate taxation co-ordination at the European level can only be limited because of Member States' taxation autonomy.

An option would be to generate a progressive convergence of the tax systems in the EU. This convergence would suppose agreements on taxation principles, tax base harmonisations and minimal tax rates. This would raise difficult issues: how to account for local taxation? Should reduced rates for less-developed countries, areas or sectors in difficult economic situations be authorised? Who, between the Member States and the Commission, would have the initiative of introducing measures aiming at reducing taxes temporarily (in bad times) or permanently (to boost R&D spending, for example)? Accounting for the subsidiarity principle in taxation, the Commission gave up pursuing this strategy.

On

On tax base harmonization

The Commission ( 2001) suggested a reform of the tax base, with four alternative possibilities. Two suppose a compulsory system:

-A European Union company Income Taxation (EUCIT) will unify corporate taxation all around Europe. In the long run, it is the best solution, but it supposes that countries agree to lose all autonomy in that field. Countries with low tax rates will have to raise them. They can agree only if their possibilities to subsidize their firms are increased. So, Member States should agree to leave all industrial policies at the European level. It is not realistic nowadays.

-A harmonised Tax base (HTB) unifies the bases, but lets each country free to choose their tax rate. But a common basis main would exacerbate tax rate competition.

Two introduce an optional system for European firms:

-In the Common Tax base system (CTB), a European firm could chose to compute its whole profits according to some specific European rule.

-In the Home State Taxation system (HST), a European firm could chose to compute its whole profit according to the rules of the country of the parent company.

In both cases, the profits of a group would be shared between the various Member States in which it operates, according to some allocation keys (added value, wage bill, etc), each State taxing the profits returning to their country. The principle of profit sharing, already used in the US and Canada, according to appropriate allocation keys impedes profit shifting practices.

However, these proposals raise many difficulties:

-In the HST system, companies would have the possibility to choose between 25 rules. Some countries may choose very favourable regulations to attract headquarters. The system would be incontrollable by national administrations. Tax competition will not be totally avoided.

-Even in the CTB system multinational firms would be taxed differently (and, in fact, less) than national firms.

-It seems difficult that subsidiaries of a multinational corporation make a tax assessment only to the tax administration of the country of the head office. How would the coherence of the subsidiaries' tax assessment be ensured in the host country? Profit assessment allows national administration to check the consistency of value added and wage bill assessment. The simplification at firms' level has a counterpart, which is the loss of control for national administrations.

On tax rate harmonisation

So we do not see how Europe could escape painful negotiations on convergence of corporate taxation. Corporate taxation is not the most appropriate tool to attract firms to locate in less developed countries or deprived areas, due to risks of profit shifting (companies may benefit from low tax rates in a country while producing mainly elsewhere). Our preferred strategy would be to exchange the corporate taxation convergence against more freedom given to Member States to subsidize their companies. This could be done in four steps:

-Some convergence of the tax bases.

-Clear recognition of the source principle. In fact, the logic would be to tax the 'net operating surplus' rather than profits. European taxation could progressively move in this direction with the introduction of taxes like the Italian IRAP.

-Introduction of minimum rates, depending on the level of development reached by the country, for instance 20% for New Member States and 30% for the old Member States. The lower minimum rate will increase as countries converge. Countries providing specific advantages to companies could of course set a rate higher than 30%, at their own risk.

-Less developed countries would be allowed to subsidise their companies (possibly via the EU structural funds), with value added or wage bill bases, rather than through low corporate tax rates, so as to minimise the risks of profit shifting. Company subsidies could also be allowed more easily for regions or economic sectors in difficulty, aid for innovation and research.

In any case, the fight against tax havens should be strengthened, at the European or world levels. Companies and financial institutions should not be allowed to have subsidiaries or to transfer funds in these countries.

On dividends taxation

Value added goes to wages, interest, dividend incomes and non distributed profits. Fair taxation would ensure that all these elements are similarly taxed. This would suppose, in particular, that social contributions (for pensions, unemployment benefits, etc.) are well differentiated from taxes. For interest income, taxation should apply only to real interests. Similarly, the logic would be that real capital gains are taxed like dividends. Then, the question of corporate taxation arises. Can this tax be considered as a tax on the owners of the company, which would justify taxation under the residence principle or like a tax on the company (but in this case, why not tax interests)?

Let us consider a country where the corporate tax rate is 33.3%; the maximum income tax rate is 50%; the tax rate on bond interest income is 25%. Effective taxation is 50% on high wages; 42% on real bonds income (for an interest rate of 5% and an inflation rate of 2%). The tax rate on dividends is 33.3% (if dividends are completely tax exempt), 50% (if dividends benefit from an imputation system), 50% (if they benefit from a rebate of 50%), 66.7% in the event of double taxation. The tax rate on capital gains is 33.3% if they are exempt from income tax (and if capital gains equal retained profits); 50% if they are taxed at 25%. On the whole, the coherence of taxation is not automatically guaranteed.

The imputation system is logical if corporate tax is considered to be a tax on company owners. The double taxation system could be justified if corporate tax is a specific tax on firms. But this would suppose that the corporate tax is also levied on interests and that its rate is strongly reduced. The schedular tax system is a compromise that makes it possible to adapt income tax and corporate tax rates.

In 2003, five countries maintained the imputation system (see table 15): France2 , Italy, Spain, Finland and Sweden. One country has integral double taxation: Ireland (but the corporate tax rate is very low). The Netherlands tax financial assets independently of their effective returns. Dividends are exempt of income tax in Greece. In six countries, dividends are subject to a double taxation, but with a schedular tax system: they are incorporated in total income after multiplication by a reduction factor (Germany, Austria and Luxembourg). If t is the marginal rate of income tax, s the corporate tax rate and x the reduction factor, the total tax is: s + (1s)x instead of being t. This system is all the more unfair for the taxpayer that t is low. For example, if s = 33 %, x = 0.5, a household taxed marginally at 50 % will be taxed at 49.75 % on its dividends; a household taxed marginally at 30% will be taxed at 43%. This system has no fair logic; x is arbitrary. In four countries, capital gains are not subject to taxation. Only six countries ensure the same tax rate on dividends and capital gains.

The ECJ requests that the same system is applied to domestic and foreign dividends. In practice, this forces countries to adopt an income-tax scheduled system. The fairness of this system is arguable. Let us imagine for example a country A where the corporate tax rate is 33.3 % and with a scheduled taxation of dividends at 25%. The income tax rate is 50% (see table 16). In the neighbouring country, B or C, the corporate tax rate is 20%. The total tax rate for savers in A, who invest in B, is 40%. This is not justified since profitability is the same in B and A. But if the low tax rate compensates for some economic disadvantages, as in C, such a discrepancy can be justified. However, this compensation would not exist in an imputation system. The imputation system reduces the impact of tax competition. So, switching from an imputation system to a schedular system supposes an overall agreement on tax rates levels, countries with high rates accepting lower rates in less developed countries or having natural disadvantages. Another option would be to standardize corporate tax rates, to maintain the imputation system while allowing countries to give direct subsidies to their companies. The Netherlands Rate: 30%. Base: 4 % of asset value.

46%

1. We assume that dividends are taxed at the maximum income tax rate. We include the amount of the corporate tax already paid by the company on behalf of the shareholders. 2. We assume that the company made a 10% profit before-tax, of which 2 points are distributed in the form of dividends. Capital gains equal retained profit; total capital gains are imposed.

Conclusion

Unfortunately, there are no simple solutions in the field of tax harmonization. Until now, European countries seem to have more or less succeeded in maintaining their desired level of redistribution and public expenditure. However, it is difficult to say if lower taxation on the richest and companies results from globalisation constraints or reflects rising trends of liberal ideas.

Europe will have to live for a long time in a contradiction between capital and goods markets where unification is rapid, and taxation (and more generally budgetary, social and political institutions) that remain national. In far as taxation is concerned, the problem is institutional:

Community authorities and the States should care for maintaining the ability of countries to tax their residents, and political: tax co-ordination will be easier if all governments agree explicitly to maintain the European social model, i.e. significant and redistributive taxation to finance public expenditure and transfers.

Basically, Europe can choose between two strategies. The first consists in maintaining the European social model, characterized by a significant level of transfers, public expenditure and thus of taxation. The system will have to be preserved from tax competition by harmonisation in Europe that will have to include the prohibition of unfair competition, the introduction of minima rates in certain cases, and by tough measures against tax havens at a worldwide scale. The European Social Model will have to rely on its comparative advantages (free education and health for all, public infrastructures, social security benefits) to remain competitive in spite of globalisation. The second strategy consists on the contrary in moving towards a more liberal model, where privatisation of welfare will allow for cuts in tax rates that are assumed to promote employment, education and vocational training, savings and investment. This strategy supposes that Europeans agree to live in a Society with rising inequalities. Tax competition would then a tool to support this trend.

But what should be done at the European level if European countries wish to make different choices?

Table 1 : Tax to GDP ratios, percentage points

 1

	1990	2003

Table 2 . Tax to GDP ratios in the EU*

 2

	1990	2002

*As a percentage of GDP; Source: OECD, Revenue Statistics 2004.

Table 3 . Tax revenue structures, in terms of tax bases in 2002

 3

	As a percentage of GDP
		Ger.	Austria	Belg.	Den.	Spain	Fin.	France	Greece	Ireland	Italy	Lux. Neth. Port. Swe.	UK EU-15 Japan USA
	Income taxes	10.1	13.0	18.3	28.9	10.4	18.6	10.5	8.9	11.1	14.1	15.4	10.7	9.6	17.7	13.5	12.6	7.8	11.8
	Of which
	-Households	9.1	10.6	14.8	26.0	7.1	14.3	7.6	5.1	7.4	10.9	6.8	7.2	6.0	15.3	10.6	9.9	4.7	10.0
	-Companies	1.0	2.4	3.5	2.9	3.2	4.3	2.9	3.8	3.7	3.2	8.6	3.5	3.6	2.4	2.9	2.7	3.1	1.8
	Wage taxes	14.5	17.4	14.7	1.9	12.6	12.2	17.4	11.8	4.5	12.5	11.2	13.9	9.2	17.5	6.1	12.6	9.9	6.9
	of which:
	-Social security contributions	14.5	14.7	14.7	1.7	12.6	12.2	16.3	11.8	4.3	12.5	11.2	13.9	9.2	15.1	6.1	12.3	9.9	6.9
	-Wage taxes	0.0	2.7	0.0	0.2	0.0	0.0	1.1	0.0	0.2	0.0	0.0	0.0	0.0	2.4	0.0	0.3	0.0	0.0
	Property taxes	0.8	0.6	1.5	1.7	2.4	1.1	3.3	1.7	1.5	2.2	3.4	2.1	1.1	1.6	4.3	2.4	2.8	3.2
	Taxes on goods and services	10.5	12.4	11.4	16.2	10.2	13.9	11.2	13.4	11.2	11.4	11.7	12.1	13.9	13.3	11.7	11.4	5.2	4.6
	Other taxes	0.0	0.5	0.5	0.2	0.1	0.1	1.6*	0.1	0.1	2.6** 0.1	0.4	0.1	0.1	0.2	0.6	0.0	2.9
	Total	36.0	44.0	46.4	48.9	35.6	45.9	44.0	35.9	28.4	42.6	41.8	39.2	33.9	50.2	35.8	39.6	25.8	26.4

Table 4 . Average tax rates in 2001, two-earner married couple, two children, spouse earning 70% of husband's wage

 4

	Wage level/APW	0.7		1		2		3		5
		a	b	a	b	a	b	a	b	a	b
	Germany*	0	33.2	9.5	40.2	27.1	48.0	34.6	48.7	40.3	48.6
	Austria*	1.6	25.1	13.8	35.7	27.7	43.8	35.6	45.4	41.4	46.9
	Belgium*	20.8	39.9	28.2	46.4	39.1	56.4	49.9	62.2	48.9	66.0
	Denmark**	28.5	33.1	32.5	37.2	43.9	48.0	49.1	52.9	53.0	56.8
	Spain*	3.3	30.6	7.9	33.9	16.9	40.3	21.0	40.2	29.2	40.7
	France*	6.6	23.5	11.2	40.0	16.9	47.9	21.5	51.0	27.5	54.9
	Italy*	13.4	38.0	16.9	42.8	25.8	49.8	30.3	53.0	34.5	56.0
	Netherlands**	12.4	27.1	15.5	32.0	30.1	41.1	37.9	43.6	43.6	46.7
	UK**	12.8	19.0	16.1	25.2	21.5	32.2	26.8	36.1	32.2	40.3
	Sweden**	26.2	42.8	29.0	46.1	37.0	53.1	41.4	57.4	48.4	63.4

a) Personal income tax/net wage; b) (Personal income tax+social contributions-family benefits)/super gross wage earnings. In France, personal income tax includes CSG/CRDS. * Entitles to proportional retirement pension; ** Entitles to lump-sum retirement pension.

Source: Author's calculations, based on OECD, Taxing

Wages, 2000Wages, -2001Wages, , 2002. .

A common trend towards lower tax progressivity can be seen among European countries. The French higher marginal tax rate has declined from 56% in 1988 to 48% in 2004. Since 1988, higher marginal tax rates have been cut by 11 percentage points in Spain and Germany. The introduction of a 2-rate threshold, with the highest rate set at 33% is being considered in Italy. These trends follow the strong cuts of higher marginal income tax rates introduced in the US in the early 1980s as well as in the UK, where the highest marginal tax rate was cut from 98% in 1979 to 40% in 1988. The highest marginal tax rates currently stand around 50% in the EU (except in Spain: 45% and the UK: 40%, see table

5

).

Table 5 . Higher marginal income tax rates in 2003 (%)

 5

	Germany	48.5
	Austria	50
	Belgium	56.2
	Denmark	59
	Spain	45
	Finland	53.8
	France	53.2
	Italy	46.4
	Netherlands	52
	UK	40
	Sweden	55.5
	Japan	50
	US	45.35

Source:

Table 6 . Taxes on households' wealth

 6

	As a percentage of GDP, in 2002	Taxes on wealth	Inheritance taxes
	Germany	0.01	0.14
	Austria	0	0.07
	Belgium	0	0.46
	Denmark	0	0.19
	Spain	0.17	0.22
	Finland	0.08	0.32
	France	0.16	0.60
	Greece	0.07	0.23
	Ireland	0	0.12
	Italy	0	0.06
	Luxembourg	0 .71	0.14
	Netherlands	0.01	0.38
	Portugal	0	0.07
	Sweden	0.16	0.13
	UK	0	0.23
	Switzerland	1.04	0.31
	Japan	0	0.29
	US	0	0.32

Source:

Table 7 : Interest income taxation in Europe, in 2003 (excluding derogatory regimes) Interest incomes included in taxable income, with bank assessment to the administration

 7

	Denmark	Personal income tax (maximum rate: 59%)
		Withholding tax
	Spain	Personal income tax (maximum rate: 45 %)
		Withholding tax: 18 %

Interest income generally included in taxable income, no bank assessment to the administration requested

	Portugal	Personal income tax (maximum rate: 40%)
		Withholding tax: 20%.
	Luxembourg	Personal income tax (maximum rate: 42 %)
		No withholding tax.
	Germany	Personal income tax (maximum rate: 48.5 %)
		Withholding tax 25% (bonds) or 30 % (bank deposits).
	UK	Personal income tax (maximum rate: 30%)
		Withholding tax: 20 %

Choice between withholding tax and income tax with bank assessment to the administration

  After long negotiations between EU countries and neighbouring countries(Switzerland, Monaco, etc…) an agreement was reached in 21 January 2003 and a directive came into effect on 1 July 2005. The directive sets out the generalisation of exchange of information in Europe. However, Austria, Belgium and Luxembourg have refused it, opting instead for a withholding tax (15% in 2005, 20% in 2007, 35% in 2010; 75% of the tax revenues being paid back to the taxpayer's residence country). Monaco, Andorra, Liechtenstein, Switzerland, San Marin, associate territories of the Member States have agreed to levy a similar withholding tax. This agreement is a compromise, but has the advantage of ensuring that each country may tax their residents and prevents tax competition. The agreement is an incentive for Member States to introduce measures against tax havens, especially when they are nearby.

	Belgium	Rate: 15% or personal income tax
	France	Rate: 15% (+ 10% of social taxes) or personal income tax (+10%)
	Withholding tax
	Austria	Rate: 25%
	Finland	Rate: 29%
	Greece	Rate: 10% (bonds) or 15% (deposits)
	Ireland	Rate: 22 %
	Sweden	Rate: 30%.
	Italy	Rate: 12.5 % (bonds) or 27% (deposits)
	Asset taxation
	Netherlands	Tax base: 4% of market value of financial assets (shares and bonds)
		Tax rate: 30%
	As countries do not tax non-residents incomes, the single Market could have allowed

households' financial assets to escape from any taxation if invested abroad. Taxpayers are supposed to assess their incomes to their national tax administration, but the latter have hardly any possibility of checking interest income assessments. Non-taxation of non-residents financial incomes was clearly a typical case of unfair competition.

Table 8 : Company taxes, in % of GDP in 2002

 8

		Corporate	Property	Others	Total	Employers' social
		tax	Tax			contributions
	Austria	2.3	2.7	0.1	5.1	7.0
	Belgium	3.5	0	0.1	3.6	8.8
	Denmark	2.9	0.2	0.5	3.6	0.3
	Finland	4.3	0	0.3	4.6	9.2
	France	2.9	1.1	2.1	6.1	11.1
	Germany	1.0	0	0.3	1.3	7.1
	Greece	3.8	0	0.0	3.8	5.6
	Ireland	3.7	0.2	0.3	4.2	2.7
	Italy	3.2	0	2.5	5.7	8.7
	Luxembourg	8.6	0	1.8	10.4	5.2
	Netherlands	3.5	0	0.7	4.2	4.6
	Portugal	3.6	0	0.2	3.8	7.0
	Spain	3.2	0	0.0	3.2	8.9
	Sweden	2.5	2.4	0.4	5.3	12.2
	UK	2.9	0	1.7	4.6	3.4
	Czech Republic	4.6	0	0.1	4.7	11.1
	Hungary	2.4	1.2	0.2	3.8	9.1
	Poland	2.0	0.2	0.7	3.1	4.8
	Slovak Republic	2.7	0	0	2.7	8.3
	Japan	3.1	0	1.2	4.3	4.5
	USA	1.8	0	1.6	3.4	3.4

Source:

OECD (2004)

Table 9 . Indicators of companies' situation

 9

		Wage share in value added	Profitability
					index*
		1970	1990	2004	2005*
	Germany	72.1	66.8	65.6	100.9
	Austria	73.2	77.2	69.6	141.9
	Belgium	66,6	70,1	70,7	96.7
	Denmark	74,5	70.6	68.1	139.2
	Spain	72.5	68.3	65.3	104.7
	Finland	71.7	73.5	63.0	154.3
	France	73.7	69.6	66.3	122.5
	Greece	78.1	72.2	64.6	100.5
	Ireland	79.4	67.4	55.2	177.3
	Italy	79.4	69.9	64.1	120.6
	Netherlands	70.8	66.4	69.2	96.1
	Portugal	72.9	67.0	76.4	70.7
	UK	74.1	75.4	74.2	133.6
	Sweden	70.9	70.7	69.4	136.5
	Japan	68.5	69.3	66.2	83.8
	USA	72.5	68.1	65.9	134.7

Table 11 . Corporate taxes, % of GDP

 11

		1980	1990	1995	2000	2002	2002*
	Austria	1.4	1.4	1.5	2.0	2.3	5.2
	Belgium	2.2	2.4	2.8	3.6	3.5	3.5
	Denmark	1.4	1.5	2.0	2.4	2.9	2.9
	Spain	1.2	2.9	1.8	3.0	3.2	3.3
	Finland	1.4	2.1	1.8	6.0	4.3	4.5
	France	2.1	2.3	2.1	3.1	2.9	6.1
	Germany	2.0	1.7	1.1	1.8	1.0	1.3
	Greece	0.9	1.6	2.0	4.6	3.8	3.8
	Ireland	1.4	1.7	2.8	3.8	3.7	3.9
	Italy	2.4	3.9	3.6	2.9	3.2	5.7
	Luxembourg	6.6	6.4	7.4	7.2	8.6	10.4
	The Netherlands	2.9	3.2	3.1	4.2	3.5	4.1
	Portugal	0.9	2.3	2.6	4.1	3.6	3.6
	UK	2.9	4.1	3.3	3.6	2.9	4.5
	Sweden	1.2	1.7	2.9	4.0	2.4	3.1
	EU15	2.1	2.7	2.3	3.0	2.6
	Hungary			1.9	2.2	2.4
	Poland			2.8	2.5	2.0
	Czech Republic			4.9	3.8	4.6
	Japan	5.5	6.5	4.2	3.6	3.1	3.2
	USA	2.9	2.1	2 .6	2.6	1.8	3.2

* With local wages and property taxes,… Source: OECD, Revenue

Statistics, 2004.

Table 12 . Corporate tax rates in 1990 and 2004

 12

		1990	2004
	Austria	30	34 (25 in 2005)
	Belgium	43	34
	Denmark	50	30
	Finland	33	29 (26 in 2005)
	France	42 distributed profit	35.4
		37 retained profit
	Germany	36 distributed profit	25 (39.3 with solidarity tax and local tax)
		50 retained profit
	Greece	46/ 40 industry	35 (32 in 2005)
	Ireland	43/ 10 industry	12.5/ 10 industry
	Italy	36	33 (37.25% with IRAP)
	Luxembourg	34	22.9
	The Netherlands	35	34.5
	Portugal	34	27.5
	Spain	35	35
	Sweden	52	28
	United Kingdom	35	30
	EU15 (average)	41.8	34.7

Source:

Table 13 . Corporate tax rates in the New Member States

 13

		2004
	Cyprus	10
	Estonia	0 (retained profit)/26
	Hungary	16
	Latvia	15
	Lithuania	15
	Malta	35
	Poland	22
	Slovak Republic	25
	Slovenia	25
	Czech Republic	24

Table 14 . Effective corporate taxation in the EU

 14

	In 2001	Nominal corporate tax rate Rate used for the calculation* Average effective taxation rate
	Austria	34	34	27.9
	Belgium	39	40.17	34.5
	Denmark	30	30	27.3
	Finland	29	29	26.6
	France	33.33	36.43	34.7
	Germany	25	39.35	34.9
	Greece	37.5	37.50	28.0
	Ireland	10	10	10.5
	Italy	36	40.25	27.6
	Luxembourg	30	37.45	32.2
	The Netherlands	35	35	31.0
	Spain	35	35	31.0
	Portugal	32	35.20	30.7
	Sweden	28	28	22.9
	United Kingdom	30	30	28.3
	* It includes corporate and local taxes.
	Source: European Commission, 2002.

  December 1, 1997, the Ecofin council adopted a Code of Conduct, i.e. a set of measures aiming at fighting harmful tax competition. 230 regimes were pointed at as potentially likely to generate unfair competition, i.e. at impacting the location of activities within the European Union on artificial grounds. Derogatory tax regimes where Member States offer preferential tax treatment, i.e. support a category of companies (for example non residents) to the detriment of the others (for example residents) are contrary to the Code of Conduct. But low taxation -applied to everyone-is not considered unfair and is seen as a sign of good management of public finances. The Code of Conduct made it possible to remove a certain number of preferential tax systems. But the core issue remains: what global tax competition is acceptable?

Table15. Taxation of shares' income in Europe

	Legislation 2003	Dividends	Capital gains	Taxation rate Dividends 1 /Global 2
		Imputation system
	France	IT + social contributions; tax	26% if cessions are above a	57.7% /53.6%
		credit (50%)	ceiling.
	Italy	Withholding tax (12.5 %) or IT	12.5%	42.25%/42.25%
		with tax credit (58.73%)
	Sweden	IT (specific rate 28%); tax credit	28%	28%/28%
		(28/72 %)
	Finland	IT (specific rate 29%); tax credit	29%	29%/29%
		(29/71%)
	Spain	IT (45%) with tax credit (40%) 15%	49.0%/46.35%
		Schedular system
	United Kingdom	IT with specific rate (10% or	IT (with rebate according to	45.75%/51.75%
		32.5%) and tax credit (10%)	detention length if capital gains
			exceed a ceiling)
	Portugal	Withholding tax : 20%	10 % on real capital gains	44%/38%
	Denmark	IT with specific rate (28 or 43%) As dividends	60.1%
	Belgium	Withholding tax: 25%	Exoneration	50%/45%
	Germany	IT on 50% of dividends	Exoneration	54 %/44.15%
	Austria	IT on 50% of dividends	Exoneration	50.5%/39%
	Luxembourg	IT on 50% of dividends	Exoneration	44.3%/35%
		Exoneration
	Greece	Exoneration	Exoneration	37.5%
		Double Taxation
	Ireland	IT (42 %)	20% on real capital gains	47.8%/32.4%
		Asset taxation

Table 16 . Savings' profitability for a resident of country A

 16

		Country A	Country B	Country C
	Profitability ex-ante	15%	15%	12%
	Corporate tax rate	33.3%	20%	16.7%
	Profitability after CT.	10%	12%	10%
	Prof. with imputation	7.5%	7.5%	6%
	Prof. with 25% taxation	7.5%	9%	7.5%

E-mail : sterdyniak@ofce.sciences-po.fr

* Mainly professional tax; ** Mainly IRAP. Source: OECD, Revenue Statistics, 2004.

* 100 in 1970-73. Source: EU

France adopted the schedular system in 2005.

Local taxation on companies raises problems similar to tax competition between countries. There seems to be a trend towards taxing value added. Rates should be relatively uniform in each country, but could possibly be slightly modified depending on specific advantages provided by the local administration or specific disadvantages generated by the company: a minimum rate could be settled. Tax competition should be regulated by the State, with lower rates being allowed for local administration suffering from high unemployment and revenue losses being offset through state funding. This would require that the State transfers revenues between local administration, in order to compensate for their different tax potentials. Incorporating local taxation in corporate taxation co-ordination would remain a difficult issue at the European level.


Jean-Paul Fitoussi

ECB Objectives and Tasks: Price Stability vs. Lender of Last Resort

Both the a ction and the communication strategy of the E CB rely on the assumption, explicitly stated, that inflation is always a monetary phenomenon, and that the interest rate instrument should be devoted exclusively to dealing with inflation pressures. According to this prior, the ECB structured its intervention in the interbank market around short term liquidity injections, leaving the interest rates unchanged. This strategy is different from the one pursued by the Fed, that instead used (especially in a first phase) interest rate cuts to reduce the interbank rates. Both strategies were efficient in reducing short term interest rates to their 'normal' level. But they proved different in what concerns their effect on longer term rates. The rate reduction of the Fed also had effects on long run rates, while the spread in the euro zone remained quite high. Thus, from a macroeconomic perspective the two strategies are different, the one followed by the ECB being more restrictive. We may think that this was not an unintended consequence, as the ECB had explicitly asserted its will to tighten its monetary stance. The Briefing paper concludes highlighting the risk, for the ECB credibility, of such an indirect strategy.

During the last audition in front of the Committee for Economic and Monetary Affairs President Trichet defended the ECB stance in the midst of the subprime crisis, advancing a revised and sophisticated version of the neutrality argument. President Trichet's argument can be summarized as follows:



First, in line with m onetarist t hinking, inflation is an essentially m onetary phenomenon, at least in the medium-to-long run. As I noted in a previous Briefing Paper, this essential and somewhat radical assumption explains the particular importance that money aggregates growth takes in the actions and communication of the ECB; it also explains the refusal to consider differences between headline and core inflation when assessing monetary conditions in the Euro area.

 Second¸ in accordance with the treaties, any other policy objective of the ECB has to be subordinated to the inflation objective.



Third, the main instrument to affect the intermediate objective of m oney growth remains the interest rate, in spite of t he increasing difficulties posed by the development of financial markets. As a consequence, interest rates only have to be used to keep inflation near the objective level of around 2%.



Fourth, other problems, as for example ensuring liquidity needs of the banking sector in order to avoid a systemic crisis, need to be addressed without hampering the main objective of price stability; thus, on one side interest rates cannot be used for other objectives, and on the other any other operation by the ECB should not affect the medium run target growth rate of money supply.

Consistently with these a rguments, the ECB has followed in the past months a straightforward and predictable strategy, both in its actions and in its communication strategy.

The Crisis and the Need for a Lender of Last Resort

The subprime crisis represents a typical case in which solvency and liquidity problems are difficult to disentangle. Nevertheless, it is almost a unanimous opinion that in late August and in September the crisis was hitting the credit sector without r egard to the actual solvability of the individual institutions, thus creating an important systemic risk. Thus, in spite of the difficulties for central banks to act as Lenders of last resort (LLR) in a context of increasing sophistication of the financial system, the praise for the early intervention of the Fed and the ECB was unanimous. Nevertheless, this intervention took a very different form across the ocean.

The ECB and the Fed in Action, Fall 2007.

The ECB remained faithful to its credo and to its priorities. The key Euro area interest rates stayed unchanged since the latest rise, in June 2007 that brought the marginal lending facility rate at 5% and the Main Refinancing Rate (REPO) at 4%. At the time the ECB had hinted about further raises in the fall that it did not carry on. On the other hand, the grimmer growth outlook, and the significant rate cuts of the Fed, that triggered a troublesome appreciation of the Euro, did not induce the ECB to revise downwards its rates, nor to foresee possible cuts in the future.

The subprime crisis was primarily dealt with through short term refinancing operations that provided the very short term liquidity that the system needed, without nevertheless increasing the long term amount of money. If we look at figure 1, where I plotted the allotted funds in the weekly auctions for REPO markets (7 or 14 days), and the ratio of the allotted value over the bid value (a broad indicator of demand rationing), we can observe that no major trend appears between the January-July and the August-January periods. In fact, the average allotted funds even slightly decreased in the second half of the year. Thus, overall, liquidity injections in the system stayed constant. What changed, on the other hand, are the variability of both the allotted funds and the ratio of satisfied bids. These two facts, taken together with the lack of intervention on interest rates, prove that the ECB was eager to provide the required liquidity to the system, but only on a very short term, to avoid fuelling inflation. The strategy pursued by the Fed was rather different. At least in an initial phase, the US central bank used the interest rate instrument to curb the interbank rates (LIBOR), and to inject liquidity into the system. The first reaction of the Fed was a reduction of the Primary Discount Rate, in order to narrow the band for short rates (figure 2). Subsequently, the Fed cut all rates in five different occasions, keeping the window constant. Overall, Fed Funds target rates went down 225 points in 4 months.

Late in the Fall, the Fed also turned more massively to open market operations, most notably through the creation in December 2007 of the Term Auction Facility (TAF), where banks could borrow using a broader set of assets as collateral, thus transferring part of the risk of bad loans to the Fed. The TAF has been successful in providing the short term liquidity that the system needed. Facing continuing turbulence on credit markets, on March 7, 2008, the Fed announced that it will almost double the amount allotted through the TAF in the auctions due to take place in March 1 . Figure 3 shows the reference interest rates for the ECB and the 1 week Euribor. By comparing it with figure 2, it may easily be verified that while very different, both strategies succeeded so far in bringing down to acceptable levels the spread between short term rates in the interbank market and the target rates. It may actually be said that the ECB was more successful in stabilizing short rates, even if this is explained to a large extent by the different severity of the crisis in the two zones. Nevertheless, broadening the perspective we realize that the two strategies yielded very different outcomes in the credit markets, with potentially important macroeconomic consequences.

The choice of neglecting interest rates and focussing on short term liquidity injections, while successful to compensate the short term rate hikes, was not neutral with respect to the yield curve. Figure 4 shows the spread between the long term (3 months; higher maturities yield very similar graphs) interbank rates and the target rates for the two areas. It can be seen that this spread was comparable in June 2007, while today it is much higher in the Euro zone than in the US. Access to long term credit is today more expensive in Europe. The strategy followed by the Fed, as of today, seems to have been more neutral with respect to the yield curve, and to have worked in providing liquidity to the system while not tightening the monetary stance.

What the recent events seem to have proven, furthermore, is that it is impossible to cut the link between interest rates and liquidity. Using both instruments (and even mainly interest rates, as seems to have been the case with the Fed) is less disruptive and more effective. After all, the existence of such a link should not come as a surprise. We have known for a long time from standard textbook analysis that the link between interest rates and liquidity may be broken either because interest rates are abnormally low, or because money is perfectly neutral.

The first case, known as the "liquidity trap", is a pathological situation in which monetary policy is notoriously ineffective (Japan is the most famous and recent example of such a case). For what concerns money neutrality on the other hand, it may be argued convincingly that it holds in the long run; but today only the ECB seems ready to behave as if money was neutral also in the short run.

Unintended Consequences or Strategic Choice?

We may attempt at a different explanation for the behaviour of the ECB. Maybe, instead of being excessively dogmatic, it may have simply acted strategically. The ECB could have been aware of the consequences on long term rates of i ts decision to keep rates unchanged; then, it could have willingly l et the markets carry on the restriction of the monetary stance that it had planned and announced before the summer.

Nevertheless, if this explanation were true, the consequences for the macroeconomic environment would not be unintended; but we could have even more serious unintended consequences on the credibility of the institution. Markets would rightly feel that the ECB uses external shocks to implement its policies without clearly stating the objectives. For an institution that has often been accused in its short history to be insufficiently transparent in its decision process and in its policy choices, this could become an even harder problem to resolve than excessive inflation or a recession.

Fig 2 -Federal Reserve Target Rates and Interbank Short Rate.

	6.8
	6.3	Primary Discount Window Rate
	5.8
	5.3	Interbank 1 Week Rate
		Fed Funds Target Rate
	4.8
	4.3
	3.8
	3.3
		Source: Datastream
	2.8
	1/6/07 20/6/07 9/7/07 28/7/07 16/8/07 4/9/07 23/9/07 12/10/07 31/10/07 19/11/07 8/12/07 27/12/07 15/1/08 3/2/08 22/2/08

1 http://www.federalreserve.gov/newsevents/press/monetary/20080307a.htm

Fig 3 -ECB Target Rates and Interbank Short Rate.

	6.8
	6.3
	5.8
	5.3	Euro Marginal Lending Rate
	4.8
						Interbank 1 Week Rate
	4.3
	3.8	REPO
	3.3
	Source: Datastream
	2.8
	1/6/07	20/6/07	9/7/07	28/7/07 16/8/07	4/9/07	23/9/07 12/10/07 31/10/07 19/11/07 8/12/07 27/12/07 15/1/08	3/2/08	22/2/08
				Fig 4 -

Spread between 3 Months Interbank Rates and Target Rates

	0.9
	0.7
				EURO
	0.5
	0.3
	0.1						USA
	-0.1
	-0.3
		Source: Datastream
	-0.5
	15/6/07	4/7/07	23/7/07	11/8/07	30/8/07	18/9/07	7/10/07 26/10/07 14/11/07 3/12/07 22/12/07 10/1/08	29/1/08	17/2/08

We have to admit though that the period is characterised by a growing uncertainty about the level of the "natural rate of interest". It may well be that the crisis did have an effect on the latter, may be increasing it, and that we would be in a position to judge what was the best strategy only in retrospect. But our imperfect knowledge about the level of the natural rate of interest itself should lead us to prefer the strategy aimed at combating the gravest danger: depression and debt deflation.


Jean-Paul Fitoussi

ECONOMIC AND MONETARY AFFAIRS

Inflation and Trade

The first fact we can observe is that the past three decades were characterized both by an upward trend in world trade (measured as exports over GDP) and a downward trend in inflation (measured as yearly change in CPI), if we disregard the first half of the nineties. The following figure shows these trends quite well. The figure also shows that both trends accelerated since 1995.

If we look at a number of selected developed countries (figure 2), we can observe that the sharp decrease in inflation began even earlier, while the rest of the world experienced very high inflation rates until the mid 1990s (the average inflation rate of developing countries computed from the IMF's International Financial Statistics, is on average 36% between 1980 and 2000)

The increase of world trade is of course not necessarily the only factor explaining the dramatic decrease in inflation. In a speech in 2004 1 , former Fed Chairman Alan Greenspan argued that innovation and productivity increases were among the factors explaining the trend in inflation. Nevertheless, he argued in the same speech that "Because of a lowering of trade barriers, deregulation, and increased innovation, cross-border trade in recent decades has been expanding at a far faster pace than GDP. As a result, domestic economies are increasingly exposed to the rigors of international competition and comparative advantage.

In the process, lower prices for some goods and services produced by our trading partners have competitively suppressed domestic price pressures." Similarly, a recent study from the IMF2 attributed to trade a significant portion of the observed reduction in prices, while at the same time warning about the possibility that this effect could only be transitory.

Inflation -Decade Averages

How can globalization affect trade?

A number of channels through which globalization and trade affect inflation have been highlighted in the recent debate:

1. The more straightforward is the direct effect of cheap imports, which reduces the overall price level in industrialized countries. This effect is larger for countries that have a higher share of imports in domestic consumption3 .

2. Related to the former, there is the substitution effect of cheaper imports for domestic goods. According to the ECB monthly bulletin, of August 2006, China and new member states have seen their exports to old member countries of the EU double from 1995 to 2004.

3. Trade openness has also an effect on domestic prices, through the downward pressure that it exerts on wages of sectors more exposed to foreign competition. The threat of delocalization and of outsourcing has been used to moderate wage growth and to keep labour costs low.

4.

A global economy also tends to reduce bottlenecks and capacity constraints, thus reducing the sensitivity of inflation to domestic supply problems. Supply and demand are increasingly determined on a global scale.

5. Finally, increased competition implies a process of selection in the domestic market, with less efficient firms driven out of business. This implies an increase in overall productivity and a decrease of prices.

To these factors, often mentioned in the literature, I believe it is worth adding what I call the contestability effect:

6. Even when the share of imports is low, and hence the direct effect plays a limited role in affecting inflation, the simple threat coming from potential competitors will force domestic producers to keep prices low. The notion of market contestability, introduced by Will Baumol in oligopoly theory, fully applies to international trade, and explains why the reduction of inflation also appeared in relatively closed economies (like the US for example).

The Burden of International Competition

Nevertheless, if we attribute to trade globalization the positive effect on inflation, we are immediately faced to a contradiction. Contestability and increased international competition should have an impact on mark-ups as well as on prices, and we should have observed a tendency to compression of profit margins. Now, as figure 3 shows for the case of France and the USA (the only countries for which reliable data on the capital stock were available), this is not the case. For both countries profit rates (computed as the ratio of value added net of wages, revenue taxes and consumption of fixed capital over the stock of capital)

have shown fluctuations that are related with the business cycle, but no clear trend. If anything, we observe a tendency to increase since the early 1990s. Even profitability, obtained by adding capital revaluation to profits, shows no trend.

The explanation to this contradiction lies in the financial globalization that has accompanied the trade globalization described above. Capital --the most mobile production factor --has moved or threatened to move where it was more profitable. The worldwide surge of FDIs and outsourcing responds, among other things, to this objective. This has weakened the bargaining power of the less mobile factor, labour. In fact, since the early 1980s, the increase in productivity has not been passed to the wages. Figure 4, where I plot an index of productivity (GDP/employment) divided by the real hourly wages in the manufacturing sector (broadly speaking, the inverse of the wage share), shows that the trend has been upwards in the past three decades. 1 9 7 9 1 9 8 0 1 9 8 1 1 9 8 2 1 9 8 3 1 9 8 4 1 9 8 5 1 9 8 6 1 9 8 7 1 9 8 8 1 9 8 9 1 9 9 0 1 9 9 1 1 9 9 2 1 9 9 3 1 9 9 4 1 9 9 5 1 9 9 6 1 9 9 7 1 9 9 8 1 9 9 9 2 0 0 0 2 0 0 1 2 0 0 2 2 0 0 3 2 0 0 4 2 0 0 5 Most of the pressure coming from competition by the globalized economy has been put on labour, thus allowing prices to decrease without significant reductions in profit rates that on the contrary show no downward trend.

Capital Rentability and Profitability

Inflation, Globalization and Monetary Policy

In a world where inflation seems to be less and less a domestic phenomenon, researchers have been asking whether this changes the framework for monetary policy. The first obvious consequence of the established link between globalization and (dis)inflation is the necessity to frame the debate on inflation targeting and monetary policy effectiveness in new terms: if the generalized disinflationary trend that we observed in the past quarter of a century has mainly external reasons, domestic policies, and notably inflation targeting, do not have the significant impact which is generally agreed upon. An indirect proof of this argument comes from the United States, where the Fed had actively pursued a double objective of growth and inflation; in spite of this strategy, the long run inflation level in the US decreased as much as other comparable countries where central banks followed strict inflation targets. It is also worth noticing that, at the same time, the growth performance was much more satisfactory than in other areas as for example the EMU. Q3 1971 Q1 1973 Q3 1974 Q1 1976 Q3 1977 Q1 1979 Q3 1980 Q1 1982 Q3 1983 Q1 1985 Q3 1986 Q1 1988 Q3 1989 Q1 1991 Q3 1992 Q1 1994 Q3 1995 Q1 1997 Q3 1998 Q1 2000 Q3 2001 Q1 2003 Q3 2004 Q1 2006 GER ITA FRA USA Source: IMF -OECD -Datastream. Calculations of the author (1991 = 100)

Nevertheless, the debate is not settled yet, and it is probably too soon to be able to say a final word on the issue. The research agenda boils down to answering the following question: Are the effect of globalization on inflation formation permanent or not? Answering this question in one sense or in another will entail important consequences on the design of monetary policy.

Two recent articles may be taken as representative of the different positions in the field. The first is an article by Lawrence Ball 4 arguing that most of the effects of globalization on inflation are temporary, in the sense that they are linked to the current transition towards a more integrated world. Once the transition accomplished, concludes Ball, inflation will become a domestic monetary phenomenon again, and central banks will have to go back to business as usual and keep targeting inflation.

Opposed to this view is another, exemplified by an essay of Kenneth Rogoff 5 , who argues that Globalization has modified so deeply the economic environment that inflationary pressures are today permanently lower than in the past (notably through the increased competition that makes prices and wages more flexible).

While it is too soon for fully fledged empirical analyses to shed some light on the question, a number of recent papers begin giving some partial answers. A first result, that goes in Ball's sense is that the direct effect of trade openness (through imports, see item 1 above) is significant, sizeable, but temporary 6 . On the other hand, nevertheless, a number of papers 7 show through sector level analyses that the effect of increased competition on productivity, prices and wages produces a permanent downward pressure on prices.

Developed, emerging and developing economies are undergoing through a process of deep structural change that is evident even to the casual observer. The balance of domestic and international factors in determining inflation seems to be irrevocably shifting towards the latter, thus challenging Ball's thesis. But then, in this new environment in which inflation partially escapes its control, monetary policy acquires room of manoeuvre that can be used to pursue other objectives, notably economic growth.

4

  Ball, L. M. (2006). "Has Globalization Changed Inflation?" NBER Working Paper, 12687. 5 Rogoff, K (2004), "Globalization and Global Disinflation", Economic Review, Federal Reserve Bank of Kansas City.6 See for example Ihrig, Kamin, Linder and Marquez (2007), "Some Simple Tests of Globalization and Inflation Hypothesis", Board of Governors of the Federal Reserve System 7 An example is Chen, Imbs and Scott, (2004), "Competition, Globalization and the Decline of Inflation" CEPR Discussion paper no 4695.

IMF "How Has Globalization Affected Inflation?", Chapter III of World Economic Outlook, April 2006

The ECB monthly bulletin of August 2006 provides an estimate of this direct effect of the European Union