By Mitch Yoshida, Mayme and Herb Frank Research Fellow
In response to the Eurozone crisis, European policymakers have agreed to numerous measures aimed at addressing its underlying causes. In this context, Marco Fantini – a European Commission official who heads the Directorate-General of Taxation and Customs’ Quantitative Analysis Section – explains the Commission’s growing role in reforming EU Member States’ tax policies; how this could boost economic growth, improve public finances, and reduce trade imbalances in the common currency area; and the implications of such reforms for transatlantic foreign direct investment.
Q: Since the start of the Eurozone crisis in 2009, a wide range of policy measures have been put into place in an attempt to resolve the crisis and prevent its recurrence. Could you explain your work in the context of these broader efforts?
A: There is, now, a much stronger focus on preparing country-specific recommendations that go into far greater detail than was the case in the past. There is also greater willingness, not only on the part of the Commission and other European institutions, but in Member States generally, to discuss these issues in a more thorough way. Tax policy is particularly sensitive for several countries, but we are seeing a willingness to really discuss what elements of tax systems in every country are slowing growth down.
What elements could be reformed? Going beyond taxes that are harmonized at the EU level – because some taxes are harmonized at EU level, at least in legal form – there is a willingness to really look at the entire spectrum of tax policies in each member state.
My role in this exercise is to analyze the strengths and weaknesses of each of the 27 Member States’ tax systems and to formulate recommendations. This is technical work, done by a team of people looking at this from different angles. My personal contribution is to help identify performance problems in tax systems and formulate reasonable suggestions for improvement. This technical work is part of a larger process that eventually leads to a political decision.
Q: In terms of improving public finances and economic growth prospects, have you quantified the potential gains from reforming tax policy in Member States?
A: Well, we haven’t really quantified this; this would be a very difficult exercise. It’s been done for specific reforms in specific Member States, but because our recommendations are often looking at tax systems in a very general way it becomes technically very difficult to really put a number next to the potential for impact. We know that it’s going to be significant in some Member States. It’s going to be less significant in others.
Even though we have not quantified the impact precisely at this stage, this should not lead anyone to think that this makes the exercise less significant. This is the case for three reasons. First, we do have some evidence for specific Member States. Italy, for example, has been running simulations of the impact of certain reforms. Second, we will be able to assess the impact later on when these recommendations are actually implemented. And third, even though we may not be able to quantify the exact impact, we have strong reason to believe that, especially in some Member States, the impact is going to be very large because the distortions that we have identified in the tax systems of certain Member States are pretty important.
So, this exercise can surely lead to a significant acceleration in growth. It is something that will have an impact in the medium-term, probably, more than immediately. But that’s linked to the specificity of the tax system. If you improve the tax system, that’s going to improve incentives for investment, and for employment creation, but these incentives are often created gradually. It takes time to improve the system, and then it takes time before entrepreneurs realize that the system is working better and offers better opportunities. So it’s inherently a process that generally produces results over a few years. But then we also have cases where the tax situation is such that there are large distortions – there is an immediate need for reform. And there, improving or implementing a reform that makes sense could lead to a big payoff even in the short-term. I think a prominent example of that is the Italian case.
In Italy, there was a very significant tax reform package presented in December of last year, and it was implemented very quickly. Largely, in my opinion, as a result of this package (although other accompanying measures certainly contributed), we have seen the so-called spread on Italian government bonds, fall by over 200 basis points, Germany. The spread is the yield difference compared to the best performer, a measure of the quality of the debtor; a drop of this size means that markets now consider Italian government debt to be much less risky. What is the impact of that? It essentially means bringing down interest rates by 2% on an annual basis, and that translates into very large savings in terms of government expenditure because Italy’s debt is approximately 120% of GDP. Plus, it means lower financing costs for enterprises.
In these cases, where we can introduce high-quality tax reform quickly, the payoff can also come very quickly. In other cases, it will be more medium-term. In the course of my work here, we have found that in the majority of cases there are problematic aspects in Member States. While some Member States appear to have tax systems that work more or less perfectly well, or reasonably well on all counts, we have found that tax systems in many Member States are weak on several counts. Whenever this is the case, obviously the impact is going to be bigger.
Q: Do you see the reform of Member States’ tax systems as another step toward deepening the Single Market?
A: This is an interesting question. Until now, traditionally, the focus of Commission recommendations on tax policy was exactly on deepening the internal market – on trying to eliminate the tax obstacles that create fragmentation in the internal market. This has been a focus until now, and it has led to initiatives over many years. The latest initiative in this respect is this idea of creating a system in which companies that operate across different Member States can utilize essentially the same rules for paying taxes across borders. This is the so-called Common Consolidated Corporate Tax Base. So there has been work done in that area. There have also been initiatives in other respects.
But these have been the focus of attention for a long time, and what we’re seeing now is going beyond the single market or internal market issues. While not diverting attention from these long-standing priorities, there is a new focus on policies that may refer to individual countries but that, collectively, are nevertheless slowing down growth and could be improved, irrespective of the fact that they may not have a direct impact on the functioning of the internal market. So, in a sense, we’re going one step further.
Q: Investors in Eurozone sovereign debt markets may view the Commission’s efforts to improve tax policy, and therefore fiscal sustainability, in Member States as a welcome development. But they would highlight the need for credible enforcement mechanisms. How would you respond to this concern?
A: I think we need to distinguish aspects. One is the enforcement mechanism to ensure budgetary sustainability. This is has obviously been a key topic for several years now. There is also tax policy – the enforcement of reforms in tax policy. The two issues are different because, in terms of the first, there has been a strengthening of the rules, for instance, in the so-called “six-pack.” The six-pack is a package of six directives addressing budgetary sustainability, the working of the euro, and so on. And this essentially looks at the general setup of economic and budgetary policy in Europe.
With tax policy reform, there has not been a major reform of the institutional setting. The institutional setting there remains based on unanimity, essentially, but it is also true that there is a greater willingness on the part of Member States to cooperate on tax policy matters. These types of problems are often structural problems that can be tackled in a longer time frame. So I think in cooperation on tax policy we are not seeing a radical change but an incremental improvement. But we will see in the coming months and years to what extent country-specific recommendations on tax policy are taken up and implemented credibly. We have seen some good examples, for example in the Italian case which I mentioned already. We’ll have to wait and see to what extent other Member States take up the country-specific recommendations.
Q: What scope is there for using tax policy reform to address broader macroeconomic imbalances within the Eurozone?
A: Broadly speaking, there are two types of macroeconomic imbalances within the Eurozone. One is the classic problem of having a budget deficit, or debt level that is too large. This was already at the center of the Stability and Growth Pact. And although this is not a new problem, it is of course an important problem that has been critical for the past couple of years, particularly in some countries. In this specific respect, tax policy clearly plays an important role because we have seen that in the majority of cases it has been difficult to reduce deficits by cutting spending. Most countries have relied largely on tax increases in order to consolidate their budgets. We are seeing some low tax countries that are increasing taxes, primarily.
Given a general increase in taxes in Europe, and given that Europe already has a comparatively high tax rate, it becomes more and more important to structure these tax increases in a way that is not too detrimental to economic growth. So tax policy here has to ensure that the tax increases that are unavoidable are technically solid so as to minimize the negative impact on unemployment, growth, and so on.
There is another macroeconomic imbalance which is linked to the functioning of the euro and has been coming to the forefront over time: the trade deficit. A number of euro Member States have been accumulating competitiveness deficits vis-à-vis other euro countries. The countries that have accumulated trade deficits, or have found it difficult to maintain competitiveness vis-à-vis other euro Member States, have been typically those that have been affected more strongly by the crisis. So the issue is: can tax policy somehow help, not only in consolidating budgets, but also in ensuring that a country’s economy is able to improve its international trade performance? If that is possible, then tax policy could help addressing both problems at the root of the euro crisis.
Our analysis shows that on the first problem of consolidating the budget, proper tax policy is one of the main solutions. But tax policy can also help in improving the foreign trade performance of a country…not on its own, but it can help. It can do so through reforms that improve competitiveness by shifting the tax burden toward those taxes that have a lesser negative effect on external competiveness, external trade.
This is among the recommendations we have been formulating to shift the burden of taxation from labor and corporations – these two taxes tend to have a negative effect on external competitiveness – towards taxes that are like VAT, for instance, or excise duties, which do not affect the international competitiveness of countries. This is a subject which has received a lot of interest, of course. There are limits to what can be done in this respect, but it is clear that reforms going in this direction can help and we are indeed including this reflection in our recommendations.
Q: Do you view broader cooperation, through the G20 for example, as key to implementing these reforms and producing the gains that you expect them to?
A: This is a question of strategy. The G20 can help in many areas. Personally, I think that in the G20 and at the global level, one area where more international cooperation would be helpful is in the fight against tax havens…in reducing the possibilities for tax evasion in particular. It’s a problem that generally requires a lot of cooperation across different jurisdictions, and it affects many countries. There has been progress in this respect. A lot of jurisdictions have become more open to cooperation in this area so there is a general shift in this respect. I think this is a welcome trend that should continue and surely we can reinforce that. I don’t think the G20 can play an equally important role in supporting reforms that have to be taken domestically and have to find political support domestically.
Q: Are these tax reforms expected to have an impact on transatlantic foreign direct investment flows?
A: Research shows that tax factors generally aren’t the first driver of investment flows, but they do contribute. One important issue in this respect is whether the shift from direct to indirect taxation that the Commission recommends will involve cuts not only in labour, but also in business taxation. So far the focus has been on cutting labour taxes, but cutting corporate taxes is easier to implement because it has a lesser impact on the budget and may contribute more immediately to investment. Obviously, if business taxes are cut alongside labour taxes, this will directly support transatlantic investment, and then the impact could be sizeable and fairly rapid. But anything that supports growth will tend to boost investment, so even if the reforms just improved the tax system in general without reducing corporate taxes, they would still stimulate FDI.
*This interview was conducted on March 19, 2012