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THE CHALLENGES OF FISCAL REFORMS IN THE EU NEW MEMBER STATES

Nandra Eugenia Ramona Babes-Bolyai University, Cluj Napoca, Romania, Faculty of Economics and Business Administration, Phone: 0745072553, E-mail: [email protected] Hanciu Oana Maria Phone: 0744755053, E-mail : [email protected] This paper presents some aspects concerning the main steps in fiscal reforms in the EU new member states. It is focused on introduction of personal income flat tax rate in the many eastern European countries and tries to establish a connection between the flat tax impacts of economic growth. Also analysis the evolution of corporate tax rate within the EU 27 1995-2007, underlining the major changes. Key words: flat tax rate, fiscal reforms, competitiveness, economic growth,

Introduction

The European Union is the largest economic entity and the most important political entities in the world, based on the union of 27 states with an area of 4,422,773 km2. With more than 490 million inhabitants and a Gross Domestic Product of above EUR 11,500 billion1, the European Union is a major economic player in the world. The evolution of the European Union (EU) from a regional economic agreement among six neighboring states in 1951 to today's supranational organization of 27 countries across the European continent stands as an unprecedented phenomenon in the annals of history. The tax systems in the 12 New Member States of EU have undergone profound reforms during the last decade, as part of the broader process of economic and political transformation. While the initial changes at the start of the 1990s was largely driven by transition-specific demands, in recent years tax reforms in the EU acceding countries was influenced by the need to harmonize their systems with EU norms and rules.

Flat tax rate and its impact of taxation in EU

The economies that are acceded to the EU in the last two enlargements inherited from their communist past an opaque system of taxation. After 1989 there were beginning a series of profound changes and reforms at almost all levels in Eastern European countries. It was necessary to transform a socialist - communist economy into a market economy. The taxation of personal incomes at the onset of transition differed from country to country as in some centrally planned economies these had not existed at all, while in others they were somewhat rudimentary. The main objectives of NMS have been as follows: to generate enough resources in order to cover public expenses needs; to build up a modern and simple fiscal system that stimulates foreign and nation capital investments and controls tax avoidance and evasion; - to harmonize their fiscal system with EU regulations. However, participation in an economic union generally calls for wider and broader tax harmonization among the participating economies as the interactions between their tax systems tends to grow with increasing economic integration. It is often argued that diverging tax policies and tax competition can have strong spillover effects on other countries and may distort allocative efficiency across the EU (and, vice versa, tax harmonization may enhance EU-wide allocative efficiency).2 The European tax legislation has been ­mainly- limited to the harmonization of indirect taxation-VAT and excise and now are some proposal concerning the corporate tax base. The most important reform in the fiscal policy of NMS was the introduction of flat tax rate. While most advanced nations in the West had flat tax rates prior to the influence of Marxism, the modern flat tax movement in Europe began in 1994 -- with Estonia, Latvia, and Lithuania leading the way. Earning their distinction as the "Baltic Tigers", the three countries experienced an influx of foreign investment, a drop in unemployment rates, and staggering growth in GDP. Many European countries (former communist nations) choose to simplify their fiscal system introducing the flat tax on personal income as we can see in the Table 1: - - Table 1 Personal income flat tax rate and economic growth Country

1 2

Year of

2007 Rate

2008 Rate

GDP Growth Rates

GDP Growth Rates

www.wikipedia.com Cnossen, Sijbren, "Tax Policy in the European Union" (August 2002), CESifo Working Paper Series No. 758, available at SSRN: http://ssrn.com/abstract=340905

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Introduction Romania Slovakia Estonia Latvia Lithuania EU 25 2005 2004 1994 1994 1994 16% 19% 22% 25% 27% 16% 19% 21% 25% 24% -

2004 4,5% 3,9% 4,8% 6,8% 7,1% 2,3

2006(est.) 6,4% 6,4% 9,8% 10,2% 7,4% 2,8%

Source: www.worldtaxpayers.org; CIA The World Factbook From the Table 1 we can see that the GDP growth rate for the countries which have adopted the flat tax rate is higher than for EU. A fiscal system with only one tax rate for all levels of income, in which all income is taxed once and only once, might offer an advantageous alternative. The flat tax has already had remarkable results in countries around the world, such as Hong Kong, the Channel Islands, Estonia, Lithuania, Latvia, Russia, Serbia, Ukraine and Slovakia. The recent successful implementation of the flat tax in Eastern European countries has led a number of Western countries, including Germany and Spain, to discuss the flat tax alternative in their parliaments. After the experience of the economy of countries in which the flat tax has already been implemented it can be seen that is a good start for assessing the potential of the flat tax to replace a progressive tax system. Of course, every country is a unique case, and the tax system is only one of the numerous factors influencing an economy. But looking at economic developments in a series of countries that have gone through the same kind of fiscal reforms will show the possible advantages of implementing the flat tax.

3. Evolution of corporate tax rate

The most important changes concerning corporate tax rate have took places in almost all the countries from European Union both new and old members. While consumption tax can be harmonized, for labour and capital taxes the process of harmonization is very difficult. In this field we can observe the effects of tax competition because of mobility of tax base. For labour, the mobility of worker is not influenced too much of taxation, there are others factor like language, education, work conditions and the level of wage. But for the capital the mobility is more easily, especially in the context of globalization, stimulated by the development of communications, lacks of regulation and monetary borders. In Table 4 is presented the corporate tax rate for all the EU members and the average rate for EU 27, EU 15, NMS10 and NMS 12. Within the European Union in 2007 the highest corporate tax rate is in Italy and Germany 38% and in the opposite part is Bulgaria and Cyprus where corporate tax rate (CIT) is only 10%, a huge difference 28% explains why so many multinationals corporations choose to invest in eastern European countries. Bulgaria this year reduces his CIT from 15% (2006) to 10%, the lowest level from EU with Cyprus. Estonia intend to reduce his corporate tax rate until 20%, (1% per year) in 2009. Another important change was made by Greece which reduce his level of CIT from 29% last year to 25% this year and Latvia, where the level of CIT beginning with 1.07.2006 is 12.5%, the same with Ireland. Among the major nations in the EU, Germany slashed its federal tax rate from 59.7 percent in 1993 to 38%, representing a decline of nearly 36 percent in the 14-year period. This decline may be attributable to increasing competition, especially with the accession of the new EU Member States in 2004.

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Table 2 Evolution of Statutory Corporate tax rates Statutory Corporate tax rates Austria Belgium Bulgaria Cyprus Czech Republic Denmark Estonia Finland France Germany Greece Hungary Ireland Italy Latvia Lithuania Luxembourg Malta Netherlands Poland Portugal Romania Slovak rep. Slovenia Spain Sweden United Kingdom EU-27 average NMS-10 average NMS-12 average EU-15 average 1995 34 40 40 25 41 34 26 25 36,67 56,80 40 20 40 52,20 25 29 40,9 35 35 40 39,6 45 40 25 35 28 33 35,59 30,56 32,55 38,02 2000 34 40 24 29 31 32 26 29 36,67 51,63 40 20 24 41,25 25 24 37,45 35 35 30 35,2 38 29 25 35 28 30 32,02 27,36 27,93 35,29 2004 34 34 24 15 28 30 25 29 33,33 38,29 35 18 12,5 37,25 19 15 30,38 35 34,5 19 27,5 25 19 25 35 28 30 27,23 21,80 22,21 31,25 2005 25 34 15 10 26 28 24 26 33,33 38,29 32 16 12,5 37,25 15 15 30,38 35 31,5 19 27,5 16 19 25 35 28 30 25,32 20,40 19,58 29,92 2006 25 34 15 10 24 28 23 26 33,33 38,29 29 16 12,5 37,25 15 15 29,63 35 29,6 19 27,5 16 19 25 35 28 30 25,00 20,10 19,33 29,54 2007 25 34 10 10 24 28 22 26 33,33 38,29 25 16 12,5 37,25 12,5 15 29,63 35 25,5 19 25,0 16 19 19,5 32,5 28 30 24,00 19,20 18,17 28,67 Change % (1995-2007) -9,0 -6,2 -30,0 -15,0 -17,0 -6,0 -4,0 +1,0 -3,3 -18,5 -15,0 -3,6 -27,5 -15,0 -12,5 -14,0 -11,3 0,0 -9,5 -21,0 -14,6 -29,0 -21,0 -5,5 -2,5 0,0 -3,0 -11,6 -11,4 -14,4 -9,4

Source: KPMG International, 2006; http://www.worldwide-tax.com; Author's calculations

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Figure 1

Evolution of corporate tax rate

40 35 30

35,59 32,02 27,23 25,32 25,00 24,00

%

25 20 15 10 5 0

95 19

00 20

04 20

05 20

06 20

07 20

EU-27 av erage NMS -12 av erage

NMS -10 av erage EU-15 av erage

Source: Author's calculations Since the beginning of their transformation to market economies and the introduction of "western-style" tax systems and corporate income tax systems, many eastern European transformation countries have gradually lowered their corporate income tax rates over the last decade. In 1995, the average corporate tax rate in the twelve (candidate) accession countries amounted to almost 32.5 %. For 2007, an average corporate tax rate of 18.17% for the NMS 12 and for EU 15 28.67%, ten percent difference. Figure 2

50 45 40 35 30 25 20 15 10 5 0 1995 2000 2004 2005 2006 2007 Bulgaria Cyprus Czech Republic Estonia Latvia Lithuania Malta Poland Romania Slovak rep. Slovenia NMS -12 average

Source: Author's calculations With an average corporate income tax rate of 18% the Eastern European states that joined the EU in 2004 have tax rates among the lowest in Europe. Their accession to the EU also increased their attractiveness for foreign investors. Furthermore, due to the increased freedom of movement of capital and labor in the EU, these countries now directly compete with western European nations for investment and labor. The largest decline among EU countries in the 14-year period was Ireland, which cut its rate from 40 percent in 1993 down to 12.5 percent in 2006, a 68.8 percent reduction. The second-largest declines were Bulgaria and Romania with 30% and 29% between 1995 and 2007. Many factors influence economic growth, and tax rate reductions may very well be one of those factors, even if is difficult to prove empirically the relation between tax cuts and economic growth, the international experience shows: countries that have lowered their corporate income tax had a positive economic development.

4. Conclusions

The political debate on corporate taxes harmonization in the EU has been going on for several decades. Initially, the debate had concentrated on the potential need to harmonize regular company taxation schemes under the condition of increasingly integrating capital markets within the EU. The main conclusion is that it is not advisable to introduce a harmonized corporate tax rate in the EU-27. Most of the rate reductions were accompanied by measures designed to broaden each country's tax bases, keeping to the conventional wisdom that low rates combined with a broad base translate to sound tax policy, only in these circumstances the tax revenue are maintained at the normal level for financing the public expenses. From the perspective of the old member countries their altogether larger size as well as agglomeration economies and other location-specific rents (particularly a higher level of public services provided by governments) allow it to maintain higher corporate tax levels in comparison to the accession countries.

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The process of harmonization has to be extended not only for indirect taxation, but also for the direct taxation and the most important step in this direction is the establishing of a common consolidated corporate tax base which can enhance the benefits of the Internal Market and make the European Union more competitive compared to other countries.

BIBLIOGRAPHY:

1. 2. 3. 4. Cnossen, S., (2002): "Tax Policy in the European Union", CESifo Working Paper Series No. 758, (August 2002), available at SSRN: http://ssrn.com Doyle, D., (2004): "EU Newcomers Anger France, Germany With Tax Cuts," Bloomberg.com, June 1, 2004, available at http://www.bloomberg.com www.worldtaxpayers.org www.wikipedia.com

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