U.S. Tax Reform Has Europe Worried
Suddenly, the world’s biggest economy has lower corporate rates than the Continent’s giants.
By Joseph C. Sternberg
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Photo: Getty Images/iStockphoto The tax reform passed in Washington this week is a gauntlet thrown down to Europe’s big taxers.
This column warned of that possibility in March, but the reality has turned out worse for Europeans than seemed likely nine months ago. Once President Trump signs it, the law will open a new battleground for competition with Europe’s highest-taxing governments. It also challenges Europe’s fundamental attitude toward taxation.
The reduction in tax rates is only part of it. The bill will cut the top federal corporate tax rate to 21% from 35%, bringing the average effective rate, including state and local taxes and accounting for deductions, down to around 23% from around 39%. That doesn’t sound so bad for Europe. The U.S. will only run roughly even with the European Union’s average effective rate of around 21%.
That EU average, however, conceals notable geographic diversity, embodying Europe’s grand tax bargain with itself: The smaller or the poorer a country is, the lower it can cut its tax rate.
European leaders gripe about Ireland’s 12.5% corporate rate. But they tolerate it because Ireland’s small size limits its capacity to draw business away from big countries such as France, Germany, Italy and Spain, whose tax rates approach or even exceed 30%. The same holds for the EU’s less-affluent formerly communist member states, whose statutory rates generally max out at 22%.
No EU rule outright prohibits a large member country from cutting its corporate rates, but in practice these states haven’t needed to consider such steps, because their size offered a form of comparative advantage that offset their high taxes. Britain, with a top rate of 17%, positioned itself as the main big-economy exception, an outlier as with most other matters European.
But being the big dog in Europe is no defense when the world’s largest and most dynamic economy is slashing its tax rates. A 21% federal rate in the U.S. will be impossible to ignore, given the incentives it creates for European companies to invest in America instead of at home. That’s the main conclusion of a report released last week by Germany’s Center for European Economic Research, and lest anyone in Berlin miss the point, the title of the press release was blunt: “Germany Loses Out in U.S. Tax Reform.”
Intriguingly, that assessment and others like it rely on estimates not just of the behavior of American companies—Google and Facebook are the names that most often come up in global tax debates—but also of the response from European companies to U.S. tax reform. As American accountants and tax lawyers sharpen their pencils, German executives will start asking themselves: Why build our next factory in Germany, with a 31% statutory corporate rate, more-onerous labor regulations and an aging population, when America beckons with a 21% rate, better demographics and the world’s largest market?
It’s hard to overstate what a shock to the European system this is. The Continent has long labored under the conviction that Europe’s main tax problem was that companies weren’t paying enough. Thus the biggest tax innovations in recent years have been new laws to discourage companies from availing themselves of “too many” legal breaks in low-tax countries. Brussels also has creatively interpreted its antitrust laws, claiming that lower taxes amount to unlawful “state subsidies.”
The conceptual problem with this approach, which the Organization for Economic Cooperation and Development describes as combating “base erosion and profit shifting,” is that it’s blind to incentives. Most European tax-setting starts from the premise that the tax base is fixed, and the only thing that matters is that each national government get its “fair” share. The primary purpose of taxation, European officials seem to believe, is funding a heavily redistributive welfare state, never mind the consequences for growth.
Washington’s new approach couldn’t be more different. The U.S. reform acknowledges that tax incentives matter for investment, job creation and economic growth. One implication of America’s reform is that if Europe wants to have anything left to redistribute in this newly competitive world, it’s going to have to start paying attention to growth incentives.
Fortunately, this column’s other prediction from March also is coming true. Deregulation, improving sentiment and, now, tax reform are reviving the U.S. economy, which is on track to exceed 3% growth in 2018. This is lifting Europe’s long-suffering economies and providing fiscal headroom for tax reform. Europe even has a few leaders, such as French President Emmanuel Macron, who are prepared to push aggressive tax cuts. There will rarely be a better moment for a European tax revolution—a point for voters and politicians alike to remember.
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