Tax coordination in the European Union: What are the issues?

Abstract

Summary In principle it is not necessary to harmonise tax policies in the EU to avoid tax distortions to the location of economic activity within the single market. If indirect taxes were always collected in the country of final consumption and if income taxes were always levied by the taxpayer’s country of residence, producer prices of tradable goods would tend to be equated across EU countries even if member states choose different levels of taxation. However, because of practical obstacles to the implementation of these tax principles, the current tax systems in the EU distort the workings of the single market, and national tax policies may have significant international spillover effects. The problems are most severe in the area of capital income taxation. I argue that a fully harmonised corporation tax should be a long-term goal for EU policy. The paper presents an applied general equilibrium model of the OECD economy designed to evaluate the economic effects of tax coordination within the EU. According to the model a complete harmonisation of capital income taxes within the EU would generate a welfare gain of almost 0.4 per cent of GDP for the EU as a whole, but several member states would lose from harmonisation. I also consider the effects of a coordinated 10 percentage point increase in effective capital income tax rates in all EU countries, serving to finance a cut in taxes on labour income. This policy is estimated to benefit the great majority of EU member states and to pave the way for a 0.6 percentage point drop in European unemployment, but sensitivity analysis indicates that the welfare effects are rather sensitive to the assumptions on the degree of capital mobility and the elasticity of labour supply.

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