March 3, 2004

March 3, 2004 | Commentary on Taxes

Europe Has Caught Tax-Cut Fever

More than 20 years ago, Margaret Thatcher and Ronald Reagan triggered a world-wide revolution by dramatically slashing marginal income tax rates. In addition to rejuvenating the U.K. and U.S. economies, these supply-side tax cuts prodded other nations into implementing similar reforms. Thanks to "tax competition" between nations, top tax rates in developed nations -- on average -- are nearly 20 points lower today than they were in the 1970s.

Now a new wave of tax competition is sweeping Europe, one that could yield equally impressive results for the global economy. The genesis of this supply-side renaissance is a bit murky, but leaders in Ireland and Russia deserve considerable credit. It was Ireland, for instance, that resisted EU pressure for harmonization and enacted a 12.5% corporate-tax rate. This dramatic reform, accompanied by reductions in tax burdens on personal income and capital gains, has turned the "sick man of Europe" into the Celtic Tiger. Equally important, however, these reforms have prompted corporate tax rate reductions in many other European nations.

On the other side of Europe, Russia decided to junk its "progressive" tax system and replace it with a 13% flat tax. This new system took effect in 2001 and already has boosted economic growth and tax compliance. This positive track record, combined with the successful flat-tax regimes in the Baltic nations, has encouraged many other Eastern European nations to take similar bold steps.

Slovakia, for instance, is now a supply-side role model. Led by Finance Minister Ivan Miklos, the government repealed its old tax code -- including a top tax rate of 38% -- and replaced it with a 19% flat tax for both individuals and businesses. The death tax was abolished and the government is implementing a social-security system based on personal saving accounts.

But other former Soviet-bloc nations are close behind. Poland lowered its corporate tax rate from to 19% from 27% and enacted an optional 19% flat tax for personal business income. Even Serbia is hopping on the tax-reform bandwagon, implementing a 10% flat tax for most forms of personal income.

Other nations are focusing on tax-rate reductions. Hungary, for instance, cut its corporate tax rate to 16% from 18% and dropped the top tax rate on personal income to 38% from 41.5%. Moldova is bringing its corporate tax rate down to 20% from 25% and lowering its top tax rate on personal income to 22% from 25%. Latvia, meanwhile, cut its tax rate on business income to 19%, and Romania has announced that its corporate tax rate is dropping to 20% from 25%.

One of the most interesting tax-rate reductions is taking place in Estonia, which has enacted legislation to lower its flat tax rate to 20% by 2007 from 26% today. This is particularly noteworthy since Estonia was the first nation in Eastern Europe to adopt a flat tax -- a step that was seen as wild-eyed free-market radicalism in the mid-1990s. But then the other two Baltic nations -- Latvia and Lithuania -- adopted their own flat-tax systems, followed by Russia's 13% flat tax. And now that so many other countries are cutting tax rates and enacting low-rate flat taxes, the Estonians suddenly had to lower the rate of their flat tax lest they lose business to neighboring jurisdictions.

This is why tax competition between nations is so important. It encourages governments to adopt better tax law to keep jobs and capital from migrating across national borders. This process is very unpopular with the Paris-based Organization for Economic Cooperation and Development and the Brussels-based European Commission, but these international bureaucracies are representing the interests of uncompetitive welfare states such as France and Germany.

Fortunately, it appears that France and Germany are voices of the past. Many nations in "old Europe" are beginning to lower tax rates. Ireland is the big success story, of course, and many countries have lowered tax rates in recent years in response to competitive pressure from the Emerald Isle. Portugal is lowering its corporate tax rate to 25% from 30%, and the government has announced plans to bring the rate down to 20% next year. Last but not least, Italy dropped its corporate-tax rate to 33% from 34%.

Even the Germans are getting into the act. Individuals used to face a top tax rate of more than 50%, but the maximum burden already has fallen to 45% and will drop to 42% next year. And in a real testimony to the power of tax competition, the socialist Greek government has said that it will reduce both the personal income-tax rate and corporate income tax rate by five percentage points. The government of Austria has jumped on the bandwagon as well, announcing that the corporate tax rate will fall to 25% from 34%.

About the Author

Daniel J. Mitchell, Ph.D. McKenna Senior Fellow in Political Economy

Related Issues: Taxes

First appeared in the Wall Street Journal Europe