Last week the European Parliament approved a resolution in favor of new taxes—or, in their Orwellian language, “new own resources.”
This tax package is poorly timed, screwed together of pieces that don’t work, and practically certain to not generate any meaningful amount of tax revenue. If anything, it will make the European economy weaker, not stronger.
Before we get to the details of why this tax package is a bad idea, I cannot help but reflect on how—once again—politicians make the worst possible decision at the worst possible point in time. It reminds me of a story I heard as an undergraduate student in economics.
During a visit to New York sometime in the 1970s, the late Swedish economist Assar Lindbeck was baffled by the widespread destruction of apartment buildings throughout the South Bronx. The urban landscape he saw was portrayed starkly in Daniel Petrie’s Fort Apache, Bronx in 1981. At the time, large parts of the South Bronx were dominated by buildings that were unsuitable for human dwelling. They were often burnt out, and sometimes demolished altogether.
Upon asking how such destitution was possible in the richest city in the world, Lindbeck was told that it all had to do with rent control. Government regulations, imposed for social policy reasons, prevented landlords from charging rents that allowed them to maintain their properties.
In response, Lindbeck allegedly quipped that in terms of destroying cities, rent control was a more effective tool than the hydrogen bomb.
Many government policies have similarly destructive effects on the economy. The stated purpose—and almost always the genuine ambition—behind those policies is always benevolent, yet the outcome of such synthetic benevolence is preeminently negative. Other than rent control in major American cities, tax policy is probably the best example of how good intentions lead to bad outcomes.
As if to prove this point, the majority in the European Parliament has decided to pursue “new own resources” in order to increase the European Union’s own tax revenue. On May 10th, Reuters explained that the package consists of
a financial transactions tax and a digital levy, to help it repay joint borrowing during the COVID pandemic and cover various new spending needs. … new revenue sources could also include a slice of national corporate taxes, a levy on share buybacks and a fair border tax
On the same day, the European Parliament announced that this tax package was only the opening salvo. They are, namely, “highly worried” that whatever these taxes generate “will not be sufficient” to pay for all the new spending they want.
And we are all very surprised.
There is a lot to be said about what a bad idea it is for the EU to spend more money. Their programs will come on top of all the spending that is done by member states and local governments. Most government spending is inefficient compared to the private sector, and the inefficiency increases with the size of government. However, two other problems deserve more attention at this point.
The first problem is the bad fiscal planning that the European Parliament has engaged in. The taxes they now want are supposed to pay for spending that went out the door 2-3 years ago. This timing is in itself not unique to the EU—on the contrary, it is a very common practice among modern-day governments to spend first, and tax later. This has led to chronic budget deficit problems all over the European continent.
Proponents of spend-first-tax-later could claim that the EU needed to stimulate the European economy during the pandemic-related artificial economic shutdown. By this argument, the pandemic-related extra spending, rolled out in 2020 and a good part of 2021, was so urgent that there was no time to put together a funding plan.
Unfortunately, this argument does not hold. Putting together a funding plan—taxes or new debt—for new spending is no more time-consuming than developing the spending plan itself. By coming back with tax hikes later, the European Parliament injects uncertainty and instability into the European economy when it needs the exact opposite.
If legislators feel a need to raise taxes, the least they can do is to be upfront about it. That way, they make the tax code predictable and transparent: it is easy for taxpayers with long-term financial planning needs to tie the tax policy to the structure and size of government spending. When lawmakers are upfront about what their spending will cost, there is little risk that taxes go up after the fact.
When taxes and government spending are predictable, the tax system helps with long-term economic planning, especially for private businesses with big tax bills. Even if the upfront funding plan is based 100% on borrowed money, it brings predictability to the private sector. Over time, such predictability leads to a higher level of economic activity, which in turn improves tax revenue compared to alternatives with lower levels of consumer and corporate confidence. This means that legislatures have a macroeconomic responsibility to make government finances predictable.
If there is one thing the European economy needs now, it is institutional stability. Any new policy measures that make the future less predictable will drive Europe further into the quagmire of economic stagnation. This, in turn, will lead to deteriorating government finances—at a time when those finances are already in poor shape. According to Eurostat, as of the fourth quarter of 2019, right before the pandemic, 12 EU states had a government debt in excess of the constitutionally mandated cap of 60% of GDP. More than half of those 12 had a debt ratio above 90%: Greece (180.6%), Italy (134.1%), Portugal (116.6%), Spain (98.2%), Belgium (97.6%), France (97.4%), and Cyprus (90.4%).
The pandemic was not kind to government finances. Of the EU’s 27 member states, 20 had a higher debt-to-GDP ratio in the fourth quarter of 2022 than in the same quarter in pre-pandemic 2019. The euro zone’s consolidated government debt expanded from 84.1% of GDP to 91.6%.
With this level of debt, it is—mildly speaking—irresponsible to raise taxes and make life more expensive for Europe’s families and businesses.
It deserves to be pointed out that this critique of the new taxes is by no means a critique of government emergency spending during a pandemic. If we accept the idea that it was right of government to impose restrictions in the first place—a premise worth debating separately—it could still have been done in a fiscally responsible way. The spending could have been limited, targeted, carefully designed, and funded with dedicated ‘pandemic bonds’ to avoid tax hikes and to give EU residents a source of financial security in perilous times.
With its current plan to raise taxes ex post facto, the EU is not only doing macroeconomic harm by behaving unpredictably; the second problem is that the rise in the tax burden is ill-timed and futile. The European economy as a whole is verging on the edge of stagflation, with the threat of rising unemployment and persistent inflation. Two weeks ago, I noted that the European economy is permanently weak:
as of December 2022, only 14 EU member states had an economy that was at least 5% larger (adjusted for inflation) than it was in 2019. Five countries were 1% or less ahead of 2019, among them France, Germany, Italy, and Spain, the four pillars of the euro zone. The Spanish economy was actually 1.3% smaller in 2022.
The GDP growth rates for the second half of 2022 are equally unimpressive. For the EU as a whole, the economy expanded by an inflation-adjusted 2.05%; the 19-member euro zone came in at 1.99%. Only a handful of member states mustered growth numbers of historically acceptable proportions:
- Ireland, which has a wildly volatile economy, topped the league with double-digit growth (sure to be followed this year by equally violent reductions in GDP);
- Croatia, Cyprus, Greece, Malta, and Spain exceeded 4% real annual economic growth; and
- Portugal and the Netherlands rose above 3%.
The rest did poorly at best. The Estonian economy shrank by 3.5% for the second half of 2022. The French economy ground to a halt in the fourth quarter, growing by a microscopic 0.05%. Germany was just behind France on the downslope, with 0.75% growth for the whole second half of last year, and only 0.23% in the last three months.
In Estonia, Finland, Lithuania, Luxembourg, and Sweden, GDP growth was negative for the last quarter of 2022.
The overall trend in the European economy points in the same direction. Therefore, it is a very bad idea to raise any taxes in the EU. It does not matter that the taxes the EU has proposed are small or seemingly marginal.
The first tax is a financial transactions tax. The experience with such taxes is discouraging, as the Tax Foundation reports in a study from 2020. A research report by business and management scholar Ishani Tewari in Economic and Political Weekly (Oct. 2004; free subscription required), is damning to the transactions tax idea. Tewari concludes that there is no evidence whatsoever that this type of tax will achieve any of its desired goals.
In other words, the EU will be left without the tax revenue it desires. The same can very likely be said about the proposed tax on “crypto-assets.” Although the definition of this type of asset is a bit murky from an economic viewpoint, that will not be its biggest problem. Like the financial transactions tax, this tax is aimed at assets and related economic activity that can easily be moved from one jurisdiction to another.
Again, the EU will be disappointed as the revenue stream dries up before it begins.
The third tax on the current EU list is ambiguously referred to as “national contributions” from member states to the EU. However, it is not too hard to conclude that it refers to an EU-specific slice of the corporate income tax that member states collect.
There are two problems with this tax (in addition to the problem that corporations do not pay taxes—their owners, employees, and customers do). First of all, the revenue from corporate income taxes is highly volatile. The tax base, i.e., corporate profits, swings with significant amplitude between economic growth periods and recessions. This makes the revenue from these taxes relatively unpredictable, and it can even approach zero under some conditions. If a large enough number of corporations make losses instead of profits (common in recessions) and if the ones still making profits vigorously apply all tax deductions available (also common in recessions), then the EU may find itself barely even collecting pennies on the euro from this tax.
The second problem with the corporate income tax is that it will remain as a tax base only for as long as corporations make profits as defined in the tax code. There is no area of the economy where innovations are more driven by tax policy than in corporate finance. As the tax burden grows, corporations reorganize their cash flow and their systems for compensating executives, owners, and employees in order to reduce or even eliminate their tax burden. Corporations can even split into new entities, owned by new companies that are created and organized for the sole purpose of reducing the tax burden.
The EU tax package comes with other taxes as well, including a tax aimed at neutralizing international differences in workforce compensation. This is an almost laughably incompetent tax idea, and for that very reason, it requires more attention than it can be given here.
If the majority of the European Parliament wants to make sure that Europe remains an uncompetitive economy, they should go ahead with their higher taxes. If, on the other hand, they would like to see more prosperity across the continent, they are well advised to reconsider what they just voted for.
