Market Analysis

The Harm in Harmony

France and Germany claim they have a plan to fix the eurozone. Will it work?

Evidently Germany and France have a plan to fix the eurozone! At next week’s EU summit, Angela Merkel and Nicolas Sarkozy will present a new white paper entitled, “Ways Out of the Crisis—Strengthen Growth Now!”

France’s press agency obtained a leaked copy and published some snippets of Merkel and Sarkozy’s prescription for stronger European growth. Unsurprisingly, it zeroes in on taxes: Nations “should accelerate the process of tax coordination in order to foster growth, removing obstacles to the functioning of the single market and preventing tax abuse and harmful tax practices.”

Sounds innocuous enough—reasonable, even. Italy and Greece have shown how much tax evasion (the logically assumed definition of “tax abuse”) can corrode economic growth. Read further though, and you’ll see curbing tax evasion isn’t on the agenda. Instead, their prescription involves imposing a financial transactions tax, coordinating energy tax rules and synchronizing corporate tax rates.

As we’veoftendiscussed, the financial transaction tax has many drawbacks. Coordinated energy tax rules likely mean tougher carbon taxes and higher solar/renewable subsidies, which also typically prove solutions in search of a problem. But the most misguided component, in my view, is the corporate tax idea. “Synchronize” (or “harmonize,” their other go-to verb) is a euphemism for “raise.” If given a choice, businesses can and will seek tax-friendlier climes—like Ireland, where corporate taxes are a flat 12.5%. After all, if you’re an entrepreneur, wouldn’t you rather pay Ireland’s 12.5% than Germany’s 33% or France’s 34.4%?

Sarkozy and Merkel have spent years complaining about Ireland’s undue advantage in attracting companies, trying but failing to level the playing field. At Sarkozy’s urging, tax harmonization was written into the Lisbon Treaty, but Ireland refused to ratify it without a formal guarantee of tax policy sovereignty. Last year, Merkel offered to reduce Ireland’s bailout interest rate if Ireland conceded its 12.5%. Ireland declined. Now, they’re flat out calling it a “harmful tax practice.” But the Irish government’s commitment to its low rate remains steadfast, so the new tactic seems likely to fail.

Which is good for Ireland, especially as it tries to emerge from deficit troubles. Ireland rationally knows its lower rate encourages more entrepreneurship and more business activity. More business activity means more tax revenues—even if you have a lower rate. And it’s quite a boost. Since 2000, Ireland’s corporate receipts have ranged from 2.4% to 3.8% of GDP annually; Germany’s were only 1.3% to 2.2%. Over the same period, corporate receipts as a percentage of total tax revenue ranged from 8.8% to 13.2% in Ireland, but only 1.7% to 6.1% in Germany. As Art Laffer taught us, raising rates would likely result in lower revenues and growth over time as businesses move elsewhere—which makes Sarkozy’s suggestion raising the rate would likely shore up Ireland’s deficit troubles puzzling. And the notion of higher corporate taxes as a way to “foster” growth seems downright confusing. A corporate exodus hardly seems growth-enhancing.

Also puzzling, philosophically, is the idea a lower tax rate is somehow anticompetitive. The Oxford English Dictionary defines “competitive” thusly: “As good as or better than others of a comparable nature.” Competitive prices would be “low enough to compare well with those of rival traders.” That makes Ireland’s corporate rate pretty doggone competitive.

Which means Germany and France should, well, compete! Imagine if, instead of asking Ireland to handicap itself, Germany and France lowered their own corporate tax rates, giving Ireland a run for its money. Over time, they’d likely attract more businesses and entrepreneurs (and jobs!), grow faster and collect higher revenues.

Better yet, what if all of Europe followed suit? After all, this isn’t just a battle between Ireland, Germany and France. Italy has high rates, and Prime Minister Mario Monti’s rhetoric is similar to Sarkozy and Merkel’s. Slovakia, on the other hand, is clinging fast to its lowish 19% rate, and the UK is lowering its top rate from 26% to 23% by 2014. Neither is about to raise their rates to please their higher-tax neighbors.

If Merkel and Sarkozy push their plan, they likely end up losing a bloody political battle—not what either needs heading into their respective re-election campaigns. A more, well, harmonious solution would be to drop the notion of corporate tax harmonization and let all nations truly compete, trying to out-do one another with ever-friendlier tax and pro-growth reforms. Maybe it doesn’t “strengthen growth now!” But given the businesses that would come to and flourish in each nation, the entire continent would likely reap substantial rewards in the long run. And that puts Europe in far better shape long term than any misguided instant fix likely would.

Sources: Heritage Foundation 2012 Index of Economic Freedom; OECD.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.