Tax earthquake rocks Germany

THERE is a fatalistic motto that rules over much of government activity: never adopt the solution that works till all others have been utterly exhausted. It might usefully be framed and hung on the wall at the European Union summit in Brussels this week, when country leaders meet to discuss progress on economic integration. But it may not stay up for long. There is a growing rumble across Europe as a move to lower tax turns into a stampede.

A revolt over high tax policies is growing. The performance of the Euro-zone economies compared with the rest of the world has been appalling. Successive previous summits, with their political declarations to "ignite" growth, make the EU a world leader in competitiveness and "drive integration" while clinging to the high tax Solidarity Model have ended in ignominious failure. Indeed, one seriously wonders whether such summits have not done more harm than good.

Unemployment, particularly in Germany, is unacceptably high and persistent. Many of the policies adopted in the name of the European so-called "solidarity model" have made it progressively more difficult for the EU core economies to bring the jobless totals down. Meanwhile, taxes and social security contributions have been rammed up to help Euro-zone governments stay within the budget deficit ceilings of the Growth and Stability Pact - unsuccessfully in most instances.

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Germany, Europe’s largest economy and chief exponent of the "solidarity model", is in a state of despair: unemployment has hit 5.2 million, the highest since the Great Depression. While much of the latest increase is due to statistical changes, the underlying rate of unemployment is still rising and there is no mistaking the fateful mood that hangs over the labour market. Its population is declining, domestic demand reflects a widespread mood of depression about the way things are and few have confidence in a recovery. This is despite, or arguably because of, previous measures to stimulate confidence and growth.

Last week the resistance of Chancellor Gerhard Schrder to the option of cutting taxes finally snapped. On Thursday he announced a programme of €6bn (4.2bn) in corporate tax cuts.

Although not as radical as he sought to make out, the desperation is clear: "We have to act," Schrder declared, "because the uneven burden of company taxation in Europe is threatening our jobs. And the government will act. Unemployment remains far, far too high."

Cutting business taxes! What a colossal volte-face for Germany, with one of the toughest business tax regimes in the world. It strikes at the whole modus operandi of the EU, where politically-driven integration has failed to generate the economic uplift and deliver the benefits so long expected of it. You can’t have an unemployment rate of more than 10% during a global growth period and talk with a straight face about the superiority of the Solidarity Model.

But Germany is running out of wrong options. Schrder’s headline proposal is to slash corporation tax from 25% to 19%. But companies also have to pay hefty state or city taxes. The effect of Schrder’s plan will be to lower the average nominal corporate tax rate in Germany, including local government tax charges, from 38.7% to 32.7%. This will take it below the equivalent level in France, Italy, the Netherlands and Spain.

The news followed an announcement that Poland is cutting its corporation tax rate to 18%, part of a wider move to a comprehensive flat tax. Austria cut its corporation tax rate from 34% to 25% at the start of the year. Estonia has scrapped company tax altogether. John Chown, from the tax consultants Chown Dewhurst, talks of Berlin waking up to a tax earthquake on its own doorstep. "They’re seriously rattled by the whole movement to lower taxes among the EU’s new members."

Germany has been a leading critic of so-called "unfair" tax competition in Europe. But now it feels it must join in and respond with tax cuts of its own.

Austria’s finance ministry issued a huffy statement on Thursday pointing out that its tax rates remained below Germany’s.

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Chancellor Schrder has not become a convert to the efficacious properties of low business tax per se. Indeed, his rationale is that the previous tax regime was not raking in as much money from taxes as the government had hoped. While previous tax rates were nominally high, this had given incentives for companies to reduce their tax bills by booking profits abroad or inflating costs.

Well, there’s a surprise. The greatest consequence of all, of course, has been the wholesale closure of German businesses and their removal to Eastern Europe or the Far East. Now, forced with the consequences of the country’s previous tax ’n’ spend measures, Schrder has been forced to seize the one solution that might work: cutting tax.

Critics say it may prove to be a case of too little, too late. But such is the desperate state to which the economy has been reduced that we may be at a turning point where a combination of business tax reductions and previous reform moves which have been slow to bite will start to see a turning of the tanker.

All this will add to the gathering mood of crisis in Brussels this week and a sense that a crossroads has been reached. The stated purpose of the summit, according to EU Commission president Jos Manuel Barroso, is to relaunch the Lisbon Agenda to ensure it is not, as he puts it, "decaffeinated". That Agenda, drawn up in Lisbon in 2000, was to make Europe the most competitive economy in the world by 2010. It has, of course, failed miserably.

Central to the problem is not just high taxes but that the deep reforms Europe has to make to revive its economies have been postponed, evaded or adopted in a piecemeal, half-hearted fashion.

With Germany and France having the two most regulated labour markets in the world, high unemployment is no coincidence. A Lisbon scorecard from the Centre for European Reform think tank shows a poor reform achievement in energy and telecoms liberalisation, competition in financial services and industrial subsidies.

The countries which have been the slowest to open their markets to competition - France, Germany and Italy - have the lowest growth rates. Now France wants to protect its services sector in the same way it has for so long protected its farming. And the whole of Europe will end up paying.

What chance is there of progress this week? Barroso’s ears are still ringing from a telephone call rebuke from French President Jacques Chirac protesting at the Commission’s plans to open up the EU services market.

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Chirac, concerned over trade union hostility, told Barruso that he considered the EU Savings Directive "unacceptable", and that it should be "completely re-examined".

Barruso, for his part, says he is "amazed" at the tone of the European debate while other EU officials say the atmosphere in France about the EU has become "poisoned". Events in Germany may only feed Chirac’s evident paranoia that the Europe of high tax and subsidies may be headed for the scrapyard.