Tax competition and coordination

within the EU the case of the EU-10

Transfer
16(1) 3754
The Author(s) 2010
Reprints and permission:
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DOI: 10.1177/1024258909357872
trs.sagepub.com

Zoltan Pitti
Researcher, Corvinus University, Budapest

Magdolna Sass
Senior Research Fellow, Institute of Economics of the Hungarian Academy of Sciences

Summary
The central and eastern European Member States that have joined the EU since 2004 (referred to
as the EU-10 in this article) are often blamed for the intensification of EU tax competition. This
article first presents the tax characteristics of these countries and the factors influencing their evolution: the heritage of the Socialist period, transition-related issues, certain conditions of EU accession and global developments. During the catch-up phase, lower taxes have been introduced to
attract badly needed capital for investment. Secondly, the article briefly sets out the EUs main tax
problems. The fact that demand for state expenditure is growing while tax bases are shrinking is
putting fiscal stress on the Member States. Increasing the efficiency of tax collection may mitigate
this problem.
Resume
Les Etats membres de lEurope centrale et orientale qui ont rejoint lUE depuis 2004 (denommes
lUE-10 dans cet article) sont souvent tenus pour responsables de lintensification de la concurrence fiscale europeenne. Cet article presente tout dabord les caracteristiques fiscales de ces pays
et les facteurs influencant leur evolution: lheritage de la periode socialiste, les questions liees a` la
transition, certaines conditions de ladhesion a` lUE et levolution mondiale. Au cours de la phase
de rattrapage, une baisse des impots a ete introduite pour attirer des capitaux dinvestissement
dont on avait grand besoin. Deuxie`mement, larticle expose brie`vement les principaux proble`mes
fiscaux de lUE. Le fait que la demande de depenses de lEtat est en croissance alors que les assiettes dimposition sont en diminution accentue la pression fiscale sur les Etats membres. Accrotre
lefficacite du recouvrement des impots peut attenuer ce proble`me.
Zusammenfassung
Den mittel- und osteuropaischen Landern, die der EU im Jahre 2004 beigetreten sind (nachfolgend
EU-10), wird haufig vorgeworfen, den Steuerwettbewerb in der EU zu verscharfen. Dieser

Corresponding author:
Magdolna Sass, Senior Research Fellow, Institute of Economics of the Hungarian Academy of Sciences, 1025 Budapest,
Torokvesz ut 141/B., Hungary.
Email: sass@econ.core.hu

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Beitrag beschreibt zunachst die Merkmale der Steuersysteme dieser Lander sowie die Faktoren,
ra, den U
bergangsprozess,
die ihre Entwicklung beeinflussen, namlich das Erbe der sozialistischen A
gewisse Bedingungen fur den EU-Beitritt und weltweite Entwicklungen. In der Aufholphase haben
diese Lander niedrigere Steuersatze eingefuhrt, um das dringend benotigte Kapital fur Investitionen
anzuziehen. Anschlieend werden die Hauptprobleme der EU im Steuerbereich umrissen.
Angesichts des wachsenden Bedarfs an Staatsausgaben bei gleichzeitig schrumpfender Bemessungsgrundlage entstehen finanzielle Engpasse in den Mitgliedsstaaten. Eine effizientere Steuererhebung konnte zur Linderung des Problems beitragen.
Keywords
Taxes, tax policies, tax competition, EU, EU-10

Introduction
As globalisation proceeds, capital is becoming increasingly mobile, resulting in the increased
mobility of tax bases. Owners of capital can take advantage of opportunities in different countries more than ever before, including opportunities arising from tax differences. Besides original
culturally and historically rooted tax differences between countries, new sources of tax divergence include tax-rate reductions in order to attract either a larger tax base or more investments.
(Edwards and de Rugy, 2002). Countries which do not follow suit and reduce taxes may experience a significant decrease in their taxing capacities. Some authors (see, for example, Wilson,
1999; Strange, 1996) even warn of the acceleration of tax competition in the world economy and
its harmful consequences. However, others point to the difficulty of finding empirical evidence
on the implications of international tax competition (for example, Wilson and Wildasin, 2004;
Devereux et al., 2002), and some profess to be unable to find evidence of a race to the bottom
in the OECD (Stewart and Webb, 2003). Others draw attention to the fact that, theoretically, the
only way out of the problem would be global cooperation, assuming perfectly mobile capital
(Dehejia and Genschel, 1999). The OECD has been one of the leaders in the fight against harmful
tax competition (OECD, 1998).
Especially since EU enlargement in 2004, the issue has become pressing. The central and eastern European Member States that have joined the EU since 2004 (EU-10)1 have applied lower corporate taxes than the EU-15 in order to attract badly needed investment. This has acted as a
negative externality with regard to the most important countries of origin of investors and raised
fears among the EU-15 of unleashing a race to the bottom, which would undermine their tax
bases and significantly reduce their budget revenues. However, the main aim of applying lower
tax rates in the EU-10 was not to realise an instant improvement in the fiscal situation, but to help
with the transition process by fostering foreign and domestic investment, which had so far been
lacking.
This article analyses the problem of tax competition from the point of view of the EU-10. These
countries, on average, have lower taxes on corporate profits than the EU-15 and thus they are
blamed for the intensification of tax competition inside the EU. Here we present the circumstances
and conditions that led to this situation and examine various aspects of the question. The article is

1 EU-10 Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia and
Slovenia.

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39

organised as follows. First, the features and evolution of the tax policies of the EU-10 and the main
factors influencing those policies are presented. Secondly, major tax policies and related problems
arising in the EU are discussed, with particular attention to the efficiency of tax collection. Thirdly,
the impact of the financial crisis on national tax policies and international tax coordination is
briefly analysed. The final section draws some conclusions.

Tax policies of the EU-10

In order better to understand developments in the tax systems and tax policies of the EU-10, it is
important to outline a few factors which have played a determining role in shaping them. These
factors include the heritage of the Socialist period; the fact that more than half of the EU-10 group
are new states; the special circumstances arising from transition-related political and economic
issues; particular conditions related to EU accession; and the impact of changes in the world
economy.2
First, the historical heritage of the previous non-market economic system exercises a considerable albeit waning effect on tax policies. Basically, there were no taxes in socialist countries, so
they have all had to establish new tax systems, starting from 1989 and to develop them gradually.
As a consequence, tax consciousness is at a very low level compared to developed countries. Tax
is considered a kind of exaction and not a contribution to the state to help finance it to perform its
tasks and provide services for citizens. Another aspect of the Socialist heritage was a very high
state involvement or even monopoly in the provision of welfare, health and social services, which
could not simply be dismantled in the transition. This resulted in higher fiscal spending on these
services compared to countries at a similar level of development. With aggravated fiscal problems,
there was an effort, in some countries, to make reductions in welfare-related expenditures. This
factor, together with different forms of tax discipline, different cultures and historical roots, as well
as differences in the size of the informal economy, resulted in greater heterogeneity among the EU10 in terms of tax policies and general tax situations.3
Moreover, countries inherited different levels of state indebtedness from the Socialist period.
While Hungary and Poland had a high debt burden at the outset of the reform process, other countries inherited a much smaller or even negligible debt obligation. Poland asked for a rescheduling
of its foreign debt, which had negative consequences in the shorter term, but in the long run
significantly reduced the cost of servicing the debt. At present, it is only Hungary4 whose tax and
fiscal developments are determined, to considerable extent, by the servicing of high debt.
Secondly, there are many newly created states among the EU-10, namely the Baltic States, the
Czech Republic, Slovakia and Slovenia. Many of these countries, especially the Baltic States, have
built up their tax and fiscal systems from nothing. This has resulted, especially until the global crisis, in a relatively prudent fiscal stance, lower taxes and lower state involvement. It also provided
the opportunity to use various cost-saving methods (for example, e-gov institutions in Estonia).

2 Grabowski and Tomalak (2004) call attention to other factors which have influenced the development of
tax systems to a considerable extent, but which became less important due to the EU membership of these
countries (for example, lack of transparency, extra-budgetary funds, data problems).
3 On diversity and frequent changes in tax rates, see, for example, Grabowski and Tomalak (2004), Table
20, pp. 277278.
4 Although this high debt is related not only to the heritage of the Socialist past, but also to imprudent fiscal
policies, especially from 20012002 onwards.

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Thirdly, transition-related factors have also played an important role in influencing tax
developments. At the beginning of the transition, fiscal revenues were hit hard by falling output
(the so-called transition recession). At the same time, the privatisation of state-owned enterprises
also impacted upon fiscal revenues and expenditures, depending on the method used. For example,
it could reduce budget revenues, although in the case of cash sales, privatisation resulted in large
windfall revenues. Moreover, when investments were made in state-owned enterprises, which were
later put up for sale, this put a strain on the state budget. On the other hand, there was greater pressure on expenditure due to the growth of unemployment and poverty. These factors put less strain
on the public finances in those countries where there was a more gradual approach to privatisation
and greater room for fiscal manoeuvring because of lower indebtedness. As a result of these processes, fiscal deficits in this period were, on average, higher in the EU-10 than in other regions
(although lower than in other transition economies) (World Bank, 2007).
When the transition process started, all these economies were in a catch-up phase. In these
circumstances characterised by low investment and a lack of capital, technology, management
and other skills specific to the operation of a market economy foreign direct investment (FDI),
which was expected to bring benefits to the host country by bridging these gaps, was highly valued.
That is why relatively generous measures were introduced in order to attract FDI, especially after
Hungary (because of its high foreign debt servicing) and Estonia (the country which has liberalised
its economy to the greatest extent among the EU-10) had short- to medium-term successes in FDIbased development. While privatisation played and still plays an important role in attracting
FDI across the EU-10, other conventional incentives were also used in order to influence FDI
inflows (Sass, 2004). These measures to attract FDI were predominantly tax-related fiscal incentives, similar to the policies of less developed countries (UNCTAD, 2003), which are not able to
offer the same kind of substantial financial incentives as their developed counterparts.
While the literature does not provide conclusive evidence on the primary importance of taxes
and incentives in influencing investment decisions, governments still use these measures to a considerable extent. One reason for this may be that potential investment locations in the EU-10 have
become very similar to each other and incentives may play a role in choosing among them.5 In
addition, offering generous incentives may be an indication of an overall positive policy stance
on the part of the government towards foreign investors. Moreover, a lack of domestic resources,
domestic savings and investments also underlined the importance of a relatively low tax on profits
even from the point of view of domestic investors. Again, different approaches to the reform process resulted in greater differences in the tax policies of the countries in transition.
Fourthly, EU accession-related factors also affected tax policies. For example, state aid regulations limited (fiscal) incentives offered to investors and the demand for own resources increased
the strain on fiscal expenditures. (Own resources are demanded to accompany financial resources
received from EU funds to varying extents depending on the nature and location of the project.) An
even more important factor was that the EU-10 committed themselves, at the time of accession, to
joining the euro area in the near future. They therefore made greater or smaller efforts to meet
the Maastricht criteria on the fiscal deficit and public debt. This led to an overall reduction in fiscal
deficits in the EU-10, although with uneven results. From our point of view, it is important to note
that fiscal adjustments were achieved through a combination of a reduction in expenditure and an
increase in revenues, thus also affecting taxes.

5 See, for example, Sass (2003) and Grabowski and Tomalak (2004: 276).

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Fifthly, changes in the world economy have also influenced the environment in which tax
policies and tax systems have evolved in the EU-10. On the one hand, there have been large and
growing differences between local tax systems, not only in tax rates, but also tax bases, conditions of exemption, allowances, and so on, not to mention the gradual liberalisation of capital
and financial flows which offer opportunities to the owners of capital to maximise their profits
by shifting finances between different tax regimes. However, the acceleration of international
capital flows is only partly a consequence of but also partly a reason for the evolving tax
competition, because competition for FDI has become more intense since the 1980s. The reason
for this is that ever more governments realised the potential of multinational companies to contribute to local job creation and economic growth. Moreover, due to widespread liberalisation
and technological developments, investment locations have become more similar to each other,
which has also resulted in greater competition in the provision of incentives. Specifically in the
European Union, the case of Irelands successful catching-up, which relied on very low capital
taxes, high inflow of FDI and the use of structural funds for the improvement of human and
physical capital, provided a possible strategy whose preconditions seemed also to be present
in the EU-10.
After listing the main factors that affected tax developments in the countries reviewed here, in
the following section we look briefly at the main features of national tax systems.
Taking into consideration implicit tax rates by economic function (Table 1), the following can
be stated:


As far as taxes on capital are concerned, all countries have significantly lower rates than the
EU-25 average, and this was already the case in 1996 (except for Slovakia). There was some
small growth in rates over time. On the basis of 2007 rates, two country groups can be identified, one with extremely low capital taxes (Baltic States, Hungary and Slovakia) and a second
group with relatively higher capital taxes (Czech Republic, Slovenia and Poland).
As for consumption taxes, overall these increased only slightly, except in Hungary, which
already had a very high rate in 1996, and in Slovakia. Relatively stable rates have been applied
in the Czech Republic and Slovenia. Here, too, two country groups can be identified: those with
substantially higher consumption taxes compared to the EU average (Bulgaria, Estonia, Hungary and Slovenia), and the remaining countries, in which consumption taxes are around the
EU average.
Labour taxes decreased slightly in the period under analysis, except in the Czech Republic, and
are around the EU average or lower, except for the very highly taxed workers in the Czech
Republic and in Hungary.
Altogether, besides some specific country features, the EU-10 usually tax capital at a lower
rate than the EU average, which is compensated for by either a higher labour tax (as in the
Czech Republic and Hungary) and/or by a higher consumption tax (Hungary, Estonia and
Slovenia) or by the overall lower taxation of economic activities and consumption, entailing
smaller state involvement (as in Latvia, Lithuania and Slovakia). Just looking at the two
taxes determining household revenues, higher revenues from consumption taxes are
balanced out by lower revenues from labour tax, except in Hungary and Slovenia. Signs
of this divergence across countries were already present in 1996, but had become more pronounced by 2007.
The only country which turned its tax structure upside down was Slovakia, which reduced all
taxes significantly in the period under analysis. The other countries, more or less, maintained
their initial tax stance, with minor changes to the relative share of the various taxes.

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Source: Eurostat.

Bulgaria
Czech Republic
Estonia
Latvia
Lithuania
Hungary
Poland
Romania
Slovenia
Slovakia
EU-27

n.d.
22.3
9.3
15.6
8.9
n.d.
21.3
n.d.
n.d.
33.1
EU-25 28.3

1996
n.d.
23.7
6.4
9.6
5.7
16.4
22.5
n.d.
17.4
22.5
EU-25 30.0

2002

2007
n.d.
25.6
10.3
14.6
12.1
16.3 (2006)
22.8 (2006)
n.d.
23.1
17.5
EU-25 34.2

Implicit tax rate on capital

Table 1. Implicit tax rates by economic function

n.d.
21.2
19.8
17.9
16.4
29.5
20.7
n.d.
24.1
24.6
EU-25 20.0

1996
18.7
19.3
20.0
17.4
17.9
25.4
17.9
16.2
23.9
19.4
19.6

2002
25.4
21.4
24.4
19.6
17.9
27.1
21.4
18.1
24.1
20.6
20.0

2007

Implicit tax rate on consumption

n.d.
39.5
37.8
34.6
35.0
43.0
36.3
n.d.
36.8
39.4
EU-25 37.4

1996

32.9
41.2
37.8
37.8
38.1
41.2
32.4
31.1
37.6
36.7
36.4

2002

29.9
41.4
33.8
31.0
32.3
41.2
35.0
30.1
36.9
30.9
36.5

2007

Implicit tax rate on labour

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Table 2. Structure of taxes by economic function (% of GDP)

Capital

Bulgaria
Czech
Republic
Estonia
Latvia
Lithuania
Hungary
Poland
Romania
Slovenia
Slovakia
EU-27

Consumption

Labour

1996

2002

2007

1996

2002

2007

1996

2002

2007

n.d.
6.1

4.8
6.9

5.5
8.4

n.d.
11.3

13.7
10.1

18.4
10.7

n.d.
17.3

11.8
17.8

10.8
17.8

2.5
3.2
3.4
3.8
7.2
n.d.
2.5
9.7
EU-25: 8.1

2.1
3.1
2.0
4.6
7.8
4.8
3.5
7.0
8.1

2.6
4.0
3.9
5.3
8.8
5.4
5.3
6.5
9.4

12.8
11.7
10.9
16.5
13.0
n.d.
14.8
13.2
EU-25: 11.3

11.9
10.6
11.7
14.1
11.8
10.9
13.7
11.2
11.1

13.6
11.9
11.4
14.5
13.0
11.9
13.3
11.3
11.1

19.1
15.9
13.7
20.3
17.2
n.d.
20.7
16.5
EU-25: 20.9

17.1
14.6
14.9
19.2
13.4
12.3
20.8
15.0
19.9

16.8
14.6
14.6
19.9
13.4
12.1
19.7
11.6
19.4

Source: Eurostat.

Table 3. Structure of taxes by economic function (% of total taxation)

Capital

Bulgaria
Czech
Republic
Estonia
Latvia
Lithuania
Hungary
Poland
Romania
Slovenia
Slovakia
EU-27

Consumption

Labour

1996

2002

2007

1996

2002

2007

1996

2002

2007

n.d.
17.5

16.2
19.8

16.0
22.7

n.d.
32.5

46.2
29.1

53.7
29.0

n.d.
50.0

39.8
51.2

31.6
48.3

7.3
10.4
12.0
9.4
19.4
n.d.
6.7
24.6
EU-25: 20.2

6.6
10.8
6.9
12.2
23.8
17.2
9.1
21.2
21.5

7.9
13.0
12.9
13.4
25.3
18.5
13.9
22.1
23.5

37.2
37.8
39.1
40.6
34.9
n.d.
39.0
33.5
EU-25: 28.0

38.4
37.5
41.3
37.2
36.2
38.9
36.2
33.7
28.4

41.3
39.0
38.3
36.5
37.3
40.4
34.8
38.4
27.8

55.4
48.9
41.5
50.0
46.1
n.d.
54.5
41.9
EU-25: 51.9

55.0
51.7
52.4
50.6
41.1
43.9
54.8
45.1
51.0

50.8
48.0
48.9
50.1
38.6
41.1
51.5
39.5
48.7

Source: Eurostat.

These changes can be analysed from another angle on the basis of the data presented in Table 2.
As a percentage of GDP, capital is taxed significantly less than the EU average in Estonia, while
Poland and the Czech Republic are very close to the EU average. The data also testify to a slight
growth over time (except for Slovakia). Consumption taxes are extremely high, compared to GDP,
in Bulgaria and very high in Hungary, Estonia, Slovenia and Poland. In terms of labour taxes
as a percentage of GDP, only Hungary and Slovenia stand out; among the others, this ratio is
lower, and in some cases significantly lower than in the EU (in Bulgaria, Slovakia, Romania
and Poland).
Table 3 reinforces the trends set out above, but it is apparent that:

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Despite the significantly lower taxes on capital in Slovakia, its share of capital taxes in total
taxes is similar to the EU average.
Estonia relies on capital taxes the least, followed by the other two Baltic States, Hungary and,
interestingly, Slovenia.
Consumption taxes as a proportion of total taxes are highest in Bulgaria, followed by Estonia
and Romania. The Czech Republic relies the least on this tax. However, even in the Czech
Republic the share of consumption tax is higher than the EU average.
Labour taxes contribute a higher share of total tax revenues than the EU average in Slovenia,
Estonia, Hungary and Lithuania. On the other hand, their contribution is much lower in Bulgaria, Poland and Slovakia.

Differences and similarities in the economic strategies and performance of the EU-10, which
were mainly determined by the factors listed above, set the stage for their tax policies. For example, Hungarys position can be partly explained by its high debt servicing, which is by far the highest by regional comparison and puts an enormous strain on its fiscal and tax policy. Slovenia
operates a relatively extensive welfare state which its citizens and companies seem to be ready
to maintain by paying higher taxes.
However, as the case of Slovakia shows, strong-minded government intervention, which takes
into account the conditions of the country, can change the course of fiscal and tax policies. Slovakia introduced a flat tax regime in 2004, with a uniform rate of 19% for personal income, corporate
income and value-added tax.6 The aim of this tax reform was to create a more business- and
investment-friendly environment by eliminating the weaknesses and inefficiencies of the previous
tax laws. The main features of the tax reform were, first, a substantial reduction in taxes. The effective average tax rate was reduced from 22.1% in 2003 to 16.7% in 2004, which was then one of the
lowest rates in Europe. The effective marginal tax rate also decreased, from 15.2% in 2003 to
10.7% in 2004. The overall tax burden dropped from 40.5% in 1995 to 30.3% in 2004, which was
the largest fall of any Member State.7
Secondly, the reform simplified the tax system by abolishing certain taxes, exceptions and
exemptions and thus became more transparent and less costly for taxpayers. The simplification
of the tax law dramatically improved its business friendliness. It eliminated one of the main business barriers identified in business surveys, the excessive complexity and frequent changes in the
tax laws.8 Thirdly, there was a shift from direct to indirect taxes. Fourthly, fiscal revenues were
basically unaffected by the changes, despite the lower tax rates, because of the broadened tax base
and higher economic growth. In 2004, tax receipts fell by only 0.7%, compared to 2003. Slovakia
seized the best moment to introduce its tax reform, when the economy had started to grow at historically high rates.

6 Other EU-10 countries, such as the Baltic States or Romania, have flat taxes for personal incomes only
(Edwards, 2005).
7 For more detail, see OECD Economic Survey: Slovak Republic: http://www.finance.gov.sk/EN/
Default.aspx?CatID118; Deutsche Bank Research: EU Monitor 30, Competing government funding
systems, 12 January 2006, p. 6; http://www.ineko.sk/files/project_ukraine_paper_golias.pdf; Peter
Golias and Robert Kicina, Slovak tax reform: one year after, available at: http://www.ineko.sk/
reformy2003/menu_dane_paper_golias.pdf, pp. 10-11; UNCTAD World Investment Report series, Eurostat News Release, 62/2006 17 May 2006.
8 See, for example, the World Banks Doing Business index.

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The most criticised aspect of the Slovak tax reform is its possible conflict with the ideas of
social fairness and justice, since there is a uniform rate for personal income, corporate income and
value-added tax. There is no lower VAT rate for essential goods that meet basic needs (for example, basic food or medicines) and direct taxes are not progressively scaled, either. This hits lowincome earners especially hard. However, high economic growth has made up for this. Moreover,
besides tax policy, a number of other direct instruments were introduced to help those in need.
Nevertheless, some segments of society did particularly badly from the new tax system (for example, unemployed Roma, especially those with large families).
Tax policies in these countries are also influenced by the (in)efficiency of tax collection. Many
analyses have been conducted on the efficiency of tax collection, directly or indirectly, based on the
extent of the informal economy in these countries.9 On average, the efficiency of tax collection or
the share of the informal economy in GDP is higher than the EU-15 average, and at a similar level
to tax collection in Greece or Italy. However, there are also significant differences. According to
Schneider (2006), the extent of the shadow economy, as a percentage of GDP, grew in all the
EU-10 countries between 19992000 and 20022003.10 In 20022003, Latvia and Estonia stood
out, with a share above 40%, however, none of the countries had lower than a 20% ratio (Czech
Republic: 20.1%; Slovakia: 20.2%). Schneiders analysis shows that, in the (former) transition
countries, the increase in the extent of the informal economy can be explained by the increase in the
burden of tax and social security, the increase in unemployment and the share of direct taxation.
An analysis by Lacko (2008) of the impact of tax rates and corruption (the latter is seen as a kind
of extra tax) on tax revenues in EU economies shows that the share of the hidden economy
appears to be the highest in Poland, Hungary and Slovakia, followed by the Czech Republic, based
on 20002004 data on labour taxes. If consumption taxes are included, the following ranking
emerges, in terms of lost tax revenues in 2004: first, Poland, followed by Hungary, Slovakia and
Czech Republic. As a percentage of GDP, the extent of lost tax revenues can be as high as 8%
(Poland). Compared with the EU-15, the EU-10 together with Greece and Italy were top of the
list in terms of the share of lost tax revenues in GDP.11 A higher reliance on indirect taxes in, for
example, Bulgaria, Hungary and Poland, can also be explained by the higher propensity of companies and citizens to practise tax avoidance.

Major tax policies and tax policy problems in the EU

The European Union is not a single taxation entity; Member States operate under different tax
systems. The national tax regimes of European countries are the result of long development and
differences are deeply rooted in history, culture and economy. Tax policies and taxes have different roles and are perceived differently within the framework of the four European economic
and social development models, depending on overall perceptions of the role of the state and its
involvement in the economy and welfare provision (Sapir, 2005). The 2004 and 2007 EU
9 The transformation process has been accompanied by rapid growth in the informal economies
(Grabowski and Tomalak, 2004).
10 In an earlier study, it emerged that there was growth in the size of the informal economy between 1990
93 and 20002001 (Schneider, 2003). According to Grabowski and Tomalak (2004), there was a
negative relationship between GDP growth and growth in the informal sector between 199093 and
20002001.
11 Other countries analysed here were not included in the investigation.

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Transfer 16(1)
3 000 000

60%

2 500 000

50%

2 000 000

40%

1 500 000

30%

1 000 000

20%

500 000

10%

Percent

Million (GDP, tax)

46

LT

SK

LV

RO

EE

PL

BG

MT

SI

CZ

HU

IE

Total tax revenue

CY

EL

LU

PT

ES

NL

UK

FI

GDP

DE

IT

AT

FR

SE

BE

DK

0%

Tax revenue as % of GDP

Figure 1. Total tax revenue as a percentage of GDP, 2007

Source: European Economic Statistics, Eurostat database.

enlargements complicated this picture even more, because the EU-10 cannot be readily classified in these terms.
While differences between the tax systems of individual Member States were already marked,
the 2004 and 2007 enlargements exacerbated them. With regard to the tax/GDP ratio, the GDPrelated tax burden was moderated in almost all of the EU-27 after 2000. It reached its lowest point
in 2004, at 39.8%.12 However, in the following period, the decrease came to a halt. In the period
between 2000 and 2007, the tax/GDP ratio increased in 14 countries and decreased in 13 countries.
In all the EU-10 (with the exception of Romania), this ratio increased, while among the EU-15 this
was true only for Ireland, Italy, Portugal, Spain and the UK (Pitti, 2008).
In 2007, the tax/GDP ratio was above the EU average in Austria, Denmark, Finland, France,
Italy and Sweden; around the average in Germany, Hungary, Netherlands, Portugal, Slovenia,
Spain and the UK; and below average in Greece, Ireland and in the other EU-10. Changes in that
respect were induced mainly by changes in economic performance (GDP growth) and in the lawabiding behaviour of taxpayers of a given country (Pitti, 2009).
Taxes and social contributions as a percentage of GDP show significant differences in the EU, across
both the EU-15 and the EU-10. Historical and cultural reasons (lower or higher taxes), differences in
regulatory policies (treatment of capital gains), changes in the performance of companies which are not
immediately reflected in tax changes and higher or lower inequality in the society explain these differences. Thus income taxes are more important in the EU-15, together with social contributions paid proportionately by the employers and the employees, while in the EU-10, due to lower income levels,
consumption taxes dominate and social contribution increases are accounted for mainly by employers
contributions. However, the increase in consumption taxes is a general tendency, especially VAT.
Moreover, there is a tendency to broaden tax bases and reduce top marginal rates.
12 However, in 2004 the average tax burden had already exceeded the tax burden in the USA and Japan, the
major rival economic blocs, by 1012 percentage points.

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Pitti and Sass

47

60
Decreasing of tax burden

Growing of tax burden

tax ratio as % of GDP (%)

50

40

30

20

10

LV

PL

CZ

EE

ES

SI

EU12

2007

PT

IT

HU

RO

IE

LT

SK

EL

BG

LU

UK

NL

EU27

EU15

AT

DE

FR

FI
2000

BE

SE

DK

Figure 2. Change in taxation rates between 2000 and 2007, EU-27

Source: European Economic Statistics, Eurostat database.

In the EU, tax harmonisation only affected indirect taxes (VAT) to a certain extent. Direct taxes,
including capital taxes, have not undergone any harmonisation, despite the fact that differences are
wide and have become even wider since the 2004 and 2007 enlargements. There would be clear
advantages in further harmonisation. The lack of harmonisation results in considerable costs for
economic actors and governments in terms of problems of double taxation, and high costs of compliance and business restructuring. Linking the taxation of the parent and affiliates of multinational
companies operating in different countries would increase the transparency of the system. Standardisation of tax bases, alignment of tax rates and avoidance of double taxation would also be important in the process of harmonisation. However, various factors play a role in blocking attempts to
harmonise direct taxes and, above all, capital taxes:




Corporate taxation is perceived as a national economic policy measure. (Moreover, the Stability and Growth Pact also induces countries to keep this tax national.)
According to some experts, the problem of the lack of democratic legitimacy of EU institutions
acts as a barrier from the point of view of tax-raising powers (Nicode`me, 2006).
Member States have different methods of calculating the basis of corporate taxes. One important method is the use of accounting rules (it fulfils the international exchange requirements);
the other is according to the rules of national tax law, which also has the accounting standards
as a starting point, but the result is significantly modified by preferences based on national economic policy intentions (for example, the factors increasing and reducing pre-tax incomes).
There are major differences between Member States in the ratio of corporate tax revenues to GDP,
which after harmonisation would put different burdens on Member States with regard to making up for lost revenue (or possibly modifying the budget because of the extra revenues) (Figure 3).

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48

Transfer 16(1)
7.0

6.0

Percent

5.0

4.0

3.0

2.0

DE

EE

LV

SI

LT

HU

IT

AT

PL

FR

EU27

PT

SK

FI

IE

UK

EL

BE

NL

SE

DK

ES

MT

CZ

LU

0.0

CY

1.0

Figure 3. Tax revenue by corporate income tax as a percentage of GDP, 2005

Source: Taxation trends in the European Union, Eurostat, 2007.
Table 4. Taxes and social contributions as a percentage of GDP

EU-15
EU-12
EU-27

Indirect taxes

Direct taxes

Capital taxes

Social contributions

Total tax revenue

2000

2008

2000

2008

2000

2008

2000

2008

2000

2008

13.4
13.0
13.4

13.0
13.4
13.0

14.0
7.7
13.7

13.4
8.5
13.1

0.2

0.2

0.4
0.1
0.4

14.0
12.7
13.9

13.9
12.1
13.7

41.6
33.5
41.2

40.7
34.1
40.2

Source: Eurostat.

Table 5. Distribution of taxes and contributions according to economic functions (% of GDP)

Labour tax

EU-15
EU-12
EU-27

Consumption tax

Capital tax

Total tax revenue

2000

2008

2000

2008

2000

2008

2000

2008

24.1
17.5
23.8

24.5
17.5
23.9

13.4
13.0
13.4

13.0
13.4
13.1

4.1
3.0
4.1

3.2
3.3
3.2

41.6
33.5
41.2

40.7
34.1
40.2

Source: Eurostat.

While the harmonisation of capital taxes is the issue discussed most often, other taxes could also
be affected in the process. As far as indirect taxes especially VAT are concerned, VAT fraud
(see below) and the associated major losses could be reduced by further harmonisation and by
using the payable in the country of origin system, instead of the currently used payable in destination country principle. However, the country of origin system should also be used for the sale

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Pitti and Sass

49

14.0%
2000
2007

12.0%

Percent

10.0%
8.0%
6.0%
4.0%
2.0%

LU

IT

ES

CZ

SK

UK

BE

DE

FR

IE

EL

NL

AT

MT

LT

HU

LV

RO

FI

PL

SI

PT

SE

EE

DK

BG

CY

0.0%

Figure 4. Value-added tax revenue as a percentage of GDP, EU-27

Source: European Economic Statistics, Eurostat database.
2 000 000

16%

1 800 000

14%

1 600 000
12%
10%

1 200 000
1 000 000

8%

800 000

Percent

Million

1 400 000

6%

600 000
4%
400 000
2%

200 000

0%
BG
DK
CY
EE
SE
SI
IE
LU
FI
AT
PL
HU
NL
PT
LV
RO
LT
BE
CZ
MT
DE
SK
FR
EL
UK
ES
IT

Value of final consumption

VAT revenue

VAT revenue as % of final consumption

Figure 5. VAT revenue as a percentage of final consumption in the EU-27, 2007

Source: European Economic Statistics, Eurostat database.

of services. As for personal taxes, a presumably greater mobility of labour inside the EU calls for
more harmonisation and a decision on questions of social security and other benefits, as well as
public services used in the new country of residence, as well as taxes payable in the home country and in the new employer country. Moreover, the proportions of taxation imposed on capital
and on labour should also be reconsidered. Even recognition of the entitlement of citizens to services in proportion to the taxes they pay should also be taken into account.

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Transfer 16(1)

Table 6. Calculated VAT effectiveness index in the EU-27 countries, 2007 (at current prices, billion euro)
Denomination
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20

Actual final consumption, total

of which
Final consumption of households
Final consumption of general government
of which
Social benefits
Corrected final consumption/5 = 2 + (3 4)
Total gross capital formation
Of which
Business investment
Corrected gross fixed capital formation (8 = 6 7)
Export (sales inside the community and external exports)
Import (supply inside the community and external imports)
Balance of the foreign trade and payments transactions
(11 = 10 9)
Value of corrected final consumption
Value of corrected capital
Balance of foreign trade and payments transactions
Value of the calculated VAT base
Extent of VAT rate (arithmetic mean)
Theoretically realisable VAT revenue
Theoretically realisable VAT revenue*
Actually realised VAT revenue*
Real VAT as % of potential revenue (19:18)

EU-15

EU-12

EU-27

8,928.6
6,569.9
2,358.8
1,753.0
7,175.7
2,416.1
2,107.2
308.9
4,487.5
4,386.7
100.8

666.7
509.1
157.6
109.9
556.8
214.1
173.7
40.4
484.6
521.1
36.5

9,595.3
7,079.0
2,516.4
1,862.9
7,732.5
2,630.2
2,280.9
349.3
4,972.1
4,907.8
64.3

7,175.7
308.9
100.8
7,383.8
19.8%
1,462.0
1,462.0
787.6
53.9%

556.8
40.4
36.5
633.7
19.2%
121.7
121.7
69.0
56.7%

7,732.5
349.3
64.3
8,017.5
19.5%
1,583.7
1,583.7
856.6
54.1%

The harmonisation issue is further exacerbated by the problems facing European welfare states,
problems which are becoming sharper and affecting all Member States, though to different extents.
Maintaining the level of public services and social transfers requires a further increase in revenues
and further centralisation, which, on the other hand, would seriously undermine the international
competitiveness of the affected countries. Under these circumstances, one solution might be a
reduction in the level and content of public services and social transfers offered. However, measures in this direction, to date, have triggered immediate and heated social reactions. Another solution might be the broadening of the tax and contribution base or the further improvement of the
general and proportionate sharing of taxation systems (that is, besides consumption, taxes could
be imposed to a greater extent on assets, as well as on environmentally polluting activities).
Improving the operational efficiency of taxation systems is also an option.
The operational efficiency of VAT which accounts for almost two-thirds of all consumption taxes
is an important issue, which we shall use as an illustration. In the EU, between 2000 and 2007, the VAT
balance (net return) amounted to, on average, 78% of GDP. That is, it represents almost one-third of
total tax and contribution revenues, which makes it one of the most important taxes in all Member States.
Moreover, as VAT fraud becomes more widespread, Member States lose some 260280bn.
Tax revenues from consumption, as a percentage of GDP, differ considerably between Member
States. The reasons for this are as follows. First, in the EU-10, the base for the general and proportionate sharing of taxation is mainly consumption, due to the historically lower income levels; this
factor became even stronger with the high propensity to consume after the beginning of the economic transition. Secondly, VAT rates vary between wide extremes (at one end are Denmark and
Sweden, which apply the highest normal rate, while at the other extreme were Spain, the UK and

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Pitti and Sass

51

Germany until 2007). Thirdly, foreign trade balances also affect the share of VAT in GDP (a positive balance increases the VAT base, while a negative balance decreases it). Moreover, the degree
of law-abiding behaviour of taxpayers and the operational efficiency of the tax authorities control
mechanisms also cause differences.13
The method applied here to characterise the operational efficiency of VAT is to calculate the
ratio between real VAT revenues and final consumption to gross national product (GNP).14 The
advantages of the method are data availability and international comparability. The drawback is
that it can only indicate the difference but not the share of individual factors affecting it.
Total final consumption is corrected by the value of VAT-free social benefits. Moreover, that
part of the value of formation of gross capital formation is added, from which VAT cannot be
deducted (for example, investments by households and the non-profit sector). Investments reduce
the VAT base, but to different extents: in the EU-15, investment/GDP ratios were between 20 and
22%, and in the EU-12 countries between 26 and 30%. Economic integration has resulted in growing foreign trade between the Member States, in both goods and services. Exports to other EU
countries or to third countries outside the EU, due to the application of zero-rate VAT, decreases
the VAT base, while imports increase it.15 The so-called calculated VAT base is then compared to
the calculated VAT revenue. This is obtained by multiplying the calculated VAT base by the normal VAT rate of the given country.16 In our present calculation, however, we applied a simplified
solution. We took the mean of the EU-27 countries VAT rates to arrive at a very rough estimate of
the extent of the theoretically realisable VAT revenue. There is a surprisingly large difference
between the theoretically realisable and the actually realised VAT revenues. This result is reinforced by country level calculations (Figure 6, below).
Country and EU-level differences can be explained, on the one hand, by the slower increase in
theoretically realisable VAT revenues, compared to the actually realised ones. On the other hand,
another reason may be national differences in VAT collection efficiency.
How can the difference between theoretically realisable and actually realised VAT revenues be
explained? The following factors may come into play: deficiencies in statutory regulation; changes
in economic performance (GDP growth); changes in the composition of the tax-paying community; changes in law-abiding behaviour; and, last but not least, changes in the tax authorities control mechanisms. More importantly, these factors also influence the efficiency of collection of
other taxes. Such improvements may impact positively on the fiscal situations of all Member
States.

13 It is hardly by chance that international organisations are paying increased attention to the operation of
VAT and that they are providing methodological help to national tax authorities for the efficient
operation of control mechanisms on foreign trade of goods and services. See, for example, the OECD
Forum on Tax Administration Compliance Sub-Group and the European Union Contact Committee.
14 The so-called completeness check is a method which analyses the operational efficiency of VAT more
comprehensively. This method relying also on data provided by National Accounts, but taking correction factors into account determines the so-called VAT base following the compounds of the added
value type of tax. Taking into account the normal rate according to current regulations (in some cases,
the weighted average VAT rate, calculated after consumption) the so-called calculated VAT revenue rate
is arrived at, which is then taken as the benchmark.
15 Here another problem arises in connection with the increasing differences between declared and mirror
foreign trade statistics, which is also partly related to VAT fraud. See, for example, Ruffles et al. (2003).
16 For the sake of simplification, we do not differentiate between reduced and normal VAT rates.

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Transfer 16(1)

38.6

50

44.3

49.9

47.3

PL

IT

52.5

52.1

FR

ES

54.5

53.5
PT

SK

UK

56.1

54.7

MT

59.0

57.7
BE

CZ

60

BG

62.4

61.1

HU

67.1

FI

63.7

68.8

67.8

SE

EE

69.7

69.0

DE

75.4

70.0

76.4

70

NL

Completeness index (%)

80

45.6

2000
2007

90

45.1

100

89.9

52

40
30
20

EL

LV

LT

RO

SI

IE

DK

AT

CY

10

Figure 6. Calculated VAT effectiveness index in the EU-27, 2007

Financial crisis creating a new environment for taxation, national tax

policies and tax coordination at the EU level
The beginning of the global financial crisis was almost immediately followed by signs of distress
in the real economy. The EU-10 countries are now integrated in the world economy, but especially
into the EU. In fact, by virtue of relocation and outward processing the region makes it possible for
many companies in western Europe to withstand, to some extent, the pressures of global and European competition. This is especially true for German and Austrian companies. To date, the advantages of this situation have been apparent; as the crisis develops, however, disadvantages are
emerging. A considerable number of the negative consequences of the crisis are being exported
to these open economies and the importers mainly due to their openness cannot defend themselves. For the EU-10, the crisis is taking a number of forms: for example, falling export demand; a
strong decrease in investments, including FDI; a drop in domestic consumption; indebtedness in
foreign currencies as national currencies weaken; and problems with tackling the situation because
the room to manoeuvre is quite small in both fiscal and monetary policies. The fall in investments
is further aggravated by protectionist tendencies in the largest investor countries. In some countries, due to the closure or repatriation of plants, the annual FDI inflow might even be negative.
Although investors tend to treat the countries of the region as similar parts of a larger unit, they
differ considerably in terms of their exposure to the crisis and their fiscal room to manoeuvre.
Some have taken the approach of fiscal loosening, while others are attempting fiscal tightening,
which has diverse consequences for tax policy. This situation is the same throughout the EU. The
crisis, without doubt, has created opportunities for enhanced cooperation and coordination among
the EU-10 and/or in the EU. However, so far crisis-tackling measures, including fiscal ones, have
been coordinated to a very limited extent, as countries have tried to cope with the situation on
their own. This approach, in practice, has resulted in even more divergence in the tax field, due
to differences in fiscal prudence and the room each Member State has to manoeuvre.

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53

Conclusion
The EU-10 countries are often blamed for the intensification of tax competition in the EU. This
article shows how various factors for example, the heritage of the Socialist period, transitionrelated issues, certain conditions pertaining to EU accession and changes in the world economy
have affected the development of tax policy in these countries. It also notes that the new Member
States are in a catch-up phase, in which lower taxes are often introduced to attract badly needed
capital investment. Overall, lower capital taxation is compensated for by higher taxes on consumption and on labour, to some extent reflecting the policy stance in this catch-up phase. The article
also presents the major tax problems of the EU and draws attention to the fact that demand for state
expenditures is growing, while tax bases are rapidly shrinking. This, on the one hand, causes fiscal
stress, aggravated by the impact of the current global financial crisis, and on the other hand, higher
taxation negatively affects Member States international competitiveness. Increasing the efficiency
of tax collection may mitigate this problem. Last but not least, the global crisis is causing diverging
tendencies in the fiscal area, across both the EU-10 and the EU-27, thus making cooperation and
harmonisation more difficult.
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