Capital income taxation in Europe; trends and trade-offs

Abstract

The EU capital market integrates. Portfolios become more international, cross border mergers are the order of the day, and never before has there been so much foreign direct investment. This links national tax systems. Residents pay foreign capital income tax, foreigners pay domestic capital income tax, and no member state can afford to overlook the danger of capital flight. What is the appropriate policy response? To do nothing? To coordinate tax systems at the European level? The data do not unequivocally support the tax-race-to-the-bottom hypothesis. On the one hand, member states decrease their statutory capital income tax rates. On the other, they broaden their capital income tax bases. Thus, fear for an economy-wide undertaxation of capital income -the main tenet of tax competition theory- is as yet ungrounded. Nevertheless, tax coordination may be beneficial. It resolves relative undertaxation of particular kinds of capital, forces convergence of capital income tax rates, and creates order in the costly European tax maze. Unfortunately, it simultaneously infringes upon the sovereignty of member states, and sidelines the disciplining force that tax competition exerts on government spending. This study assesses the most important proposals for capital income tax coordination against a background of the recent trends in capital income taxation and the trade offs between distinct policy objectives. It is a guide to the debate that is easy to read, yet firmly grounded in empirical evidence and economic theory.