Tax Policy and the Financial Crisis in Europe

Tax Policy and the Financial Crisis in Europe
Richard F. Emery
Linfield College
Department of Business
900 SE Baker Street
McMinnville, OR 97128
[email protected]
(503) 883-2298
Fax (503) 883-2370
Paper Presented at the 35th Annual European Studies Conference
At the University of Nebraska at Omaha
October 7-9, 2010
Introduction
“Tax was not among the root causes of the financial crisis” (Lloyd, 2009, p. 1).
“While taxes have not generated the crisis…Tax incentives may indeed have exacerbated
the behaviour of economic agents, leading them to wrong economic decisions”
(Hemmelgarn and Nicodeme, 2010, p. 4).
Accounting and business textbooks contain little, if any, discussion on income
taxation and its impact on business decisions. This is surprising because, in most cases,
income tax expense is the second or third highest expense of most companies. Sadly,
taxation policy is left to economists for more theoretical discussion. While such
discussion is necessary, business students and businesspersons need to have at least a
basic understanding as to the realities and implications of tax policy.
As an accounting professor with a passion for tax policy, the question of the
impact of tax policy on the current recession was of interest. In short, as the above quotes
indicate, tax policy cannot be blamed for the recession; however, it is not unreasonable to
suggest tax policy was a contributing factor.
This paper will initially discuss some of the root causes of the recession. It is
important to note that although, the paper is primarily focused on tax policy in European
Union (EU) countries, the financial crisis is world-wide, and as such, much of the initial
background will be focused on a more general level. Once a general discussion of the
causes of the financial crisis has been addressed, the paper will look at changes in tax
policy, particularly in the EU and in various EU countries.
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Causes of the Financial Crisis
According to Lloyd causes of the financial crisis can be categorized as follows:
•
The boom in credit and asset prices
•
A high appetite for yield and a high tolerance of risk
•
Lack of transparency
•
Inadequate regulation
•
Inadequate governance
Lloyd goes on to say:
The banking business model facilitated by this regulatory environment and by the
specific catalysts identified in the US has been characterised by a focus on shortterm share price growth rather than long-term soundness of banks’ balance sheets.
Banks found ways of increasing profits by using derivatives to insure against high
levels of credit and market risk while reducing their borrowing costs by ringfencing liabilities in off-balance sheet conduit subsidiaries. Bank staff were
encouraged to seek short-term profits through bonuses based on fee income and
up-front revenue, rather than on sustainable lending. The same banking model
became prominent in other investment banking centres such as Switzerland,
Germany and the UK, and the same incentives, as well as market share pressures,
meant that the drive to greater leverage and off-balance-sheet activity was widely
copied around the world, both in the financial sector and beyond (Lloyd, 2009,
pp. 3-4).
At the G-20 summit in London in April 2009 world leaders adopted a number of
agreements in response to the financial crisis. Among the items adopted:
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•
A Financial Stability Board to provide early warning of financial risks and
actions needed to address them
•
Improvements to bank capital regulations in order to prevent excessive
leverage
•
Call for improved accounting standards on valuation, and generally a call
for a single-set of global accounting standards
•
Call for all countries to adopt the international tax information exchange
standard; and agreement to adopt counter-measurers against countries,
which do not meet the transparency standards
While Lloyd has described in general terms the root causes of the financial crisis and,
more specifically has pointed a finger at the banking industry, a closer look at some of
the specifics is necessary.
The twenty-first century was preceded by tremendous growth in stock markets
particularly in the late 1990s, now commonly referred to as the dot-com bubble. In the
United States, dot-coms were generally companies listed on the NASDAQ Composite
Index. The NASDAQ peaked at 5132.52 on 10 March 2000. What is generally forgotten
is the rapid growth of the NASDAQ throughout the late 1990s. For example, the
NASDAQ didn’t reach 2000 until 16 July 1998, less than 20 months before it reached its
peak. Had you purchased a typical NASDAQ stock on that date, the return on your
investment would have been more than 150 percent in less than two years. After the peak,
the bubble burst with the NASDAQ reaching a post-bubble low of 1108.49 on 10
October 2002. Your hypothetical stock purchase would have lost nearly 80% of its peak
value in just over 2 ½ years. The point of this is not to rehash the dot-com burst, but
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rather to look at the response to that event. In short, the Federal Reserve Bank in the US
systematically lowered its prime discount rate from 6.5%, at the peak, to 1% by the
middle of 2003. It should be noted that the Federal Reserve policy of low interest rates
was also exacerbated in response to the terrorist attacks on 11 September 2001.
By contrast, the key-lending rate of the European Central Bank (ECB) was 4.25%
on 10 March 2000. It continued to climb to 5.75% where it remained until May 2001. By
the middle of 2003, it was still at 3%, significantly higher than in the US. However, it is
important to note that the primary goal of the ECB is to keep inflation at or near 2%. It
does not have the same responsibility that the Federal Reserve has in providing stimuli to
the economy.
According to Hemmelgarn and Nicodem:
A second characteristic of the world economy in the early 2000s was massive
inflows of capital on international financial markets. The U.S. Capital and
Financial account is illustrative of this phenomenon. Between 1995 and 2000, it
increased from 1.54% to 4.25% of GDP and continued to rise in the first half of
the 2000’s to peak at 6.10% of GDP in 2006. The main driver of this expansion
was net portfolio investment, which grew from USD 42.7 billion in 1998 to over
USD 807 billion in 2007 – a twenty-fold increase over nine years. Therefore, the
U.S. economic situation in the first half of the 2000s was characterized by rapid
economic recovery with low interest rates, increasing financial inflows and a high
degree of risk-aversion in stock markets, following the tech bubble burst
(Hemmelgarn and Nicodeme, 2010, p. 6).
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The last sentence of the above quote provides an excellent summary of just where the
U.S. and the world economies were prior to the current financial crisis.
Tax Policy and Home Ownership
Since the Depression of the 1930s, the U.S. government has established various
governmental policies and programs that promote home ownership. The first program
was the establishment of the Federal National Mortgage Association, more commonly
known as Fannie Mae, in 1938. The purpose of Fannie Mae was to buy and securitize
mortgages to ensure liquidity for lending institutions. This was followed in 1970 by the
creation of the Federal Home Loan Corporation, Freddie Mac, whose purpose was
essentially the same, but on the secondary mortgage market. Fannie Mae and Freddie
Mac are:
a powerful instrument to refuel lending institutions with fresh cash and
subsequently allow them to engage in additional lending activities. Fannie Mae
and Freddie Mac have also been instrumented at varying degrees by U. S.
administrations to expand housing credit to middle- and low-income families as
well as in distressed areas (Hemmelgarn and Nicodeme, 2010, pp. 8-9).
Deductibility of mortgage interest on owner-occupied homes is another
significant way the U.S. federal government promotes home ownership. Prior to the Tax
Reform Act (TRA) of 1986, taxpayers could deduct interest on consumer loans – car
loans, credit card loans, payment on delinquent taxes to the Internal Revenue Service, etc.
However, the TRA of 1986 eliminated deductibility of interest on these loans and
essentially made interest on home loans the only deductible interest item. Deductibility
was irrespective of the use of the money borrowed. Want an expensive car or a dream
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vacation and don’t have the funds for it? The solution was (is) simple, if not also
perverse; take out a second mortgage on your home.
U.S. tax law also allows taxpayers to exclude up to $500,000 of gain on the sale
of their personal residence. This could easily be perceived as incentive to buy more house
than one might afford and, of course, borrow more as well.
In response to the dot-com bubble burst, taxpayers were looking for safe places to
put their money. Economic agents concluded that investment in real property was the
solution. In addition to the perceived safety of property ownership, the low interest rates
and large inflow of capital, discussed above, also provided incentive toward home
ownership. As a result, between 2001 and 2005, the number of homes sold in the U.S.
increased by 41.3%, while the average price rose by 39.3%.
On 28 April 2004, the U. S. Securities and Exchange Commission agreed to
loosen the capital rules on large financial institutions, which in effect, allowed these
institutions to significantly increase the level of risk they could take on. This led to a
significant increase in the leverage of most financial institutions. As a result, the
proportion of sub-prime mortgages rose from 7.2% of the total number of mortgages in
2001 to more than 20% in 2005 and 2006. Over a third of these homes were bought for
investment or second home purposes with the expectation of continued price increases so
that buyers could resell these homes at a profit with minimal capital gains tax – 15%. In
addition, a third of the loans made in 2002 were either interest only mortgages or
negative amortization loans. Further, an increasing number of loans made between 2001
and 2004 were adjustable rate mortgages (ARMs) despite the fact that interest rates had
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stabilized and, in most cases, actually declined. The reason for the popularity of ARMs
was an increasing number of non-credit worthy borrowers.
With the dot-com crisis essentially over, the Federal Reserve started raising
interest rates in from 1% in May 2004 to 5.25% in May 2006. This was in response to an
increase in inflation, which rose from 1.6% in 2002 to 4.3% in 2006. As a result,
borrowers, especially those with ARMs, could not repay their loans. This led to a
significant increase in the number of foreclosures from under 900,000 in 2005 to over
3,150,000 in 2008.
HSBC (formerly The Hongkong and Shanghai Banking Corporation) announced
in February 2007 that it was down for USD 10.5 billions of sub-prime MBS
(mortgage based securities). This event was followed in April by the bankruptcy
of New Century Financial, the U.S. largest sub-prime lender….The near-collapse
of the banking system happened in September 2008. On 7 September…Fannie
Mae and Freddy Mac were urgently nationalized. On 14 September, Merrill
Lynch saw itself close to illiquidity and was sold to Bank of America. The next
day, Lehman Brothers filed for bankruptcy, and the day after, American
International Group (AIG)…avoided bankruptcy only thanks to a USD 85 billion
loan from the Federal Reserve (Hemmelgarn and Nicodeme, 2010, p. 13).
All this led to a near-record collapse in the stock markets. The S&P-500 stock
index started to decline from his highest value of 1565.15 on 9 October 2007. On 9
March 2009, it reached its lowest point, 676.53, a decline of more than 56 percent of its
peak value in just 17 months.
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Recovery
Although the media has portrayed the current financial crisis as the worse since
the Great Depression of 1929, that is probably not the case. It took the stock markets
nearly three years, 1,025 days, to reach the bottom during the Depression. Surprisingly, it
took the stock markets 913 days to bottom out from the dot-com burst. The markets took
626 days to recover from the 1973 oil crisis. However, during the current financial crisis,
the markets began to recover after only 517 days.
Additionally, the return to pre-crisis levels takes a very long time. It took more
than 7 years after the 2000 dot-com bubble burst and 7 ½ years after the 1973 oil crisis,
while WWII never allowed stocks to return to their pre-1929 levels. It took just 15
months for the S&P-500 index to recover half the value lost during the current crisis.
As I indicated in a paper presented at last year’s European Studies Conference,
most experts feel that the recovery actually began during the 2nd quarter of 2009, both in
the U.S. and in the EU. Much of the recovery must be attributed to government policy
response. As indicated earlier, central banks rapidly lowered interest rates. This was
followed by governments rescuing banks – Fannie Mae, Freddie Mac, and AIG in the
U.S. “Member States of the EU committed to recapitalization of their financial
institution, guarantees on bank liabilities, relief of impaired assets and liquidity and bank
funding support for a total representation 43.6% of their combined GDP” (European
Commission, 2009, p. 44). The third part of the recovery program was fiscal stimulus
packages. For example, the U.S. has provided over USD 150 billion through various tax
credits. Also, as mentioned in last year’s paper, the EU provided EUR 200 billion in
funds for recovery.
9
Housing and Tax Incentives in the EU
Two EU countries, Ireland and Spain, faced price bubbles in the housing market
to an even greater extent than what occurred in the U.S. One measure of the
attractiveness of home ownership is the price-to-rent ratio. The ratio compares the
discounted rents for a house with its current price. If the ratio is more than 100, it is more
attractive to own a house than to rent. In 1992 the ratio in Ireland was around 60, which
meant that it was far more attractive to rent than own. Five years later the ratio was just
under 100. By 2005, the ratio had reached more than 250. This is another indicator of the
initial success of the Celtic Tiger. However, in the three years following the peak the
price-to-rent ratio had decreased to just over 150.
The swings in Spain, while large, were not as dramatic. The ratio hovered
between just under 100 and 120 throughout most of the 1990s. The ratio had a steady
climb upward reaching 210 in 2007 before falling to under 150 two years later. Other EU
countries, notably the UK, France, Sweden, and the Netherlands, experienced similar
increases in house prices, but to a lesser degree.
While taxes perhaps contributed to the housing bubble in Ireland and Spain the
driving forces were low real interest rates and the rapid expansion of credit. Another
factor was probably the introduction of the Euro, which led to lower interest rates,
particularly in these two countries.
Tax incentives on home ownership include deduction of mortgage interest as
discussed above. Another incentive is that imputed rents are not taxed. If you own a
rental property, rental income is taxed. However, if you own and live in your own home,
the imputed rental value is not taxed, another incentive toward home ownership. Also,
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although most countries do tax real estate, the tax is deductible in computing taxable
income. With the exception of the UK, the revenue generated by real property taxation is
quite insignificant. The percentage of tax revenue received from real property taxation
varies from a low of just over 0.5% in Hungary and Bulgaria to a high of just over 4.2%
in Malta and France. The UK percentage is definitely an outlier generating just over
10.5% of total tax revenues. Data for the relationship of tax revenues to GDP is
comparable with it being about 0.2% in Hungary and Bulgaria to a high of 1.8% in
France. Again, the UK is the exception with a percentage of 3.8%. With this in mind, it’s
reasonable to conclude that with the possible exception of the UK, taxation of real
property is not a disincentive to home ownership.
Financial Transaction Tax
The concept of financial transaction taxes has been discussed for many years,
especially after economic downturns. John Maynard Keynes first broached the subject in
the mid-1930s, when he argued that a “substantial government transfer tax on all
transactions might prove the most serviceable reform available with a view to mitigating
the predominance of speculation over enterprise in the United States” (Keynes, 1936, p.
143). On the other hand, he went on to say: “If individual purchases of investments were
rendered illiquid, this might seriously impede new investment, so long as alternative
ways in which to hold his savings are available to the individual. This is the dilemma”
(Keynes, 1936, p. 144).
Many studies have been conducted since Keynes’ time, and as would be expected
the results have been mixed. Nevertheless, the current argument in favor of financial
transactions taxes rests on the following assumptions that they would:
11
•
Stabilize financial markets by reducing speculative and technical trading,
especially in the derivatives market by increasing transaction costs
•
Raise substantial tax revenue while creating only small distortions in the
real economy
•
Serve as a contribution of the financial sector to the financing of bailout
costs caused by the financial crisis
Hemmelgarn and Nicodeme offer the following: “the tax would decrease price volatility
and unproductive short-term speculations since investors would concentrate on the longrun return of projects” (2010, p. 36). It is this focus on the short-term rather than the longterm that drives many financial transactions.
The basic idea is that the introduction of a financial transaction tax, which would
obviously increase transaction costs, would lead to a reduction in the number of financial
transactions. The EU has considered a uniform transaction tax on all transactions
involving financial assets, thus eliminating preference to any particular type of financial
transaction. The tax rates discussed would be very low ranging from 0.01% to 0.05% per
transaction.
In addition, it is assumed that the cost of administering a financial transactions tax
would also be low. A recent study by Bond, Hawkins, and Klemm found that the cost to
collect the stamp tax in the United Kingdom (UK) was 0.11 Pence per Pound collected,
compared to a cost of 1.59 Pence per Pound collected for the UK’s income tax.
Nevertheless, as indicated above, studies on financial transaction taxes have been
inconclusive. Probably, the most comprehensive analysis was conducted by Schwert and
Sequin in a 1993 paper, wherein they concluded, that there is little evidence that the
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potential beneficial effects of a transaction tax outweigh the potential costs due to tax
avoidance and unclear tax incidence.
Corporate Taxation and Financing Neutrality
Tax systems in the EU, as well as in the United States have long favored debt
financing over equity financing. This is accomplished by allowing income tax deductions
for interest payments on corporate debt, while payment, (i.e. return on equity through the
payment of dividends) to shareholders is not tax deductible. The result of this is that
many, if not most, firms seek to highly leverage their capital structure because acquisition
of debt is in essence tax favored. A recent study by Huizinga, Laeven and Nicodeme
found that for stand-alone companies, an increase in the effective tax rate by one
percentage point increases the ratio of debt to assets by .18%. The impact is even larger
for multinationals as it increases the ratio by .24%.
It would seem, on the surface, that any proposal to eliminate this distortion would
be favored. There are two proposals that have been discussed in the literature for a
number of years. One proposal is to create an Allowance for Corporate Equity (ACE).
Essentially, the ACE would allow a similar deduction for the payment of dividends that
currently exists for the payment of interest. This would, obviously reduce, if not
eliminate, the advantage of debt financing. However, introduction of an ACE would lead
to a narrower tax base resulting in collection of less tax revenue. In order to collect the
same amount of tax revenue, the statutory corporate tax rate would need to be increased.
Assuming that raising the corporate tax rate is not politically feasible, the other
proposal warrants consideration. This proposal, called a Comprehensive Business Income
Tax (CBIT), calls for the elimination of the deduction for interest payments on debt,
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again putting equity financing on par with debt financing. Introduction of a CBIT would
have the opposite effect of an ACE. It would lead to a broadening of the tax base, and all
things being held equal, would lead to an increase in tax revenue from corporate income
taxation. Hence, countries could decrease the corporate tax rate to achieve tax neutrality.
Economic literature suggests that there are downsides to the implementation of
either system in their entirety, so a possible solution might be to consider a combination
of the two systems. Nevertheless, EU member countries do not appear to be moving to
eliminate the distortions caused by the current system. Belgium has implemented an ACE
system, while Germany has limited interest deductibility, a move toward a CBIT system.
Italy, on the other hand, had, for a short period of time, elements of an ACE system, but
has since removed them.
Taxation Measures Taken in Response to the Financial Crisis
In looking at what measures have taken place within the EU in reaction to the
financial crisis, it is important to remember that tax policy within the EU is left to
member states, hence Brussels cannot implement and enforce any tax policy regardless of
the worthiness of such a policy. Therefore, it is necessary to look at what steps have been
taken by member states.
The majority of member states enacted some form of reduction in the personal
income tax (PIT). Greece, Ireland, and the UK were exceptions. Greece introduced an
extra tax on personal income for earners with income above € 60,000 - € 1,000 to a
maximum of € 25,000 for those with income above € 900,000. Ireland introduced an
income tax levy of 1% on gross income up to € 100,100; 2% on gross income up to €
250,120; and 3% on gross income above € 250,120. Effective 1 May 2009, these rates
14
were doubled and the bases were reduced to € 75,036 and € 174,980 respectively. The
UK introduced an additional tax of 50% that applies to income above GBP 150,000. In
addition, the personal income tax allowance has been restricted for those with annual
income above GBP 100,000.
Several member states chose to increase the VAT as a way to increase tax
revenue. Ireland increased its VAT from 21 to 21.5% effective December 2008. Hungary
chose to increase its VAT from 20 to 25% effective 1 July 2009 and introduced an 18%
rate on diary products, baked goods, and fuel costs. Latvia increased its VAT from 18 to
21%, while Lithuania increased its VAT from 18 to 19%. On the other hand, the UK
chose to reduce its VAT from 17.5 to 15% for the two-year period 2008 and 2009.
Finland decreased its VAT on food products from 17 to 12% effective 1 October 2009.
The remaining EU member states have not toyed with their VAT rates.
Lithuania was alone in member states that elected to increase its corporate income
tax (CIT) rate from 15 to 20%. That said, Italy chose to introduce a 5.5% surcharge
applicable to companies involved with oil refining and production. On the other hand,
Luxembourg and Sweden elected to reduce their CIT rates – Luxembourg from 22 to
21% and Sweden from 28 to 26.3%. Although, more member states have not changed
their CIT rates, they did target business investment through other means such as more
generous depreciation allowances or through the introduction of or increases in
investment tax credits.
Minimal changes have been enacted in regards to taxation on capital gains.
Ireland increased its capital gains rate from 20 to 22% and then to 25% effective 8 April
2009. On the other hand, Romania chose to exempt from the capital gains tax,
15
transactions that occurred on the Romanian stock exchange. Romania also chose to
exempt transactions of non-residents from the capital gains tax. Obviously, both of these
decisions were in an effort to boost foreign direct investment.
In other areas, member states enacted changes in response to the slump in the
housing sector and to provide incentives for tourism. For example, Italy capped the
interest rate for adjustable rate mortgages (ARMs), wherein the government would
reimburse banks for their losses through tax credits. In addition, Italy is providing tax
incentives for purchases of household appliances and furniture. Also, in Italy, the first
property owned by a taxpayer has been exempted from property taxes. Bulgaria has
introduced a mortgage interest deduction for young families.
Cypress has temporarily reduced the VAT for hotel accommodations from 8 to
5%. It has also decreased landing fees on airlines and eliminated transit taxes for
overnight stays. In Malta, the travelers’ departure tax has been eliminated. Greece
eliminated airport landing and parking fees during the six-month period from April
through September 2009. Greece also reduced from 2 to 0.5% the transit tax on hotel and
other short-term rentals as well as on the gross revenues of bars and restaurants.
These tax measures obviously vary considerably across EU member states, but,
while justified by specific budgetary and financial constraints, it does raise the question
as to whether industry-specific measures represent the best approach in dealing with a
financial slump, not only in the EU, but worldwide. Certainly, such a patchwork of
incentives is incoherent at the EU-level, making future centralization of tax policy even
more difficult.
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As is well known, the EU is one of the most highly taxed areas in the world. Over
the past decade the tax burden has been somewhat reduced. However, with the added
debt burden and the retirement of the baby boom generation, there is legitimate concern
that the tax burden will return to historic levels, significantly impacting the active
working force.
There are a couple of results worth mentioning in looking at the tax measures that
have been implemented. The measures introduced seem “to point to a continuation of the
recent trend towards greater reliance on consumption rather than labour or capital taxes.
This would be in line with the remarkable decline in CIT rates observed since the end of
the 1980s” (Eurostat, 2009, p. 11). In spite of the continuation of this trend, evidence
suggests that over the past decade the tax-to-GDP ratio has declined very modestly,
raising the question as to whether this shifting of the tax burden has contributed to
economic growth.
A second result, not articulated here, is that the financial crisis has forced more
transparency in the reporting of and more effective taxation of portfolio investment
income held in offshore tax havens. This is seen as a positive outcome as it is something
that both the EU and U.S. have long advocated.
Concluding Comments
As stated at the outset, taxation was not a primary cause of the current financial
crisis. Yet, taxation is often looked to, to cure many societal ills, whether they be
financial or otherwise. It is obvious, that there has been little, if any, coherency or
consistency to taxation measures, at least during the current financial crisis. Some
countries raised tax rates, while others lowered tax rates. What works in one country may
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or may not work in another. All this does raise the question as to whether the EU would
be better off if tax policy were determined at the federal level or if tax policy should be
left to the discretion of the member states as currently exists. After all, as an example, the
EU, through the European Central Bank, does set EU-wide interest rates. This begs the
questions as to why are member states so determined to hang onto tax policy, while
having given away so much other authority to Brussels?
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