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Part 1 Continued

The proposed Directive and the objective of creating a level playing field in European financial markets

1.2. Fairness, and the search for its fair definition

The definition for 'fairness' that inspired the German Constitutional Court and that has been carried into the proposed Directive is centred on a comparison between the tax treatment of salaries and wages and of financial gains on investors' savings. Such an approach sounds fair enough as long as the issue is not raised of whether these savings are not, in many cases, what remains of earned salaries and wages once they have been taxed a first time already.

a) Not all interest payments are windfall inheritances: the VAT reference

The implicit reference is indeed to wealthy savers with little more to do than watch their money grow (the French refer to this as 'l'argent que l'on gagne en dormant'). The reality, however can be quite different as millions of today's European citizens worry about the future of the present pay-as-you-go (PAYG) pension schemes.

In this sense, the proposed Directive is dealing with issues too closely related to pensions and savings for this increasingly important perspective to be ignored.

Although law-makers in most countries - the Netherlands and the UK being the exceptions - are slow to adjust, citizens can see that demography is not on their side as far as their future pensions are concerned, and they do their best to put aside money for their old age as a supplement to what they understand will be a shrinking supply of PAYG money. The point can be made therefore that there is nothing inherently fair in taxing the interest payments accruing to this set-aside money as if it were windfall profits or additional salaries/wages. In any case, the issue is of a political nature and defining what is fair involves more complex analysis.

The growing importance of pension considerations in savings decisions is likely to call for new definitions of 'fairness' by reference, this time, to the two ways in which citizens can choose to dispose of the money they have earned; namely by saving it or by purchasing goods and services. The appropriate benchmark for a 'neutral' approach in this case would not be income tax but the value added tax (VAT) collected at the time of consumption. Unlike income tax, VAT is a tax paid on revenues that have already been cleared through the tax system.

If these revenues are saved rather than consumed, one receives interest payments rather than a basket of goods and services, with VAT rather than income tax a natural benchmark. Actually, the case could be made at a later stage that, just like VAT, the tax on savings could distinguish between different types of (differed) consumptions, some being taxed at a low rate (e.g. those invested for pension purposes) while short term bank deposits could be in the higher bracket. Such a debate may sound a little esoteric today, yet there is hardly one country that does not distinguish between different types of savings. A European debate would be a true contribution.

b) Savings, interests, pensions and the changing relation of citizens and society to time

Gradually, all EU governments are coming to realise that unfunded pensions are a time bomb for the national well-being. They realize that this calls for new approaches to the taxation of money earmarked for pensions. The ongoing reassessment by the French 'Gauche Plurielle' government of its own previous opposition to pension funds is simply the most recent example of the thorough rethinking going on, above and across ideological divisions.

One may regret in this sense that the German Constitutional Court approach does not reflect yet this new awareness that citizens are now expected to take the initiative to save for their old age rather than rely on official PAYG schemes.

The same governments calling for high levels of withholding tax are now busy setting up tax exemptions and tax incentives of various types to invite citizens to save money as well as the interests earned on such money. In this sense, they are moving - with good reasons -away from the objective of 'ensuring a minimum of effective taxations of savings income' which ECOFIN mandated the Commission to put at the centre of the proposed Directive.

Of course, in the old economic paradigm, there was a crystal clear difference between money saved to prepare for retirement and money saved simply for being spent later. This difference, let us suggest, is likely to blur at a rapid pace and to call for comprehensive agiornamento.

The rethinking going on regarding pensions is too recent to have already carried to challenging established views and policies that were coherent with the PAYG world and that will not be coherent with the new approach still in the process of being formulated. And yet, which government in Europe today would dare say that they know at what age a given citizen will really 'retire' - or, too often 'be retired' or simply find herself out of the job market?

As long as they save, citizens are deferring consumption and preparing for 'the future'. And, increasingly, this is 'their' future rather than 'the' future as described in official age limits. We are moving from the easily understood succession of school years, working life and retirement toward far more complex 'life experiences' in which citizens need to find new 'balances of work, report and leisure' - forced or chosen. And these new customised life experiences are harder and harder to describe with the words and references inherited from a simpler period when a worker was a worker, a student was a student and a retiree was, quite simply, a retiree.

Life has become more complex for the invisible European citizen and this calls for more sophisticated policy trade-offs. Pension instruments of various types are likely to flourish, and the moment will soon come when the Union as a whole will be under a strong incentive to come up with the equivalent of the US '401k' tax regime. It is a little unfortunate that the proposed Directive does not offer an opportunity to reflect and to steer policy discussions on what is likely to emerge quite soon as a major dimension of the euro/USD comparison and relationship. This certainly calls, anyway, for a withholding tax set with a broader intellectual perspective than some quasi-automatic comparisons between 'work income' and 'financial income' and for deeper and more informed debates than the one that the short time available has left in the preparation of the proposed Directive.

An obvious additional dimension that would need to be taken into account is the impact of inflation on the real value (as opposed to the nominal value) of this 'virtual basket' of goods and services acquired by the investor in exchange of his or her willingness to defer consumption.

Altogether, the purpose, in the present report is not to make the case for one definition of 'fairness' over another neither is it to present a fully fledged view of the ways in which the Union as a whole should adapt its policies regarding savings in light of the present economic and demographic transformation. It is simply to call attention to the fact that 'fairness' is a very complex and multifaceted notion. Students of John Rawles' Theory of Justice could elaborate better than is possible here on the conceptual and political challenges involved in this quest. Suffice it to say that one should beware of statements such as 'fairness resides in taxing income and interest at the same levels.' Such statements bring together very different notions of work, salary and wage rates, differed consumption, inherited wealth, real interests vs. nominal interests, time and the discount rate reflecting society's inter-generation arbitrages.

Thus, one should be suspicious of the possibility to define 'fairness' and its economic implications across so many important dimensions without deeper analysis and debate. Indeed, unless backed by a thorough analysis of the different trade-offs involved, such statements can be little more than well meaning political sound bites. Hence the strong call this report presents for looking at the proposed Directive as an opportunity to launch a thorough, well informed dialogue.

1.3. Taxes for the level playing field, but at what level?

On the proposal itself, the Ministers of Finance of the EU are expected to continue debating what is the right level for the common withholding tax. The proposed 20% is higher than levels that had been in place in some Member States in the recent past. France is asking to set this tax at 25%. The German withholding tax is set at 30%.

The Commission stresses that it has adopted 'a balanced solution to the problem of setting the rate of withholding tax' not only by taking into consideration the risks of setting it too high, but also by having put in place 'a corrective mechanism enabling the beneficiary, at his own initiative to be taxed according to the rules of his Member State residence'.

Yet, for all these efforts to reach a 'balanced' approach, the level at which the tax is set will quickly become a de facto reference that all countries will have to take into consideration when setting their own national taxes on interests. Three possible approaches would be:

• To set that common reference close to the highest levels experienced in any of the EU Member States, with citizens being reimbursed for what they have to pay abroad in excess of the level in their own country under the 'corrective mechanism'. This approach would serve the quite understandable objective of keeping as much of the savings as possible in the country of residence while accommodating individual situations such as those of European citizens employed or studying in a Member State different from their home country.
  
• To set the withholding tax at a level conceived first and foremost to contribute to the competitiveness of European financial markets on a global scale, as called for in point 4 of the ECOFIN Resolution of 1 December1997. In this case, a higher degree of competition inside the Union should be accepted before being labelled 'harmful', with no premium being put on keeping savings within the country of residence. Intra-European competition has always served Europe well when it comes to adapting to higher levels of global competition.
  
• To treat the withholding tax as an unavoidable concession markets should make to politics and to seek the lowest possible level for that unavoidable concession.
  

The natural tendency of national exchequers will be to opt for the first approach which preserves their 'rights' over 'their' citizens.

The clear preference of market practitioners will be for the third approach, as it minimises the interference of governments into the smooth working of markets. During our interviews, it was clear indeed that market practitioners would look much more positively at the proposed withholding tax if its level were in the order of 10%. They see this level as the limit under which the proposed tax would not be likely to trigger the delocalisation strategies described below, at least not on a worrisome scale. Below that level, the tax would be offset, in the eyes of investors and intermediaries, by the 'friction costs' associated with moving financial operations abroad or with setting up new channels for receiving interest payments in non-EU jurisdictions.

Let us suggest that both 'polar' approaches one and three fail to meet the test of a true step toward European harmonisation as a contribution to closer and closer integration.

The first one (setting the tax as high as possible) uses the notion of a 'level playing field' as a convenient excuse to keep citizens at home, which is hardly what European integration is supposed to be about. Indeed, although it is coming in the footsteps of the euro, it would succeed in turning the Maastricht criteria on their head by substituting protection against foreign practices to mutual recognition and the search for best practices.

The third approach puts the smooth functioning of markets above that of Europe as a human community with its social and political objectives. It has clear and understandable advantages for markets but it may also disregard the objectives of European integration by creating capital movements that would give very little meaning to the European level, something increasingly inconsistent with a single currency.

Altogether, we believe that the level of the tax should balance two major objectives:

• Eliminating 'off-shore' pockets within the Union itself by having a tax in place irrespective of which EU country is chosen by an EU individual investor.
  
• Preserving the role of the Union as a catalyst for change. Much of the economic success of 'Europe' has come from the rational and from the institutional framework it has provided to challenge time-honoured national habits that had become dysfunctional: without 'Europe', French citizens would still need to go to the pharmacist to procure baby diapers (at pharmacist's prices rather than at far cheaper supermarket ones!) and the two million French citizens who rushed to buy shares in France Telecom would still be lectured that overpaying for communication is the best way to create jobs in the information age.
  

Hence our recommendation to balance these objectives by choosing a level for the tax that preserves a significant incentive for citizens to look on the other side of the border without nevertheless placing them in front of a simplistic 'no tax/high tax' choice.

A reason to insist on preserving a strong incentive to look beyond the border is that there are many tax-free havens inside national borders. Any bank member of the Association Française des Banques will point to the major distortion in competition and efficient allocation of resources stemming from Livret A (a tax-free savings account over which the Caisses d'Epargne have a monopoly). Key elements are presently challenged by DGIV but it nevertheless remains that the 'level playing field' inside national borders leaves much to be done. Similarly, the fact that banks in several countries cannot pay interests on checking account deposits and must provide a number of services for free also represents major distortions. More generally, all Member States have built impressive, sometimes extravagant tax-incentive architectures, not least to attract savings toward the financing of Government debt.

As we have seen, the need to address massive unfunded pension liabilities is likely to lead to more rather than less tax exemptions within the Member States, to the point that the Union-wide withholding tax regime will probably have to offer similar tax exemptions in the not distant future.

Therefore, in addition to the reasons above, a genuine 'level playing field' for financial services in Europe requires significant incentives to balance this bias toward keeping savings at home within easy reach of the national governments.⁷ It also calls for going beyond the call for 'a minimum of effective taxation' to acknowledge that an increasing part of savings - whether at home or cross-border - will go toward pension-related instruments. Again, now is more a time to think than a time to dictate.

1.4. The level playing field ...and the convergence game that will be played on it

The US and Swiss examples as well as the discretion left to national governments by the VAT tax harmonisation Directive itself are a reminder that a well working 'internal market' need not imply full harmonisation. An element of competition among the Member States will always be needed to encourage convergence toward best practises rather than 'convergence toward the bottom' (the bottom being, in that case, the lowest levels of disposable income for the private use of European citizens, in other words, the highest level of tax).

After all, the Maastricht criteria required all countries to converge toward the interest rates and the inflation rates of the three best performing countries, in other words toward the lowest rates. They did not set a 'floor' of, for instance, a 6% inflation level and a 5% interest rate, under which no country would have been allowed to go. Convergence toward the most efficient tax system rather than protection of all national systems is what the Maastricht experience would suggest to promote through the Directive.

The term 'harmful' used to describe what the proposed Directive should stand against is a highly subjective one: the economy is not simply about the wealth that already exists, it is also about Joseph Schumpeter's 'creative destruction'. Destruction is bound to be harmful at least in some sense. This, however, is part of a slightly broader agenda than the one we can address here. Many of the practitioners we interviewed stressed how important it is for Europe not to provide a justification for Member States to hide inefficient practices under a blanket of heavy taxes that the same government can then blame, very conveniently, on 'Brussels'. Europe succeeds economically to the extent that it allows Member States to learn from one another and to challenge those of their own national practices that tend to reflect a less open mind, a more self-complacent approach.

A central objective of European integration is to achieve a higher level of prosperity than would be possible in isolation. It is fully accepted now that this implies competition among the private sectors of Europe as well as among former 'natural monopolies'. It would be important for the proposed Directive to state that emulation toward best practices in matters of taxing and spending also contributes to higher standards of living and employment. Such emulation has been central to the process of convergence triggered by the Maastricht treaty. Countries like Italy, Portugal and Greece have been widely acclaimed for their capacity to manage their public affairs in a more efficient manner as part of the European convergence process and of the search for efficient approach to their important social and public objectives.

Looking back to the first four decades in European integration since the Treaty of Rome, it is clear that Europe has already succeeded on two major fronts - creating an internal market and achieving economic and monetary Union - and that it has done so by accepting higher levels of competition and by converging toward best policy practices (e.g. the German monetary policy) rather than by satisfying itself with some form of merge.

A third major agenda is now taking shape around taxes, savings, pensions and the adaptation of the European 'model' to the new economic, demographic and technological situation.

The Commission has all the capacities it takes to help address this agenda in a forward looking manner, including through a proposed Directive on taxation of interest payments. This will call, however, for additional work and even more so, for a true, indepth dialogue.

⁷ We find ourselves in agreement with ISMA which also points at the systematic use of tax incentives by national governments.

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