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Part 2

The coexistence mechanism and the key policy choices of the proposed Directive

After this brief review of the philosophical underpinnings of the proposed Directive and this discussion of the desirable level, let us turn to qualitative aspects of the proposal that our interviews suggest could create major implementation problems. We shall first review briefly the coexistence mechanism and turn our attention then to the non-final character of the proposed withholding tax.

The report argues for making the withholding tax final and presents technical as well as political reasons to do so. The political reasons have to do with the gradual creation of a 'Citizens' Europe' in which loyalty is shared between the national and the European levels like it will be around the euro and like it is already the case through such EU achievements as the Court of Justice, majority voting, the Schengen Treaty and the right of EU nationals to vote in the local elections of other EU countries where they reside. Meanwhile, a brief discussion of the costly failure of an electronic system known as TAURUS aims to alert to the magnitude of the technical risks implicit in the present drafting of the proposed Directive.

2.1 The coexistence principle

An essential aspect of the proposed Directive in political terms is the choice open to all Member States of opting either for full exchange of information or for the withholding tax.

In practice, however, Member States will have no incentive whatsoever to choose that road as it would put them in the role of subordinate tax collectors for other Member States. Collecting the withholding tax and keeping its proceeds is clearly a far more attractive option for host countries. Indeed, the consensus view is that all Member States will choose the withholding tax-approach.

The role of the coexistence model is, at least, a symbolic one to clarify how the withholding tax has been identified as the preferred alternative. This political significance will remain even if all countries choose, as is likely, to adopt the second alternative. Unfortunately, some symbols can be more costly than others. In this case, the fact that the tax is only one of two possibilities contributes:

• To very complex procedures aimed at keeping both options open - to the point of having a 'corrective mechanism' to allow individuals to come back to the first branch of the alternative (providing information on their case through the 'certificate' procedure) even if the country where they earn interest has opted otherwise;
  
• To prevent the Commission from developing the withholding tax branch of this alternative to the full extent. If this tax had been recognized as the preferred choice of all Member-States, it could have been conceived and drafted as a major step toward European integration rather than merely a second best choice for Member States not yet ready to open their banking books to other Member States.
  

Clearly, if it turns out that all Member States choose the withholding tax, which seems very likely, some reassessment of the two-track approach would be essential.

2.2. The reasons for not making the withholding tax final... and the cost for not doing so

A related principle in the proposed Directive is that the withholding tax is merely one step in complying with one's tax obligations, aimed at ensuring that these obligations are not ignored altogether.

Here, clearly, the cost-benefit analysis of such a complex partial mechanism would seem to call for a major reassessment, either by lowering the costs, by increasing the benefits or both. In the view of all interviewees and of this report, one such step is that the withholding tax should be made final, even at the cost of saying that if the 'coexistence model' is king, this is a naked king indeed.

In a nutshell, the Commission is making its proposal hostage to major complexities and uncertainties by insisting on not making the proposed tax final without achieving much more than a symbolic objective of little practical consequence. The Commission's choice for a non-final withholding tax is a natural consequence of the 'coexistence model' whereby, as we just said, the host countries can choose as an alternative to collecting the withholding tax, to make information on interests paid available to the countries of residence of the payee. The fact that the withholding tax is not final implies that complex procedures will have to be put in place so as to conform both with host-country and with country-of-residence tax rules.

The only justification for what will be massively complex administrative procedures is the freedom that the proposed Directive aims to leave to the individual tax payer of having his or her interest earnings taxed in his or her country-of-residence. This may be more attractive if such gains are less taxed in that country or are taxed together with all other sources of income at levels which would then be lower than the 20% withholding tax.

In the words of the Commission itself:

"From the point of view of this Directive, the withholding tax levied by the Member State in which the interest is paid is not normally a definitive deduction and does not fully discharge the beneficiary's tax liability in his country of residence. The deduction of withholding tax is regarded as a practical means of allowing a minimum of effective taxation of cross-border interest payments in the Community. That objective is also achieved when the beneficiary can prove, by means of a certificate, that he has informed his own tax authorities of the income he is receiving in another Member State: the deduction of withholding tax is not considered necessary in such cases, as it is possible that the income will be taxed in the beneficiary's Member State of residence."⁸

This statement shows, first, that the notion of 'minimum of effective taxation' is a relative one, specific to each individual situation rather than an absolute one as it might sound.

In theory, this objective is extremely well meaning and certainly deserves a lot of support in the 'Citizens' Europe' perspective of this report. A major problem however has to do with the complex procedures that all Member States would need to put in place to make it possible. What this statement really mean is that all tax systems in all Member States must coordinate for each citizen to be taxed in the way that will be considered as fair within his or her country of residence. As our interviews and the IPMA and ISMA works available clearly show, simplicity will not really be the right word to describe the convoluted procedures that will have to be put in place. In addition, as Europeans, we regret that politicians do not envision that citizens could make any other choice than to come back to their Member State of residence, to the exclusion of choosing to be taxed under the rules of the country where they happen to have their deposit and to earn interest payment.

The Commission however must be given credit for taking into consideration the freedom of citizens, even if only partially. Yet it would be worthwhile to push this line of reasoning one step further by looking at citizens as belonging both in one Member State and in the Union as a whole.

The pro-integration alternatives to non finality of the withholding tax

In the spirit of Jean Monnet, one should probably ask the question of whether a non-final common withholding tax is really the appropriate next step in the effort toward a level playing field and greater European integration.

This question is all the more urgent if the procedures to have each individual citizen taxed according to his country laws but with procedures in place in 15 countries appears to be extraordinarily complex to implement.

Two other possible options come to mind that could probably serve better the objectives of the proposed Directive:

• A first alternative, the pro-integration one, would be to look at the withholding tax as the first element of a truly European income system. Citizens would be taxed in their own country, of course, but also - as far as interest payments are concerned -they would pay taxes in the Member State where they have their deposits at a commonly agreed level. In other words, they would be treated as citizens of the Union as well as citizens of one Member State. This approach would be comparable to the important political precedent set by the Maastricht treaty as it provides that: citizens of one Member State residing in another one, have the right to vote in local and European elections of other Member States even though they are not citizens of that country. In that sense, the proposed Directive would not be limited to the defensive objective of fighting what is seen as 'harmful tax competition' but after VAT, it would constitute a second important step toward the positive objective of developing, over the next decades, a common tax structure for the Union.
  
• A second alternative, the more traditional form of harmonisation, would be to begin to harmonise key-aspects of national tax systems regarding interest payments so as to greatly reduce the diversity of situations that will have to be addressed by financial intermediaries as they administer the withholding tax. In this way, the Union would avoid the present situation which looks like putting the cart before the horse by creating a common tax in a greatly heterogeneous system. The common withholding tax would be the crowning jewel of a reasonably harmonised system rather than a complex substitute to harmonisation.
  

Both approaches would contribute to genuine integration well beyond what the proposed Directive would allow.

The first approach - making the withholding tax final - has the additional benefit of incorporating the objective of subsidiarity in a more open manner and of relying on de facto, market led convergence rather than on administrative measures.

In a longer term perspective, if this first approach were chosen, the withholding tax could be the starting point for a EU wide dialogue on taxes, benefits and pensions. It could also be used like VAT in connection with EU budget as the EU evolves toward a common approach. This, however, is a subject for another report : suffice it to say that an integrating Union will probably not be able to resort to VAT only for its funding over the next half century to come.

2.3. Punitive heterogeneity

Coming back to the proposed approach, one should stress the differences between national approaches to the taxation of interest are so important as to make a non-final common tax the source of a punitive level of heterogeneity when it comes to assessing the specific individual situation. Table 1 in section 1.1. above shows how different the various national systems are at the present stage.

These difficulties are compounded by the complex nature of modern investment vehicles and funds, to the point that banks will have to compute the after tax value of some of these instruments everyday and for each and every Member State, with possible variations according to the individual tax situation of each individual investor.

In some cases, such as zero coupons and discounted securities, the real value of the investment can only be known on redemption day. This will imply ex-post adjustments and partial repayments or additional tax-claims. This will be a complex and costly approach.

Complex procedures, however, are not good or bad per se as the full cost-benefit analysis depends on the purposes served and objectives achieved. Several of our interviewees have deplored that the proposed Directive includes not even the beginning of a cost-benefit analysis of the measures it puts forward.

Procedures as complex as those envisioned in the proposed Directive would probably be proportionate to the benefits if the latter was involved in the creation of a fully fledged EU-wide income tax system.

In this present case, however, the complexity of the procedures and the costs for intermediaries do not appear to be proportionate to the benefits of what will be only a very partial tax affecting:

• Only tax residents from other EU countries, to the exclusion of nationals and of tax residents of third countries.
  
• Only the interest part of their savings income, with the possibility for them to dilute or swap their way out of the withholding tax altogether.
  
• Last but not least, only those savings that EU nationals will deposit outside of their country of residence but within the Union, to the exclusion of third countries such as Switzerland, the Channel Islands or via securitized Internet access on the off-shore screens of some on-shore banks (see Part 3).

With due respect for the technical skills of the Commission, it appears that little of economic significance would be lost (outside of a relatively empty-sounding 'coexistence') if the proposed Directive was greatly simplified by making the withholding tax final. Again, for supporters of European integration, much would be gained by acknowledging that citizens do not 'belong' to their governments: when the same citizens are entitled to cross intra-EU borders without police check-points, can take their own governments to the EU Court of Justice, can vote in local elections in other EU countries and share the same currency, then they can probably begin to pay their taxes to several countries in line with their actual private choices. This decision, therefore, would do more than fight 'harmful competition': it would acknowledge that the Union is also a Europe of citizens.

2.4. Too many birds for one stone: the TAURUS warning

In assessing the potential cost of too complex procedures and preparing the much needed cost-benefit-risks analysis, the Commission may want to reflect on recent failures of large scale IT projects that were designed to serve too many purposes at the same time. One such project was the TAURUS clearing and settlement project in London.

In 1989, the London Stock Exchange launched a new version for its TAURUS project, a central data base to maintain all share records while respecting the various types of relationships that investors and registrars were used to. The project was supposed to be finished by early 1991. After many delays, on 13 March 1993, TAURUS had to be abandoned, at a cost of 400 million GBP, of which 75 million GBP for the stock exchange and the rest for market participants. This had major negative implications for the overall image and standing of the City.

Part of the failure of TAURUS had to do, precisely, with the decision made by the British Parliament and British tax authorities (as embodied in the DTI legal framework of May 1991) to provide the option of holding shares in paper form.

The logic of TAURUS as an electronic system was electronic book-entry and it was realized that preserving a paper option would be mostly symbolic as only a small number of shareholders would still insist upon it. Yet, the whole system had to be designed to accommodate this dual mode of custody, thereby raising the cost and complexity to levels that turned out to be in excess of what the London market and its professional associations could pay.

Reflecting on the TAURUS example (as well as, for that matter, on the difficulties and costs experienced regarding the 'Year 2000') should make clear that huge costs will be the consequence of the effort in the proposed Directive to maintain a link between the withholding tax as collected in the host-country and the tax system of the taxpayer's country of residence. Having to navigate between several different national environments will add at least one order of magnitude to the complexity of the procedures and to the costs they imply in terms of computer programming, clerk training, administrative record keeping, reporting requirements and the like. Yet, the purpose being served by this 'bridge' between tax systems is likely to be mostly symbolic. It aims to preserve the country of residence as the final reference in theory while the reality of the system will be that of a withholding tax entirely kept by the host country.

These efforts to reconcile symbols and reality might lead a student of scientific revolutions (to use Kuhn's famous phrase) to refer to Ptolemy, the Greek-Egyptian geographer. The latter had succeeded in describing quite accurately the trajectories of planets by resorting only to circles. In the views of the time, the circle (our metaphor for full national tax sovereignty) was the only geometric figure deemed appropriate to describe natural movements. The reality of planet trajectories, however, was that of ellipses. By considering a good dozen circles rotating around one another, Ptolemy nevertheless succeeded in preserving the reference to the circle as central figure while accounting relatively well for the ellipse as the true trajectories. Since then calling an ellipse an ellipse has turned to be not just simpler but more efficient in reaching final objectives.

Similarly, the Commission would move much closer towards its objective if they left the good-meaning, 'politically correct' references to the State of residence out of the procedures and treated what will be in most cases a de facto final withholding tax as a de jure final withholding tax. The more so as the Union as a whole is embarked on a political journey that is taking it, even if gradually, from the world of national circles to that of a genuine European ellipse.

⁸ COM (1998) 295 final, op.cit, page 8

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