Laffingly Serious

February 2, 2005
COMMENTARY
By VITOMIR MILES RAGUZ
February 2, 2005
Poor cousins from the East they may be, yet the politicians from New Europe can be quite rich in policy ideas. So enticing in fact that Brussels may be about to take up one of their recipes as a way to revive the lackluster economies of Old Europe. And this may happen quickly if the new Commission president has his way.
Today in Strasbourg, José Manuel Barroso is expected to tell the 732 lawmakers in the European Parliament that the way to economic rejuvenation and job-creation in Europe lies primarily with intra-border competition, technological innovation, less rigid labor regulations and more stringent welfare programs. As a way to promote competition within the borders of the Union, Mr. Barroso is also expected to step away from a strict interpretation of single market principles. He will likely oppose calls for tax harmonization, including the controversial issue of minimum corporate tax rates.
What may be music to the ears of leaders in new members states out East will be a sour note to Gerhard Schröder, Nicolas Sarkozy and others. The German chancellor recently called moves to cut corporate tax rates in New Europe dangerous "tax-dumping." Mr. Sarkozy said this was unfair competition and suggested cutting EU transfers to states practicing it.
While the issue of lower tax rates is accepted wisdom in the U.S., made famous in the 1970s by Arthur Laffer, it's still counter-intuitive in Europe. Mr. Laffer argued convincingly that lower tax rates, at some optimum level, will promote risk-taking and investment, thereby increasing production and government revenue.
Apart from Ireland, newcomers Slovakia and Lithuania are the Union's only real-life laboratories for Mr. Laffer's ideas. Their overall tax burdens on corporate profits are below 15%, compared to tax rates in Old Europe states that can be twice as high. Despite lower rates, these countries collect more corporate tax receipts than those with higher rates. Ireland's inflows are at 3.3% of GDP, Slovakia's at 2.2%, while Germany's, for instance, linger at 0.7%.
Slovakia reduced tax rates last year, and went a step further by making them flat. It now has the same 19% rate on corporate profits, personal income and sales tax. The fact that the government was able to bring in two new major car production lines has made the country the Detroit of Eastern Europe -- and a bellwether state for economic policy. U.S. President George W. Bush will stop over in Bratislava later this month, due to in no small part to this development.
Meanwhile, Poland's leading opposition party, the conservative Civic Platform, has suggested that Warsaw should introduce a flat tax four points below Slovakia's. Similarly, Romania just this year reduced its corporate and personal income taxes from 25% to a flat 16% rate, while keeping VAT at 19%. Serbia seems to want to outdo them all with its recent corporate rate cut to 10%, to be followed by additional tax reductions in June. Even the spend-happy Czech Republic has now commenced a process to reduce its corporate rate to the low-20s from the high-20s over a period of a few years.
To be fair, New Europe states are not doing this only because they believe Mr. Laffer. Rather, they fret that they're becoming less attractive to foreign investors due to rising wages. Not only are the wages in the region now relatively higher, but payroll taxes supporting the Communist-era social programs remain extravagant. Thus, to lower the burden of doing business in their countries, they look to lower corporate taxes. Hungary, for instance, has seen close to 10 foreign investors, such as IBM and Philips, move some or all of their Hungarian operations to cheaper pastures further east and south.
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But New Europe is no policy nirvana. While a number of Central Eastern European states are now in the vanguard on tax policy, many are still laggards on fiscal policy. They can use the advice of Mr. Barroso in this respect. His support for lower taxes should also be seen as a de facto petition for smaller governments, especially in the East, where they are particularly bloated, slow and nontransparent. They're the major obstacles to a new phase of robust economic expansion needed to catch up quickly with Western levels of prosperity. Countries like the Czech Republic, Hungary and Croatia have been most profligate in recent years, running budget deficits in the 5-13% range, compared to the 0-3% levels elsewhere in Europe. This is largely due to a lack of political will to break away from Socialist-era welfare comfort and vote-buying dependency.
As a consequence, Prague, for instance, may have more single mothers than any other city in the world. Of course, almost all wear matrimonial bands but are officially single to be able to collect hefty handouts. Croatia, meanwhile, has yet to grasp what economic policy means beyond IMF stability packages. It muddles along only thanks to its resilient private sector, tourism earnings and émigré transfers. And Hungary, once a favorite among international investors, is now seen as a weakling in the region due to its long-running twin deficits, which put constant pressure on inflation and the exchange rate.
The health care, judiciary, pensions, subsidies and entitlement schemes need a major overhaul in the East. The last three are also a problem in the West. Health sector reform can begin with cost-participations, which is anyway already part of the system in the form of routine bribes of doctors and key personnel. The judiciary can be improved by transferring commercial disputes to special arbitration courts. But most of all, public sector wages in the East ought to be brought in line with Western standards. They cannot be higher than the private sector earnings as is now often the case.
Lower taxes in new member states prevent capital flight to cheaper Asian markets. If combined with reforms, that'll increase the wealth and buying power there. After all, the region still accounts for only 5% of the Union's output or demand. It isn't a threat to Western Europe. As new Romanian Prime Minister Calin Popescu Tariceanu pointed out during a visit to Brussels last week, the region can produce more consumers with deeper pockets for the EU.
While Europe's backyard has taken the lead on taxes, Brussels should embrace these benefits for the front yard as well. Moreover, it should insist on fiscal responsibility across the Continent, all the more so because the old leaders of economic policy in Europe, Berlin and Paris, have lost credibility on both taxes and fiscal policy.
Thankfully, Mr. Barroso seems to have the courage to lead. He doesn't sound worried about offending the old guard. He's confident enough to side with the upstarts out East when they're right. Now if only everyone, whether New or Old Europe, followed his advice.
Mr. Raguz, a former Bosnian-Herzegovene ambassador to the E.U. and NATO, is a banker in Vienna.

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