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Tax Troubles

The Welfare State Is Dead. Long Live the Welfare State!

By Gabor Steingart

Western countries are expensive, developing countries are cheap. Such is the problem facing welfare states in Europe and North America. How can it be fixed? It's the taxes, stupid.

Editor's Note: The following essay has been excerpted from the German best-seller "World War for Wealth: The Global Grab for Power and Prosperity" by SPIEGEL editor Gabor Steingart. SPIEGEL ONLINE is publishing a series of daily excerpts from the book.

No one should bemoan the demise of the welfare state. There is no reason to feel discouraged about its viability, even if claiming the opposite is currently in fashion. The pared-down state, as a response to globalization, is a possibility but not a foregone conclusion.

Indeed, globalization hasn't stopped Europe from maintaining a welfare state of its own design. Whether that state is substantial or diminutive, generous or parsimonious, no one will forbid or even spoil it for the Europeans if they choose to expand their welfare state into every conceivable sphere of life. The healthcare system can be costly or inexpensive, under private control or nationalized. If the European Commission suddenly decided to require everyone to drink sage tea, wear leg warmers and attend yoga classes, a number of valid arguments against such a decision may emerge -- but globalization wouldn't be one of them.

The globalized world does not always function like some standardizing force that imposes uniformity on all. Societies can consume vast amounts of gasoline, the way the Americans do, or they can be more frugal, like the Germans. They can spend 7 percent of their gross domestic product on healthcare, as the British do, or they can take the German approach and spend substantially more. The products for which money is spent are not important. It means absolutely nothing to an economy whether a society generally prefers rail over air travel, and whether it builds beautiful houses or spends its money on vast armies of geriatric care workers and massage specialists.

The difference lies in spending per se, not in the things on which societies spend their money.

The tax policy minefield

This is where the globalized world is strict -- practically dictatorial even. Nation-states can only continue to use their traditional methods of financing themselves -- income taxation and withholdings -- if they are willing to accept decline in affluence. The way a country raises money directly affects the production factors of labor and capital, which in turn triggers efforts to minimize and circumvent the damage. Tax policy has become a minefield; those who take the wrong approach have a lot to lose.

Many European countries have long funded their social welfare systems through paycheck withholdings. It's a method which stems from the days when the Western economies were still competing with equals. After World War II, there was plenty of work to go around and plenty of workers to satisfy the demand. Full employment was virtually the norm in the days when Europe's social welfare systems were being established. Under those conditions, it seemed abundantly obvious that the best approach to building a system that could support the retirees, war widows and small numbers of the unemployed that existed in the late 1960s was to divert a small percentage from the economy. The welfare state was as national as the labor market. Until the mid-1970s, even capital was plentiful.

The social commitments governments entered into in those days are still in effect today, but the conditions under which they were introduced no longer exist. For this reason, the contribution-based welfare state does not, as is frequently claimed, make labor more expensive. It did so in the past. The only thing it makes more expensive today is the labor of German, French and Italian workers.

Mobile telephones from Korea, refrigerators from Taiwan and computers from China are not affected by the social costs European states tack on to labor. As a result, the contribution-based European welfare state is the best thing that ever happened to those economies. Their labor remains unburdened by social welfare costs and their products are less expensive as a result.

The contribution-based welfare state is probably the biggest import promotion program any country has ever established. It attracts foreigners and their goods and it grants them preferential conditions. Meanwhile, mounting social welfare costs force domestic producers to increase prices even further, driving many companies out of business.

Withdrawing from the system

It would be easy to destroy the advantage enjoyed by Asian manufacturers and at least place them on equal footing with domestic producers. A welfare state that funds itself primarily by taxing consumer goods rather than the production of those goods would treat domestic and foreign producers equally, and in fact would do so with mathematical precision. The value-added tax would make an automobile from Korea just as expensive as one made by Volkswagen or Opel. The buyers of all products would essentially be paying the welfare state, and not just the workers who produce German, French or Italian products. The only way a foreign company could avoid such a taxation system would be by opting not to sell its products. But why would it do such a thing? Foreign companies would suffer no disadvantage if the value-added tax were increased. They would only be losing their previous advantage.

The same sense of urgency applies when it comes to corporate taxation. Corporations contribute relatively little to state financing. Corporate tax rates are being lowered everywhere -- the absolute and relative numbers make it clear that companies are gradually withdrawing from the state financing system. The German corporate income tax produced only as much revenue for the state in all of 2005 as the value-added tax did in the first six weeks of the year.

This too is a self-inflicted problem. The prevailing tax law in Europe is practically an invitation to astute financial executives and their tax lawyers to choose the path of least resistance where taxes are concerned. In fact, the boards of stock corporations are required by law to do what is best for their shareholders and to avert losses to their companies. They are forbidden from paying high taxes when alternatives exist. And there are plenty of those to go around. For many an investor, Europe is one big tax oasis.

The competition among finance policy makers has become nothing less than self-destructive. They compete in offering the highest possible subsidies and the lowest possible tax rates to attract foreign companies, and they even promise companies that the tax authorities will leave them alone for the first few years. Raising capital, of all things, is the one area where European countries are astonishingly insistent on preserving national sovereignty. Europe established itself as a single, domestic market, it introduced a single currency and it has made great strides in standardizing products and liability laws, and yet tax law has remained in the hands of individual states. Tax sovereignty is seen as the central right of a nation.

Raising taxes is no longer an option

They refuse to understand that globalization has played a dirty trick on them. In fact, national governments have lost their tax sovereignty precisely because they were so determined to retain it. They wanted the ability to make independent decisions, which is precisely what they are no longer able to do. When it comes to taxation, the only freedom European states enjoy today is to lower, freeze or eliminate taxes altogether. Raising taxes is no longer an option. Only abandoning their claim to sovereignty would enable them to create new sovereignty.

This, of course, is easier said than done. Eastern Europe plays an inglorious role in tax policy. All new EU members from the former Soviet bloc receive generous subsidies from Brussels, which eases pressure on their national budgets. The Poles get twice as much as they pay in; Latvia receives four times the amount it contributes to the EU. For these countries, Europe today is a casino where winning is guaranteed.

These funds only encourage Eastern European governments to use them against their benefactors. When the governments in Poland, Hungary and elsewhere saw their revenues rising, partly as a result of Brussels subsidies, they promptly reduced taxes on corporations. The goal was to attract foreign businesses, particularly those based in Western Europe. Corporate taxes in Poland, Hungary and Latvia are now among the lowest in the world. Companies there pay taxes at rates ranging from 15 to 20 percent. The rate in Germany, even if corporations do everything they can to minimize their tax bills, averages 38.3 percent.

This wide gap in tax rates is unlikely to last very long. A Europe-wide tax on corporations has become inevitable. The only question is: who will create this tax? Will politicians manage to achieve consensus or will this tax be pushed through in an archaic, even primeval struggle among states? A shared approach would presumably be far easier on national budgets than an aggressive struggle, which would only further erode the basis of government financing. The concerns of Eastern Europeans, some of whom view their low corporate taxes as their most important competitive advantage, would have to be set aside ahead of any decision, using political pressure if need be. After all, the Eastern Europeans' generosity to business is based on the West's naiveté. It may not be what the Eastern Europeans want to hear, but the fact of the matter is that they are living it up on the money of others who should have no qualms criticizing them for it.

Naturally, European taxation of corporations cannot be a uniform tax. The conditions under which companies operate are too varied across Europe. It would have to be a minimum tax, or what the Americans call a "floor tax." Nevertheless, a floor tax system would differ from the current tax competition among states in one very important respect: While allowing states to assess higher taxes, it would bar them from setting their corporate tax rates below the minimum level. Downward competition would be eliminated.