Taxing Interest Income In Europe: Policy Harmonisation Will Reduce Tax Evasion

If resident and non-resident investors in individual EU countries faced the same tax rates on their interest income, then tax evasion would be considerably reduced. A more effective alternative would be for EU countries to agree on a minimum tax rate on interest income while allowing differential taxes on residents and non-residents. These are the conclusions of Professors Eckhard Janeba and Wolfgang Peters, writing in the January 1999 Economic Journal. Either option, they suggest, would be preferable to the current position where tax policies are not coordinated; banking secrecy laws facilitate tax evasion; and countries have strong incentives to compete on offering low taxes to non-resident investors – tax competition that is ultimately self-defeating.

Throughout the EU, interest income is taxable under the personal income tax system. But because of banking secrecy laws in some countries, investors may evade taxes by investing abroad. This has led to the effective elimination of taxation on the income of certain investors. For example, Luxembourg has attracted large amounts of capital from Germany, partly by not taxing the interest income of non-residents.

Janeba and Peter”s research explains this undesirable outcome as the result of tax competition between governments. Acting alone, each government has the incentive to discriminate positively in favour of non-residents in order to attract foreign capital while containing tax evasion by residents through domestic withholding taxes. But since this incentive is common to all governments, tax competition for internationally mobile capital drives tax rates on non-residents” interest income to zero.

The research assesses the likely success of various reform proposals. For example, the European Commission has proposed the introduction of the status of ”community resident”. According to this idea, each government taxes interest income at the same rate regardless of where the investor resides. Such a ”symmetric”, non-discriminatory tax treatment of resident and non-resident investors represents an improvement on the present situation by lessening the extent to which governments are willing to compete for non-residents” capital. Yet it would make only those countries better off which, like Luxembourg, already attract foreign capital.

An alternative proposal is to consider a minimum tax rate on interest income in the EU. Under this scheme, tax competition for internationally mobile capital would also be limited, thereby reducing the opportunity to evade taxation by investing abroad. But the proposal would be more effective if governments were allowed to levy differential taxes on residents and non-residents. This would give governments flexibility in taxing interest income from residents who mostly invest in their own country.

The analysis emphasises the importance of whether residents and non-residents are treated identically by individual EU countries. When tax policies are not coordinated, there are strong incentives to use differential tax policies, although this may be self-defeating. Differential treatment of residents and non-residents limits tax evasion only if a Europe-wide minimum tax on non-residents” investment income is imposed.

An experience of the German government demonstrates the problem of treating residents and nonresidents identically without harmonisation. In 1989, it unilaterally imposed a uniform withholding tax on residents and non-residents but found this to be damaging: government debt had to pay higher interest in order to keep foreign investors. Since 1993, the tax has been imposed only on German residents.

”Tax Evasion, Tax Competition and the Gains from Non-Discrimination: The Case of Interest Taxation in Europe” by Eckhard Janeba and Wolfgang Peters is published in the January 1999 issue of the Economic Journal. Janeba is Professor of Economics at Indiana University, Bloomington, Indiana 47405; Peters is at the European University Viadrina in Frankfurt.

Eckhard Janeba

+1-812- 855-7084 | ejaneba@indiana.edu