Fiscal Forum: Future of the EU Tax Mix with Dr. Aitor Navarro

In August 2024, I had the opportunity to interview Dr. Aitor Navarro, Senior Research Fellow at the Max Planck Institute for TaxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. Law and Public Finance, about the future of the EU tax mix. A lightly edited transcript from that interview is below and shows that the EU should be more proactive in tackling challenges together. All views expressed by Dr. Navarro are made in his personal capacity and do not necessarily represent the views of his employers.

Sean Bray: How would you characterize the current EU tax mix?

Aitor Navarro: I will say that one should distinguish two dimensions. One is the tax mix of the EU Member States. If you would like it in aggregate terms as the tax mix of the EU as an institution, that has to be funded itself. The tax mix of Member States, I will define it as remarkably stable. In the 2024 European Commission annual report, it clearly shows that the percentages of the distribution of the tax burden among labor, capital, and consumption are pretty much the same. They change in a very small range throughout the years. Labor accounts for about half of the tax burden. Consumption is around 27 percent, and capital is the remaining 23 percent. The trend is to tax capital more heavily, but from what I’ve seen, from 19 percent in 2009 to 22 percent, the spread is still minimal. Therefore, it’s pretty stable. It’s true that if one looks at the level of each EU Member State, individually, this distribution may change, but on an aggregate level, I would say in the long run, it will probably stay like that.

Regarding the tax mix of the European Union, or the sources of funding of the European Union, I will define the system as pretty unorthodox. I should start by stating that there are no EU taxes, strictly speaking. Most of the funding of the European Union comes from cross-national income-based resources at around 56 percent. The closest we have to something that we might call a European Union tax are customs duties, although they are collected by the Member States and then transferred to the union. The union doesn’t have a collection body equivalent to the IRS or any other body that would take care of collecting and assessing taxation. Customs duties account for 15 percent of the EU budget or the EU resources. With value-added tax (VAT), something similar happens. VAT is collected by the Member States, and then they give a portion of what was collected to the European Union. It’s just 12 percent. So, the percentages are certainly minimal compared to these contributions from the Member States. I wouldn’t use the term tax mix to define how the European Union is funded, but this might change in the future. There are proposals by the European Commission to continue further in these resources and try to focus them on taxes such as Pillar One, even if Pillar One is probably not happening and doesn’t have a bright future. Or Carbon Border Adjustment Mechanism, CBAM. The emission trading system, which is not a tax strictly, but let’s say that the sources of funding might be expanded. Right now, all of these are just proposals, but they may happen in the future. And of course, we should not forget about the 750 billion Recovery and Resilience Facility, which was the European Union’s response to COVID-19. This is a huge fund, and it is still not known how it will be repaid outside the budget of the European Union. I would say the scenario is very heterogeneous, and it’s difficult to predict what will happen in the future.

Sean Bray: What are some improvements that need to be made for a stable and democratically legitimate European tax system?

Aitor Navarro: That’s a great question. I will say, at a very general level, the most important remark is that the European Union should know where to go. It will be great to see a European Union that is not only reacting to major events such as the pandemic or the Russia-Ukraine war, and just acting exposed, but also coming together and having a more thought-through, defined policy based on cooperation and tackling challenges together. And of course, with a focus on boosting EU competitiveness, compared to other major economic regions that are doing much better than us, such as the US or China. There should be a focus, a midterm perspective, from a democratic legitimacy view. As we all know, the institutional structure of the European Union is very peculiar. There are a lot of problems that we should be tackling in this regard. But just to mention one, the most relevant challenge, at least from a tax perspective, is probably the requirement of unanimity, which gives a huge power to recalcitrant countries that may block widely supported policies or relevant projects from moving forward. It very much distorts decision-making, and it should probably be corrected. 

Sean Bray: What is tax fairness, and what would make the future of the EU tax mix fairer?

Aitor Navarro: In my opinion, tax fairness is a slogan. I have a very critical approach to tax fairness. I must say, I honestly dislike the term because of its vagueness. It’s subjective, and because it usually serves to either emotionally charge a discussion that should remain technical regarding taxes, or it masquerades hidden preferences by the discussants or both. What is fair for me might not be fair for you or for anybody else. There’s the first element to be determined: what one would consider fair in the first place. That said, I understand the marketing appeal of saying that this or that reform will improve fairness. Of course, I don’t think anybody will sustain that by adopting a proposal, one wants to further unfairness. I always encourage everybody to remain skeptical when hearing about tax fairness. I would rather evaluate reform proposals that use more specific and meaningful terms, such as neutrality, efficiency, and simplicity, that give a specific benchmark on whether a tax policy makes sense or not. For instance, as I mentioned before, labor is taxed more significantly in the EU compared to capital or consumption. The reason for that is because taxing labor is efficient in the sense that most of the workforce cannot react to changes in taxation, especially to an increase in the taxation of labor, and therefore the taxation of labor is efficient. Because even facing changes to the base, the workforce cannot react to them. It’s something very similar to what is being done right now, regarding market taxation from the perspective of corporations. So, governments tax corporations where the market is located, where the consumers are located, because corporations cannot decide where consumers are. And therefore, the market components cannot be manipulated the same way that tax residency is, or where the factors of production are located.

After tax fairness is removed from the equation, what is the way to go in the European Union? I think that what should be done is to continue enhancing cooperation, especially in the fight against fraud, in the fight against abuse. There’s still stuff to be done on that end, like adopting policies to ensure progressivity on a reasonable and sound basis. And I know that this is a very difficult topic to handle, but surely a reference to tax fairness will not help or will not contribute to a meaningful discussion to that end. And on the design of regulatory taxes and environmental taxes, for instance, or any other taxes to achieve sensible goals for the European Union, there’s a wide array of options there. And I think there are other benchmarks that are much more useful than fairness to define a clear path.

Sean Bray: How should the EU look at corporate tax reforms in the future?

Aitor Navarro: I would say corporate taxation has been the main subject of discussion in the last 10 years worldwide. In the European Union, there have been some major achievements in recent years. I’m referring to the anti-tax avoidance directive (ATAD) that is the result of BEPS, the OECD proposals on base erosion and profit shiftingProfit shifting is when multinational companies reduce their tax burden by moving the location of their profits from high-tax countries to low-tax jurisdictions and tax havens.. Of course, the latest development, a huge one, is the adoption of Pillar Two, the minimum taxation proposal by the OECD. I will say that moving forward in corporate taxation in the EU as a bloc is pretty difficult because the policy interests of the different Member States are very difficult to reconcile. It is very difficult to achieve unanimity. For instance, the adoption of Pillar Two was a major achievement, but it was the result of this huge wave generated by the OECD, with its international tax proposals, so that put a lot of pressure on EU countries that were, in principle, against the project to bend and approve the adoption of Pillar Two. Recently, this FASTER proposal to streamline and enhance the procedure of withholdingWithholding is the income an employer takes out of an employee’s paycheck and remits to the federal, state, and/or local government. It is calculated based on the amount of income earned, the taxpayer’s filing status, the number of allowances claimed, and any additional amount the employee requests. tax relief was agreed upon. But I will say that’s a more minor proposal adopted. There is an array of options, an array of proposals by the European Commission on the table. Member States have discussed them already for several years. I’m referring to the UNSHELL proposal to tackle shell entities in the European Union and others. Probably the most relevant one is the longstanding proposal to introduce formulary apportionment in the EU, right now renamed as BEFIT. It would be a major achievement if adopted, but this will be extremely difficult. And probably after the demise of Pillar One. In my view, Pillar One was never a realistic project, but that’s another story. Maybe the European Union comes up with a unified proposal.

Some years ago, there were talks about the adoption of a so-called European Digital Levy, but this somehow went out of the discussion. I don’t want to say secretly, but it was in the debate and then suddenly, it was not—probably due to political talks with the United States and how to approach digital service taxes and other taxes that were problematic because of targeting mainly US multinationals. If Pillar One is not successful, it could be that the European Union will come up with something similar, or at least the Commission will propose such a European Digital Levy that perhaps will be designed along the lines of Pillar One. As talks are never-ending, we have the Commission proposing, the EU Parliament evaluating the proposals, but ultimately the Council of the EU, meaning the governments of the different Member States, having to come up with a unified position. To achieve unanimity is very complicated. It’s really difficult to say what the prospects are for corporate taxation in the European Union. And in the meantime, we will continue to have the European Court of Justice (ECJ) decisions on the discriminatory treatment by Member States of cross-border investment compared to domestic investment. Perhaps we have more cases on state aid opened by the European Commission because state aid is a very powerful tool in the hands of the European Commission to address what it considers harmful tax competition. So, a lot of uncertainties, I would say, to wrap it up.

Sean Bray: What role should corporate taxation play in rebalancing the tax mix away from labor taxation? And how do you think Pillar Two will fare over the next 5 to 10 years?

Aitor Navarro: Corporate taxation is in general pretty distortive, and most of the incidence ends up falling on consumers and workers. Meaning, corporate taxation is a tool that is very difficult and unlikely to replace labor taxation or consumption taxation because both are pretty stable anyway. And also, there’s a lot of empirical work showing that whenever countries need to raise revenue, they will put the burden on either labor or consumption instead of capital, the productive factors of enterprises, or passive investments. And in this regard, the way to go should be to simplify corporate taxes and to move towards a more stable base. As I said at the beginning of the conversation, probably to move to, or at least partially move to, taxation where the market is, where the consumers are located, so that corporate taxes are not so easily avoidable by, in this context, multinational corporations that are very much benefiting from the EU internal market.

And as regards Pillar Two, I’m pretty critical of the adoption by the European Union of the 15 percent minimum taxation of the profits of multinationals. It has worked very well in the European Union to achieve, as I said before, unanimity. But when one starts to analyze the technical components of Pillar Two, one realizes that the 15 percent is not of the whole taxable base, but there are significant reductions that multinationals can access. The substance base income exclusion, for instance, will be very distortive because it focuses on specific production factors. In this case, labor costs and tangible assets. So, it will impact different sectors of the economy very differently.

Also, I don’t know if you have followed all of this discussion on how to treat refundable and non-refundable tax credits. The exclusion of certain types of tax credit is probably because of the request of the United States, so that Pillar Two doesn’t significantly impact credits given by the InflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spendin Reduction Act. There are also very important safe harbors that seem to be specifically tailored to carve out, at least for the moment, because these are temporary safe harbors. The impact of Pillar Two on US multinationals and the overall impression is that a lot is happening behind the scenes. Behind the technical documents issued by the OECD in very neutral terms, in a very technical fashion, if one scratches the surface of it, one notices that it is very likely that the OECD is trying to reduce the impact of an instrument that jurisdictions are not taking neutrally because it’s not at all neutral. It’s impacting, or it might impact, multinationals in a significant manner, and the US will probably not adopt it anyway. Let’s see what happens with GILTI and BEAT depending on the election that will take place in November. I have the impression that GloBE was in principle a good idea in 2018, which was the year the proposal was raised first, but a lot has happened since then, including COVID and the Russia-Ukraine war. And now, countries are focused on subsidies. Subsidies, in the form of direct subsidies, but also in the form of tax credits and Pillar Two, are unfit for this new world. This is something that is not so much in the debate right now, whether Pillar Two makes sense at all, according to how the world is right now. A lot has happened in the last six years and Pillar Two, as I said, at a very technical level, at the level of administrative guidance, is trying to cope with the new world.

Sean Bray: How has the ECJ affected EU integration from a tax perspective?

Aitor Navarro: I should start by saying that the ECJ has played and plays a very important institutional role in the European Union. At the end of the day, it is the highest court in the Union and the one that ultimately decides on disputes on a wide array of very relevant issues. Even constitutional topics, like calling the treaties of the European Union a constitution, are a longstanding debate. In my opinion, de facto, the treaties are indeed a constitution, and the ECJ is a constitutional court that will decide on topics ranging from the functioning of the internal market—which is, of course, very relevant for taxation—to the fundamental freedoms, to the protection of fundamental rights, including fundamental rights of taxpayers. There have been very interesting decisions lately of the Court of Justice striking down European legislation to make fundamental rights, such as the right to secret communication with your attorney, or data privacy, to prevail over, in these cases, requests for information.

It also plays a very relevant role in defining the architecture of the European Union at a governance level, at an institutional level, because any doubts about the interpretation of the funding treaties of the EU constitution are assessed by the ECJ. And I should put the emphasis on the fact that no commentator defines the whole picture of ECJ case law of the ECJ decisions. Let’s say on an overall level as neutral, the ECJ jurisprudence, and there is a lot of research on this matter that reaches the same conclusion, that the Court of Justice is very integration-oriented, meaning individual decisions by the Court of Justice are, in general, very well-reasoned, they are rational, they fit very well with what is expected by a court that operates under a rule of law system. But in case of doubt or in hard cases, they tend to favor European Union legislation over the competences of the Member States.

And this has a very clear reflection on taxes. Taxes are a very good case study to illustrate this. Especially in regard to the internal market and fundamental freedoms, because the ECJ has interpreted these fundamental freedoms in a very strict way, strict in the sense that they have been reserved by the ECJ over discriminatory rules adopted by the Member States, favoring domestic investments or domestic scenarios over cross-border scenarios. They have been used as a non-discrimination tool or have been defined as a non-discrimination tool by the ECJ, which has put a significant limit on the tax sovereignty of Member States. Tax is one of the few areas in which Member States have been very reluctant to grant competences to the European Union, especially on income taxation. Consumption taxation is pretty different because there the European Union has strong legislative powers, but at the income taxation level, competences remain in the hands of the Member States, but they have to comply with these fundamental freedoms of the European Union internal market. And this generated such attention that Member States were at a certain level, even raising the possibility of excluding the ECJ from deciding on income tax matters. And then, let’s say the ECJ got the message.

One can see the evolution of how cases have been decided in the past century. So, before the 2000s, there was a clear tendency for the ECJ to strike down Member States’ tax measures, including income tax measures, because they were incompatible with these fundamental freedoms. The ECJ noticed the tension that was being created and it changed its direction in allowing for more leeway for Member States to adopt measures that will entail discrimination, and in principle will go against the fundamental freedoms against the internal market, but will be allowed because of pursuing other public policy goals, such as the fight against abuse or a balanced allocation of taxing rights. Let’s say that the ECJ became more lenient towards the type of measures adopted by Member States. And, as is known, the ECJ continues to decide on tax cases. So, the proposal to exclude the ECJ from deciding on these matters was not successful.

Sean Bray: In the future of income taxation in the EU, what are some drawbacks of the unanimous voting rule, and does the ECJ have any role in changing that?

Aitor Navarro: Unfortunately, the only way of moving from unanimity to majority voting is by achieving unanimity in eliminating the unanimity requirements. So, it’s a vicious circle, a catch-22 situation. The drawbacks are significant in terms of governance. For starters, the European Commission will probably restrain itself by only proposing things that might achieve unanimity among the Member States, because otherwise, this is just lost time and a loss of resources. In the negotiation process, the content of measures to be adopted at the EU level may be restricted due to the need to accommodate all the interests of all Member States involved, leading to texts that will result in ambiguous language. And also, of course, this often leads to the discussion not being focused on the specific tax measures, but to put the negotiation of tax measures in larger packages in which there’s bargaining with those Member States that are recalcitrant in adopting measures by just saying, “If you don’t get along with the adoption of this tax directive or regulation, then we will not give you extra funding or we will start investigations on this or that topic or whatever.” “We want you to vote in favor of this proposal that is very much in your interest.” So, this bargaining that usually should lead to a better quality of legislation in this setting is certainly a drawback rather than an advantage.