Fiscal Forum: Future of the EU Tax Mix with Dr. Dominika Langenmayr

In July 2024, I had the opportunity to interview Dr. Dominika Langenmayr, Professor of Economics at Catholic University of Eichstätt-Ingolstadt, about the future of the EU 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. mix. A lightly edited transcript from that interview is below and shows that well designed tax reforms in Germany and across the EU could improve both fairness and economic growth.

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

Dominika Langenmayr: There’s not one EU tax mix, right? Although European countries are more similar to each other than they are to the US, there are still quite a lot of differences between the countries. For example, in southern Europe, there’s more reliance on indirect taxation. In Germany, income tax and social security play a larger role. But in general, there are two big pillars: value-added taxes and income taxes. The other taxes don’t add up to that much.

Sean Bray: How should the EU improve its tax mix over the medium term?

Dominika Langenmayr: I think to answer that, we need to think about the spending side a little bit as well. Europe has big challenges ahead. We have the transformation into a more sustainable economy. There’s lots of digitalization that needs to happen. We need to spend more on defense than we have. This means we need more government revenue, but it also means that we need to mobilize private sector investment because most of this investment will have to come from the private sector. That has implications for how tax policy should look. Mobilizing private sector investment will require lowering corporate income taxes. They’re not a big part of the tax mix revenue-wise, but they cause distortions and put a substantial drag on firm investment. So, to really encourage firms to invest, some larger economies need to lower corporate income taxes. 

For the other part, I think it’s hard to say how the tax mix should change in general and across all countries. For the German case, we can either raise taxes, probably value-added taxes, to raise more revenue, or we can lower spending on some parts like pensions or social security. In the end, it is a political decision of what is going to happen there. I don’t think there’s a right or wrong decision here, but political preference.

Sean Bray: Given Europe’s declining population, do you think policymakers should try to lower the tax burden on labor?

Dominika Langenmayr: Partially. When we look at the elasticities of labor supply, for many people, these are very low. Especially for men, they’re basically zero. So, the labor supply does not react to taxation all that much. There are some groups, however, that react much more. Pensioners react very strongly to taxes. If they already receive a pension and nevertheless want to work, then taxes can matter a lot. So lowering taxes for such a group makes sense. Women with children are much more sensitive to taxes as well. Taxes affect the whole decision of whether to work, how much to work, and even on how much to spend on childcare. Some European countries, for example, Germany, really disadvantage that by the way they tax couples. I think that is a place where a reform could really help labor supply. But I would not agree with the broad statement that we have to lower labor taxes to increase labor supply. That’s not something that holds up empirically for a large share of the working population.

Sean Bray: How do you think capital should be taxed in the broader tax mix?

Dominika Langenmayr: To start with the big picture, if we would create a tax system from scratch today, I’m pretty sure corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. would not be part of the tax system that we would create. I believe we would rely more on capital income taxes instead. But politically saying we get rid of corporate income taxes is not something that is going to happen. It’s also a bit peculiar that we’ve introduced the global minimum tax (Pillar Two) at the point in time where we have enough information exchange to properly tax capital income. One reason why there is a corporate income tax is that, for a long time, we weren’t able to tax capital income well at the shareholder level because it was so easily evaded. Now, we can tax it pretty well at the shareholder level, but we tax it at the corporate level largely for historical reasons.

I agree that it makes sense to think about how to reform corporate income taxes in a way that puts the least drag on investment possible. I think improving loss offset possibilities is an important way to do that because better loss offsets have several positive impacts. First, lowering tax rates is irrelevant for all the firms that are currently not profitable, and those are many firms. No matter which country you look in and in which year, there’s always something between 30 and 50 percent of firms that don’t make any profits. For those firms, the main tax policy that matters is whether they can use those losses in the future. When they can use the losses to offset profits, it’s the same as having a zero percent tax rate. So, it really improves investment incentives. It also gives liquidity to the firms after a loss. And what my own work has also shown is that this loss offset in the tax system acts a little bit like insurance. If everything goes well, you pay high taxes. But if things go badly and you make a loss, you get something back from the government and that improves incentives to make risky investments. And these risky investments are what we need.

Sean Bray: What does your research say on how to improve the local business tax in Germany?

Dominika Langenmayr: One of my papers studies how local business taxes affect the location decisions of wind turbines. This is an interesting setting because the location decision for wind power plants mostly depends on exogeneous wind conditions. That is helpful for an empirical study. We see that as soon as a wind turbine locates somewhere, that municipality sets higher tax rates. That is because these wind turbines are very immobile. They cannot relocate in response to the tax hike, and immobile capital can be taxed at high rates. We also have a follow-up paper that shows other firms anticipate this and try to avoid municipalities that are prime locations for wind turbines. In the end, it’s an example that tax competition works the way we think it works. If you attract immobile capital, you tax it, and you can’t really commit to keeping tax rates low.

However, while we see some tax competition among German municipalities, that is not a major issue. German municipalities have quite substantial spending needs, and a lot of this spending is dictated by the federal government. But the local business tax is one of their main sources of revenue. That raises a conflict because as a tax on profits, the revenues from local business taxes vary a lot over time. So, it is ill-suited to finance spending needs that mostly stay constant over time or go up in a recessionA recession is a significant and sustained decline in the economy. Typically, a recession lasts longer than six months, but recovery from a recession can take a few years. . To solve that, policymakers have made the tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. of the local business tax very broad. For example, some interest expenses are not deductible. It does not allow loss carrybacks. This makes it a very distortive tax, and it’s about half of the tax burden on profits in Germany. I think for the last 50 years, researchers have had a quite broad consensus that we need to replace this local business tax. However, many big municipalities that get lots of business tax revenue are against any reform. Abolishing local business taxes and replacing them with a municipality level surcharge on personal and corporate income taxes would be a real step forward in Germany. Policymakers could keep revenue stable, and it would also lower compliance costs a lot because you wouldn’t have to calculate your tax burden according to two different tax bases.

Sean Bray: To go back briefly to your comment earlier that the corporate income tax is distortive, can you provide more detail on why you believe so? Policymakers in Brussels have indicated that there is a meta-study that disproves this idea.

Dominika Langenmayr: I think you’re referring to a meta-study on corporate taxes and their effect on growth. The issue with meta-studies is that they can only be as good as the studies that go into them. Growth is affected by so many things, and corporate taxes don’t change randomly, and only rarely. So, it’s basically impossible to get a causal estimate for the effect of taxes on a macro measure like growth. So, I think we learn very little from this meta-study.

Where we have really good empirical studies is the effect of taxes on investment. Investment is closely linked to growth; not one-to-one, but there’s a close link. The empirical effect of taxes on investment is much easier to measure because you can use variation between firms. Sometimes, like in the US, S and C corporations are similar, but only one of them is affected by a tax cut. Then, you can look at how the tax cut affects investment. Such studies have shown really strong effects in different settings. For example, there is also a recent study on investment effects of local business taxes in Germany, and they also find big effects. There’s also theoretical work on this question, and one key result is that when you distort production decisions, distortions add up. If you distort input decisions in one firm, their output is distorted. If these goods are bought by a different firm, their output is distorted even more, and you want to avoid having these distortions add up. So, what optimal tax theory has proposed is to tax transactions between the productive sector and households. That means income taxes. That’s the side where households receive money from the production sector, and value-added taxes, where they spend the money. But having taxes within the production sector is quite inefficient, and that includes corporate income taxes. They make it more difficult for firms to raise money for their investment because it lowers the return that investors get on their money.

Sean Bray: Can you describe the economics of an inheritance taxAn inheritance tax is levied upon the value of inherited assets received by a beneficiary after a decedent’s death. Not to be confused with estate taxes, which are paid by the decedent’s estate based on the size of the total estate before assets are distributed, inheritance taxes are paid by the recipient or heir based on the value of the bequest received. , and what role these taxes should play in the future of the EU tax mix?

Dominika Langenmayr: Inheritance taxes currently play very little role in all EU countries, and I think that’s a pity. They are a good tax instrument, although they’re not free of distortions. Sometimes you hear this argument that inheritance taxes are great because they don’t cause any distortion, but that’s only true if you leave an inheritance by accident—when you’re hit by a train, never planned to leave anything to your children or anyone else. But that is rarely the case, and inheritance taxes can thus affect decisions to work or to invest because one motive to earn money is that you want to give it to your kids. But all taxes cause distortions, and the distortions by an inheritance tax can still be smaller than those of an income tax. One other way to look at it a bit is from the perspective of the person receiving the inheritance. Their labor income is taxed at relatively high rates. Why is the inheritance not taxed at similar rates?

A further problem with inheritance taxes is that they are poorly designed. For example, the German inheritance tax is a tax on the “poor” rich people. If you’re not rich at all, you don’t pay inheritance taxes because you won’t inherit enough. If you’re very rich, you also don’t pay inheritance taxes because you can structure things in a way that you don’t pay them. I think that’s a problem. There’s a lot of policy discussion that we want to redistribute more wealth, that income taxes are not doing a good job because income is not realized. If there is political will to redistribute more wealth, inheritance taxes are a very good instrument to do it.

One important argument against inheritance taxation is that lots of the wealth is in business assets. In Germany, business assets are the main asset class of richer people. Inheritance taxes on businesses might fall on the business and might lower investment. For this reason, the current inheritance tax in Germany has lots of exemptions for continued businesses. But these exemptions also cause distortions. They give an incentive to less qualified heirs to continue the firm when it might be more efficient to sell the firm. There are also very generous rules when people inherit large firms but are not able to pay the tax because they have not enough other assets and would have to use more than half of other assets they inherit. That other half can be millions, but then they are counted as too “poor” to pay inheritance tax on the business.

A good reform option would be to have a very broad-based inheritance tax without any exemptions, but at a very low rate. Perhaps a 7, 8, or 10 percent rate. I think that would increase fairness because then you would catch everyone who inherits significant wealth, including the very rich that currently pay very little inheritance tax. You could still have a large exemption, say a million euros, so that not that many people ever pay it—and you avoid some of the valuation problems for smaller businesses and houses. It could be a signal that a government wants to take wealth redistribution seriously.

Sean Bray: What do you think of Mr. Zucman’s global wealth taxA wealth tax is imposed on an individual’s net wealth, or the market value of their total owned assets minus liabilities. A wealth tax can be narrowly or widely defined, and depending on the definition of wealth, the base for a wealth tax can vary. proposal for the G20? Do you think inheritance taxes or another form of tax on capital would be more efficient or fairer?

Dominika Langenmayr: It’s a very good question. It’s something I’ve been thinking about, and I have to say that I don’t have a clear opinion on it. I find the G20 proposal interesting. It’s not a straightforward wealth tax, but it’s more like a minimum wealth tax. If you pay income taxes, you don’t pay any additional tax. In contrast to the proposal, I think I would at least want to include corporate income taxes paid. Lots of taxation on family-owned businesses takes place at the firm level because profits are reinvested. So, this should be considered. It is an intriguing proposal that I really need to think more about. In his proposal, Gabriel Zucman talks about whether inheritance taxes are a good substitute, and he basically says they are not because they’re not working anywhere. There is some truth to that, but in theory, I think the inheritance tax, like I just sketched, would be better. The fact that it is not working anywhere, and that we’re not making any progress in that direction, might imply that there is a second-best policy that we should think about. Or maybe we should try harder to close loopholes with the existing taxes. I still have to form my own opinion about it.

Sean Bray: What do you think “tax fairness” is about, especially in the European context?

Dominika Langenmayr: I don’t think tax fairness is only about taxing rich people. It’s also about raising revenue efficiently, without distorting decisions. I find this concept of tax fairness very tough because it’s really hard to nail down what it means. In the end, you could say that a fair tax mix is one that really reflects the preferences of the population. In that case, the “fair tax mix” is probably something that differs between EU countries quite a bit. People in Latvia might have very different preferences than they have in Italy, for example. How progressive do they want the tax system? How high should value-added taxes be? How high should inheritance taxes be? A fair tax mix, to me, would be one that takes these preferences seriously.

The EU should focus on providing a single market and making it possible to follow these preferences in the most efficient way possible. What would that mean? It might require some rules to keep tax competition among EU countries at bay, so the countries can put the tax system in place that they want to have. I think it also means trying to lower compliance costs. That’s something we’ve not talked about a lot, but I think it’s a very important issue. So, what would I do? I think instead of what we’re currently seeing, that the EU is trying to meddle with countries’ tax systems in a very detailed way through directives, what I would prefer is to have some real harmonization. Let’s try to find an EU corporate tax base that really has the same tax base, with one EU tax administration, so firms that are active in several EU countries just do one tax return. That might mean that there’s, let’s say, a 5 to 7 percent EU level corporate income tax. And then countries can have top-up taxes on this joint tax. I think that would really lower compliance costs. Countries could still decide how much to tax profits, but there is a minimum. I think that would be fair in the sense that everyone can follow their own preferences. I think that would also boost growth in the EU to have this as lots of compliance costs arise when you cross borders with different tax bases. Now you also have the global minimum tax, which again has a different tax base. It could be a worthwhile European project to have one corporate tax base. You still have to allocate it between countries and that requires all the transfer pricing and the trouble that that brings. However, I’m skeptical about the main alternative, formula apportionmentApportionment is the determination of the percentage of a business’ profits subject to a given jurisdiction’s corporate income or other business taxes. U.S. states apportion business profits based on some combination of the percentage of company property, payroll, and sales located within their borders. . I wouldn’t go in that direction. However, I think having this common tax base would be very valuable.

Sean Bray: What are your views on the OECD’s two-pillar project (Pillars One and Two)?

Dominika Langenmayr: I think Pillar Two has a lot of potential. I think the hope we have with Pillar Two is that once it’s in place, we would get rid of a lot of other tax avoidance measures. The decluttering project has not really started to happen. So, I really hope that will happen when countries see that Pillar Two is working. If that’s not happening, then we’ve just added on even more compliance costs. The revenue effects, I think, for the large European economies will be very small. But if the decluttering happens, it might be an efficient thing to have. I think the EU is somewhat large enough that, if the decluttering happens, it might still be a good idea to have even just an EU project. And many low-tax countries now want to have the top-up taxes. So, they will also see some benefits of the minimum tax too. If the goal really is to only make sure all firms pay at least 15 percent of profit taxes, and you don’t care about where they are taxed, then Pillar Two might work. But for it to be a good thing for European firms, the decluttering of anti-avoidance rules really needs to happen. We’ll see if it does.

Pillar One, I’m much more skeptical about whether it will ever be in place. I personally don’t think so. It’s also a mess, right? It’s so complicated that I’m not sure it provides any benefit. I think the only benefit it might have is that it could be a first step towards more of a destination basis for corporate taxes, and in the long run, that basis might be efficient and might be a way forward for corporate taxes. But I’m not too optimistic that we’ll see that.