What the EU Gets Wrong About “Tax Fairness” and How Principled Tax Policy Can Help

“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. fairness” has been a lingering theme in EU policy circles since the 2008 financial crisis and subsequent Euro crisis.

The prevailing sentiment among policymakers is that European tax authorities need to work together to eliminate tax fraud and avoidance because government budgets depend on these missing revenues to provide essential public services. Without them, large corporations are given a free pass and the common taxpayer suffers.

In this view, breaking the law by committing tax fraud is unfair, and using legal loopholes to avoid tax feels unfair. Therefore, EU policymakers believe it is necessary to intervene, despite taxation being a Member State competence.

And the EU did intervene in 2011 by adopting the Directive on Administrative Cooperation (DAC) followed by five subsequent amendments. The European Parliament created multiple temporary tax committees to investigate leaks such as the LuxLeaks and Panama Papers before permanently establishing the FISC subcommittee. By 2020, the European Commission published a tax action plan called “An Action Plan For Fair and Simple Taxation Supporting the Recovery Strategy.”

Due to the nature of tax fraud and avoidance, “tax fairness” largely meant European governments working together to change tax statutes, reduce the opportunity for tax arbitrage, and increase tax enforcement. Tax fraud, by its nature is illegal, while tax avoidance (usually legal) is something that many governments find unacceptable and want to use new laws to address. This concept of legal fairness was straightforward.

However, between 2011 and today, the meaning of “tax fairness” expanded. EU policymakers now also use the term to describe a vision of economic fairness.

For example, when European Commission President Ursula von der Leyen announced her support for the OECD’s Global Agreement on International Taxation Reform in 2021, she stated that “asking big companies to pay the right amount of tax is not only a question of public finances. It is above all a question of basic fairness.” President von der Leyen said later in her remarks that the EU will in parallel, “continue to crack down on tax avoidance and evasion.”

Another example is the Chair of the European Parliament’s FISC subcommittee, MEP Paul Tang, describing the committee’s purpose. He states that the committee can “shine a light” on tax avoidance and make tax policy more transparent. He then added that there would likely be proposals to raise revenue after the COVID-19 pandemic and “what better place to start [than] with the big corporations that do not pay their fair share; the big polluters and the very wealthy.”

The examples show that, at least in the minds of prominent EU policymakers, there is a clear distinction between EU actions aimed at legal fairness and others aimed at economic fairness.

But what happens when policymakers use a legal notion of fairness to justify fairness in economic policy? They get the economics wrong.

There are usually two ways economists define fairness (also known as “equity” in the literature).

One framework says that individuals with more resources should pay more taxes than individuals with fewer resources. An example is a progressive income tax structure where higher-income earners pay a higher marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. than lower-income earners.

Another framework says that people who have the same resources but make different lifestyle or consumption choices should pay the same taxes. In general, this is difficult to achieve because governments give tax breaks that result in similar individuals paying different tax rates. An example is a mortgage interest deductionThe mortgage interest deduction is an itemized deduction for interest paid on home mortgages. It reduces households’ taxable incomes and, consequently, their total taxes paid. The Tax Cuts and Jobs Act (TCJA) reduced the amount of principal and limited the types of loans that qualify for the deduction. for home ownership where the homeowner pays less than a non-homeowner in the same income bracket.

Based on these frameworks of economic fairness, it might seem like the EU is correct in asserting that large corporations or wealthy people should pay more in taxes. After all, common people are suffering from the economic consequences of the pandemic and the Russian war in Ukraine.

But by making this argument using the legal notion of “tax fairness,” the EU fails to account for an essential economic aspect of its tax policies: who actually pays the tax.

This is called tax incidenceTax incidence is a measure of who ultimately pays a tax, either directly or through the tax burden. This burden can be split between buyers and consumers, or different groups in the economy. , and there’s a difference between statutory incidence (who the law says must pay the tax) and economic incidence (who bears the economic burden of the tax).

As my colleagues explain:

The statutory incidence is generally very different from the final economic burden. Because taxes influence the relative prices facing individuals, they lead to changes in individual behavior. These tax-induced changes in behavior cause some portion (or all) of the economic burden of taxes to be shifted from those bearing the statutory incidence onto others in society.

For example, the statutory incidence of 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. es typically falls on companies. But economists agree that some portion of these taxes is shifted forward to others, in the form of higher prices for consumers, lower wages for workers, reduced returns to shareholders, or some combination of the three.

Consider three examples of the EU justifying a tax policy by claiming “tax fairness” without accurately disclosing the real economic burdens of the tax and the fairness of those burdens.

On 30 September, the Council of the European Union agreed to impose an EU-wide windfall profits tax on fossil fuel companies to fund relief for households and businesses facing high energy prices. The EU anticipates the policy will raise about €140 billion.

President von der Leyen described the tax as a “solidarity contribution” for fossil fuel companies “because all energy sources must help to overcome this crisis.” The assumption: if the EU taxes these companies with super-profits, then the common person will benefit. It’s about fairness.

However, the President did not disclose the economic burden this tax will likely put on consumers (i.e., the common people). This might come immediately in the form of higher prices at the gas pump and for home heating costs this winter, or later due to reduced domestic energy production by these companies.

Another example is value-added tax carveouts for certain products. The EU Parliament believes reduced rates on essential goods will “benefit low-income households and, as such, tackle the regressiveness of the VAT system,” as well as mitigate future exceptional circumstances like pandemics, humanitarian crises, or natural disasters.

However, recent research shows that reduced rates and exemptions are not an effective way of supporting low-income households and could even increase the regressivity of the system if, to achieve revenue goals, the general VAT rates are increased. In other words, these carveouts make the EU’s VAT system less equitable.

Finally, in 2018, the European Commission proposed legislation to make digital companies pay “their fair share of tax.” This statement came despite the fact that economist Matthias Bauer at the European Center for International Political Economy (ECIPE) showed that digital companies have roughly similar tax burdens as other industries. Furthermore, my colleague Daniel Bunn pointed out at the time that the proposal was regressive and hurt those companies less well off:

A tax on revenues would, as the DSTs have done, continue the return of turnover taxes back to Europe. Unlike taxes on profits, taxes on revenues are regressive, taxing firms that are less profitable at higher effective rates than more profitable companies. The low statutory tax rates disguise the harm that this inefficient approach to taxation can bring.

The examples of windfall taxes on fossil fuel companies, VAT carveouts, and taxes on digital companies show how the EU can present tax policies in a “tax fairness” framework but implement policies that hurt those who can least afford it. A better approach to taxation is principled EU tax policy based on simplicity, transparency, neutrality, and stability.

To this end, policymakers should accurately explain the tax burdens put on EU citizens and firms because of EU policy design choices. This explanation must account for tax incidence and the fairness of the tax burden across income levels. Transparency is not only about reporting profits data to the government. It is also about EU citizens understanding the taxes they pay and why.

Once tax burdens are understood in the public debate, citizens can make informed decisions about the level of taxation a big corporation, a big polluter, or the very wealthy should pay relative to others in society.

A more principled EU tax system will increase economic growth across the economy and provide the government with stable finances for spending priorities. Ultimately, that should be the goal of EU taxation.

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