Income tax discrimination: still stuck in the labyrinth of impossibility.

• Author: Graetz, Michael J.

ESSAY CONTENTS INTRODUCTION I. EFFICIENCY AS THE NORM II. THREE EFFICIENCY STANDARDS FOR INTERNATIONAL TAX NEUTRALITY Ill. THE ASSUMPTION THAT TAXPAYERS CANNOT CHANGE RESIDENCE IV. THE NORMATIVE CASE FOR COMPETITIVE NEUTRALITY V. THE TAX LAW REQUIREMENTS OF COMPETITIVE NEUTRALITY VI. THE PROPOSED CONSTITUTIONAL VERSION OF COMPETITIVE NEUTRALITY VII. THE POSITIVE CLAIM FOR COMPETITIVE NEUTRALITY VIII. COMPETITIVE NEUTRALITY AS A WAY OUT OF THE LABYRINTH OF IMPOSSIBILITY CONCLUSION INTRODUCTION

The foundational treaties of the European Union establish a unique system of government. (1) In general, they leave decisions about how to levy income taxes and at what rates to the member states. If the member states agree unanimously--a rare occurrence indeed--the European Commission, Council, and Parliament can together issue income tax directives, but so far these few directives have been limited to rather technical matters. (2) Within Europe, as elsewhere, cross-border transactions involving income taxation are also governed by an extensive network of bilateral income tax treaties that, while reflecting many common principles, often vary in their details. (3)

In this context, the European Court of Justice (ECJ) is charged with ensuring, to the extent appropriate and practicable, that the member states' income tax laws do not interfere unduly with the "four freedoms" guaranteed by the Treaties: free movement of goods, (4) services, (5) labor, (6) and capital. (7) These freedoms of movement were intended to create an economic market relatively free of internal barriers, as well as greater social and political union within Europe.

There is considerable tension inherent in this structure, in which each member state retains a veto over European income tax legislation, including proposals that would promote the cohesion of the internal market, while the ECJ reviews the tax laws of the member states to ensure that they do not violate the Treaties' guarantees of free movement. The national income tax laws at issue vary across the Union, generally providing an important source of revenue and implementing national distributive and economic policy goals in light of each member state's economic and social conditions, as well as internal political dynamics and conflicts. Variations in income tax laws and rates across Europe affect taxpayers' decisions about where to work, live, and invest, as well as tax planning efforts about where to locate income and deductions to minimize income tax burdens. (8)

In the 1980s, the European Court of Justice began deciding income tax cases with an aim to strengthening the Union and to limiting the member states' ability to favor their own residents or to favor domestic over foreign investments? Although there is considerable doctrinal confusion in the decided cases, the essential construct used by the ECJ to achieve its goals is the concept of discrimination against cross-border transactions as compared to purely domestic transactions. (10) While a number of commentators, including us, have criticized these decisions as being incoherent in terms of tax policy, doctrinally confusing, sometimes conflicting, and constitutionally questionable in terms of democratic decisionmaking, those decisions have no doubt contributed to the economic, social, and political union in Europe?' In recent years, the European Union has expanded to twenty-seven members, enlarging the membership of the court and creating even greater diversity among the member states' economies and income tax laws. After that expansion and the rejection of a proposed European constitution, the court has become less aggressive in striking down aspects of member states' income tax laws, accepting justifications offered by the member states that in earlier times the court would have rejected. (12)

Competition in Europe has had a notable effect on income tax structures and rates in the member states. Although efforts to harmonize income taxes in Europe to alleviate downward pressures have been advanced since the 1960s, (13) such harmonization efforts have proved unavailing; income tax rates and bases differ markedly throughout the EU. Indeed, one recent quantitative study concludes that "tax competition is stronger in the EU than the rest of the world." (14)

In two previous articles, we criticized the court's income tax jurisprudence. (15) We argued that its reliance on nondiscrimination as the basis for its decisions did not (and could not) satisfy commonly accepted tax policy norms, such as fairness, administrability, economic efficiency, production of desired levels of revenues, avoidance of double taxation, fiscal policy responsiveness to economic circumstances, inter-nation equity, and so on. In addition, we argued that the court could not achieve coherent results by requiring nondiscrimination simultaneously in both origin and destination countries when goods, services, individuals, or capital move from the first country to the second. With regard to the latter point, we contended that-in the absence of harmonized income tax bases and rates--the court had entered a "labyrinth of impossibility." (16)

Let us restate what we mean by this labyrinth of impossibility. (17) The following three principles cannot hold simultaneously in a consistent and coherent way in the absence of harmonized tax bases and rates:

Principle 1--Sovereignty in the Origin Country: The origin country (18) can choose how and at what rates to impose income taxes on its citizens or residents. The origin country, for example, may decide to tax all of its residents or citizens (including individuals, resident corporations, and other business entities, such as partnerships) at progressive rates based on their ability to pay, as measured by their total worldwide income, with whatever personal or family allowances the origin country deems appropriate.

Principle 2--Sovereignty in the Destination Country: The destination country (19) can choose how and at what rates to impose taxes on income earned within its borders. The destination country, for example, may decide to tax individuals (or corporations) on income earned there regardless of whether the earner is local or foreign.

Principle 3--Nondiscrimination: To implement the freedoms of movement, equal treatment of domestic and cross-border income-producing labor, capital, and business activities is required in all member states in their capacity both as countries of origin and destination. (20)

A simple example may help to illustrate the conundrum that the ECJ faces. Assume that one country, let us call it the United Kingdom, taxes income at a 40% rate, while another country, which we shall call Hungary, taxes income at a 15% rate. As a destination country, the United Kingdom may tax Hungarians (as well as Britons) working there at its 40% rate. But this, of course, means that there is an additional tax burden on Hungarians earning income in the United Kingdom, compared with Hungarians earning income at home. Hungarians are taxed differently when they move from Hungary to the United Kingdom. Taking a job in the United Kingdom is not "free" movement for Hungarians (at least in the sense of being costless), even if Hungary does not tax its citizens residing abroad. There is clearly no obligation for Hungary to reimburse its citizens or residents working in the United Kingdom for the 25 additional percentage points of income tax they face in the United Kingdom, nor does any country do so. Making either Hungary or the United Kingdom compensate Hungarians for the additional 25 percentage points of tax they pay when they work in the United Kingdom would violate sovereignty in the origin or destination country, respectively. Now consider a U.K. national who works in Hungary. Forcing Hungary not to tax Britons would violate Hungary's destination-based sovereignty, so Hungary will typically impose its 15% tax on income earned by foreigners working there. (21) Forbidding the United Kingdom from taxing the income earned by a British person in Hungary would violate the United Kingdom's origin-based sovereignty (and the ECJ has said that member states have no obligation under European law to prevent international double taxation (22)), but if the United Kingdom imposes its 40% tax on the income earned in Hungary-even if it allows a deduction or credit for the Hungarian tax paid-Britons working in Hungary will bear a higher tax burden than Hungarians working there.

While rate differences are important, it is not only tax rates that produce such disparities between cross-border and purely domestic activities. Consider, for example, a charitable organization, organized in one country (the country of origin) that has some activities in a second country (the country of destination) when the two countries have different criteria for favorable income tax treatment, such as eligibility for a charitable deduction or exemption from income taxation. (23) Exemption in the destination country might, for example, be based on the premise that the activities of the organization relieve that country from having to provide certain public services to its residents. (24) From the perspective of the origin country, requiring the organization to qualify with additional requirements in the destination country would burden cross-border activity more than domestic activity. From the perspective of the destination country, there is, however, no extra burden because all charities operating there must satisfy the same criteria. Attempting to eliminate barriers to cross-border activity by requiring nondiscrimination from the perspective of both the origin and destination countries does not therefore provide an answer to the question of whether a guarantee of free movement across borders means that such an organization must or must not meet the requirements of the destination country in order to operate there. Rather, a court presented with that...