Capital Income Taxation in the EU: Financial

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Taxation of income from capital is among the most important factors affecting ... may interfere with the process of integration by contributing, along with other ..... (c) Including taxes on labour income imputed to the self-employed and payroll taxes. ... to distributed profits -- are deductible from the corporate tax base, while at ...
Capital Income Taxation in the EU: Financial Integration and Beyond (*) Roberto Violi Bank of Italy, Asset Management Department. The quest for financial integration in Europe has created pressures to adapt the taxation of income from capital to the new reality of free capital movements and access to global markets for investments. Taxation of income from capital is among the most important factors affecting investment decisions, as relative returns on real and financial assets may be altered substantially by taxes levied on income and/or capital gains. As a result, cross-border capital flows are also significantly affected by the orientation of tax policy regarding saving and investment. International tax coordination, which requires a dose of political integration, may be limited and cannot always provide a feasible alternative. Substantial improvements in the efficiency of the European markets for government and corporate bond were achieved in the 1990s; successful unification of monetary policy in Europe has played an important role. Capital income tax reform has caught up only partially with the rapid changes in the European financial markets. The granting of tax-exempt status to foreign investment in virtually all European countries — Italy’s experience being an important case in point — proved to be a crucial factor in fostering a level playing field by removing the distortion generated by double taxation on interest income. By contrast, the integration of European stock markets has proceeded at a relatively slow pace when compared to the rapid convergence of money and bond markets. Different corporate tax regimes and cross-country disparities in the tax treatment of dividends and capital gains appear to be significant factors segmenting European bourses. Differences in capital income taxation across borders and investors are still driving a non-negligible wedge across stock market returns and valuations within the euro area and between it and other currency areas. Keywords: European Financial Market Integration, Capital Income Taxation, Tax Policy Coordination. JEL Classification Code: G11, G12, G15, H24, H25.

Forthcoming in “Review of Economic Conditions in Italy”, No.3, September-December 2006.

Electronic copy available at: http://ssrn.com/abstract=1269531

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1. Introduction This paper provides a critical assessment of capital income taxation in the European Union (EU). The introduction of the single currency has paved the way for important changes in the European financial sector. The quest for financial integration in Europe has created pressures to adapt the taxation of income from capital to the new reality of free capital movements and access to global markets for investments. However, the EU Treaty does not provide explicit authority for harmonising income taxes. So far, little coordination has taken place, even though the capital income tax base is much more mobile and therefore difficult to tax than are, for instance, consumption and labour. At a more fundamental level, a broad discussion of whether, where and how capital income in the globalised world should be taxed seems to be lacking in the current European policy debate. These questions have received increasing scrutiny from tax economists, as growing capital mobility and the ensuing tax competition have driven down statutory tax rates on capital income throughout the world. Those who believe that returns to savings should not be taxed have typically welcomed capital tax competition, hoping that it will push governments towards greater reliance on consumption-based taxation. However, many other observers fear that an erosion of capital income taxation will undermine the integrity and political legitimacy of the tax system and lead to greater inequality and to an undersupply of public goods — the well-known spectacle of a “race to the bottom”. Policy-makers in Europe need to come to grips with the broad implications of capital mobility and economic integration within Europe and beyond. Taxation of income from capital is among the most important factors affecting investment decisions, as relative returns on real and financial assets may be altered substantially by taxes levied on income and/or capital gains. As a result, cross-border capital flows are also significantly affected by the orientation of tax policy regarding saving and investment. International tax coordination, which requires a dose of political integration, may be limited and cannot always provide a feasible alternative. Apart from more general considerations of how the taxation of savings influences capital formation, there are at least three different ways in which taxation and asset prices are linked. First, stock price gains and earnings from dividends are often taxed differently. Second, the taxation of retained earnings differs from that of distributed profits. Both aspects touch on the distribution of dividends and hence influence asset price levels. Thirdly, the timing of portfolio adjustment is influenced by the possibility to offset asset price gains and price losses for tax purposes. This could affect the timing of sales and purchases — and thus cause asset price movements. All three aspects are

Electronic copy available at: http://ssrn.com/abstract=1269531

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therefore bound to have an impact on market efficiency and trading activity. As tax regimes may differ across jurisdictions, they may interfere with the process of integration by contributing, along with other factors, to market segmentation and barriers to trade. While many developments in the choice of tax regime for income from capital have been influenced by country-specific features, such as the need to save on government debt servicing costs or the pressure to reduce corporate income tax rates in order to limit the tax burden, several features of the changes experienced are shared across Europe. The design of the taxation of capital income has important implications for the corporate tax structure and rates, both of which exert a strong influence as determinants of financial assets returns and the cost of capital in Europe (and elsewhere). Integration between corporate and personal taxes, which has resulted in a move away from the imputation system to a classical system and more frequent resort to withholding taxes, has been a significant development in Europe, with a broad impact on corporate valuations and the cost of capital. The degree of integration with international capital markets and the tax treatment of foreign investors are crucial factors for market efficiency and integration across European financial markets. An appropriate tax treatment for foreign investors in Europe is often stressed as a key to promoting the market role of institutional investors, whose activity is perceived to be of the utmost importance in fostering capital market efficiency and integration in Europe (and worldwide). This is perhaps one of the most crucial aspects of market structure and regulation relating to the general problem of a feasible tax regime for capital income that would not pre-empt or hinder closer capital markets integration in Europe. As Italy's experience with capital income tax reform shows, even minor differences in tax treatment across taxpayers may give rise to significant inefficiencies and distortions by creating barriers to investment, with significant repercussions on financial markets development and integration. The rest of the paper is organised as follows. Section 2 lays down the main economic issues relating to the taxation of capital income for open economies; the evidence and experience of OECD countries regarding the corporate income tax is also briefly reviewed. Section 3 illustrates the main stylised facts concerning the taxation of income from capital in Europe. Section 4 analyses the substantial improvements in the efficiency of European fixed income markets and the role played by the removal of tax distortions. Italy’s experience is reviewed in detail as an important case-study that sheds light on the changes in tax regime in Europe. Section 5 investigates the integration of European stock markets in light of the persisting differences in corporate tax regimes, the tax treatment of dividends and that of capital gains in Europe and beyond. Section 6 summarises the main conclusions.

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2. Taxing capital income: basic concepts and issues Capital income takes many forms, including interest, dividends, capital gains, business profits and the value of the housing services enjoyed by owner-occupiers. Some types of capital income are technically and political harder to tax than others, so in practice capital income tax systems tend to be highly complex, inconsistent and discriminatory. A basic distinction is that between source-based and residence-based taxes on capital. Under the source principle (the return to) capital is taxed only in the country where it is invested. Source-based taxes may therefore be termed taxes on investment. Under the residence principle tax is levied only on (the return to) the wealth owned by domestic residents, regardless of whether the wealth is invested at home or abroad. Since wealth is accumulated saving, residence-based taxes may also be termed taxes on saving. A classic example of a source-based capital tax is the corporate income tax, since most countries only tax corporate income generated within their borders.1 In contrast, the personal income tax and the personal wealth tax are based on the residence principle, since domestic residents are liable to tax on their worldwide capital income and on wealth invested abroad as well as at home. As a rough approximation, we may therefore say that the corporation tax is a tax on investment, while the personal taxes on capital income and wealth are taxes on saving. In an open economy with free international mobility of capital, the two types of tax have very different effects on the domestic economy and international capital flows. If the government of a small open economy wishes to stimulate domestic real investment through lower taxes on capital, it should concentrate on lowering source-based taxes on investment such as the corporation tax. Lowering savings taxes such as the personal taxes on dividends and capital gains on shares would not stimulate domestic investment but, rather, domestic saving and most likely lead to some shares in domestic companies previously owned by foreign investors being taken over by domestic investors, thus

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Some countries, like the United States, also tax the profits that their multinational companies repatriate from abroad, but only to the extent that the domestic corporate tax exceeds the foreign corporation tax already paid in the foreign source country. Moreover, in practice most of the profits earned by the foreign affiliates of multinational companies tend to be retained and reinvested in the host (source) country and are thus taxed only in that country. As a first approximation, it is fair to say that corporate income is taxed according to the source principle.

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increasing the percentage of the domestic business sector controlled by domestic owners.2 Thus a lowering of personal taxes on capital could have some positive influence on domestic investment, but the conclusion remains that the most powerful capital tax instrument to affect investment is a genuine source-based tax (like the corporate income tax). A fundamental distinction in the theory of capital income taxation is that between taxes on the normal return to capital and taxes on rents. By definition, (quasi) rents are “pure profits” in excess of the going market rate of return on capital. For debt capital, the normal return is the market rate of interest on debt in the relevant risk class, and for equity it is the required market rate of return on stocks with the relevant risk characteristics. If markets for risk pooling are underdeveloped, the required risk premiums will tend to be higher, and so will the normal return. In a closed economy a tax on the normal return to capital will tend to reduce the volume of saving and investment (if the elasticity of saving with respect to the net return is positive) whereas a tax on pure rents will be non-distortionary. However, in the open economy a source-based tax on rents will reduce domestic investment if the business activity generating the rent is internationally mobile, that is, if the firm is able to earn a similar excess return on investment in other countries. In that case we may speak of firm-specific or mobile rents. In other words, when the economy is open, a source-based tax will be non-distortionary only if it falls on location-specific (that is, immobile) rents. According to Razin and Sadka (1991), in the absence of location-specific rents, a small open economy should not levy any source-based taxes on capital.3 Under perfect capital mobility a small open economy faces a perfectly elastic supply of capital from abroad, so the burden of a source-based capital tax will be fully shifted onto workers and other immobile domestic factors via an outflow of capital which drives up the pre-tax return. In this process, the productivity of the domestic immobile factors will fall as production becomes less capital-intensive. To avoid this drop in productivity, it is more efficient to tax the immobile factors directly rather than indirectly via the capital income tax. If governments pursue optimal tax policies, we should therefore expect to observe a gradual erosion of source-based capital income taxes in the recent decades marked by growing capital mobility. To see whether all this is actually happening, let us look at the most important source-based capital income tax, i.e. the corporation tax. Here we are faced with a puzzle. On the one hand, the statutory corporate 2

A qualification is in order. Although the personal tax on income and wealth is formally based on the residence principle, in practice it is often very difficult for the domestic tax authorities to monitor (the return to) a taxpayer’s personal wealth invested abroad. For this reason even personal taxes on capital may in reality end up falling mainly on capital invested at home, as would be the case if the source principle were applied. For a formal analysis of these issues, see Sorensen (2006).

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income tax rate has fallen significantly in almost all OECD countries since the early 1980s, as illustrated in Figure 1.

Figure 1

OECD corporation tax revenues as % of GDP 1965-2004 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0%

GDP weighted average

unweighted average

0.0%

1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

0.5%

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Note: all taxes are levied on profits and capital gains of corporations are included Source: Devereux (2006)

On the other hand, corporate tax revenues have actually increased in relation to GDP in most countries (the main exceptions being Germany, Japan, and the United Kingdom), as shown in Figure 2 3

The same theorem had originally been derived by Gordon (1986).

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Figure 2

Average OECD statutory corporation tax rates 55%

50%

45%

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35%

30%

median

25%

unweighted mean

2004

2003

2002

2001

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20%

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Note: All taxes levied on profits and capital gains of corporations are included. Source: Devereux (2006)

Hence the corporate income tax base must have grown sufficiently to (over)compensate for the drop in the statutory tax rate. To explore these trends in greater detail, it is useful to decompose the ratio of corporate tax revenue to GDP in the following manner: R R C P = ⋅ ⋅ Y C P Y

Here R is total corporate tax revenue, Y is GDP, C is the total profit earned in the corporate sector, and P is the total profit earned in the economy as a whole. The fraction R/C may be seen as a rough indicator of the average effective corporate tax rate, since it measures total corporate taxes paid relative to the total pre-tax earnings of the corporate sector. Thus the decomposition suggested above will show whether an increase in the ratio of corporate tax revenue to GDP is due to an increase in the effective tax burden on the corporate sector, R/C; whether it reflects an increase in the share of total profits accruing to the corporate sector, C/P; or whether it is due to an increase in the profit share of total GDP, P/Y. While the corporate sector has tended to expand at the expense of non-corporate enterprises, reflecting both the secular decline of sectors such as agriculture, where the non-corporate organizational form is dominant and income-shifting into the corporate sector induced by the sharp cuts in statutory corporate tax rates, the profit share of total GDP has increased only marginally across OECD members. Thus it seems that governments have made up for the reduction in statutory tax rates by broadening the corporate tax base, e.g. by eliminating special deductions and moving towards less generous rules for asset depreciation and in other respects — in a word, implementing the tax-cut-cum-base-broadening philosophy that became popular in the 1980s and early 1990s. Corporation tax revenues have actually been very robust in recent decades. Source-based capital income taxes may be able to survive despite growing capital mobility. If location-specific rents are present — firms can earn above-normal returns by investing in a particular location4 — the government of that jurisdiction may impose some source-based tax without scaring investors away. Furthermore, when location-specific rents co-exist with foreign ownership of (part of) the domestic capital stock, the incentive for national governments to levy source-based capital taxes is strengthened, since they can

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Access to natural resources, attractive infrastructure and availability of a pool of skilled labour are classic examples of the type of ”agglomeration forces” providing incentives to agglomeration of economic activity.

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thereby place part of the tax burden on foreigners whose votes do not count in the domestic political process.5 The prediction that source taxes on capital will vanish also assumes that capital is perfectly mobile. In practice, however, there are costs of adjusting stocks of physical capital, which therefore cannot move instantaneously and costlessly across borders. Since (convex) adjustment costs tend to rise more than proportionally with the magnitude of the capital stock adjustment, the domestic capital stock will only fall gradually over time in response to the imposition of a source-based capital income tax.6 One important function of the corporate income tax is to serve as a “backstop” for the personal income tax. The corporation tax hits not only returns to (equity) capital but also the labour income generated by entrepreneurs working in their own company. In the absence of a corporation tax, taxpayers could shift labour income and capital income into the corporate sector and accumulate it free of tax while financing consumption through loans from their companies. Still, while it is easy to see why protection of the domestic personal tax base may require a corporation tax on companies owned by domestic residents, it is not obvious why it requires a source-based corporation tax on foreign-owned companies whose shareholders are not liable to domestic personal tax. The answer is that exempting foreign- from domestic corporate income tax could encourage the establishment of corporations that are nominally foreign-owned but are really controlled by domestic taxpayers, say, through a foreign tax haven.7 The backstop function of the corporation tax may be eroded if the tax is not levied on foreignowned companies. Political constraints are also likely to play a role in explaining a government’s decision to raise some revenue via a source-based capital income tax, even if such a tax is (perhaps) highly distortionary on pure efficiency grounds. The government could then try to restructure the corporation tax to reduce the inevitable distortions. For example, by broadening the corporate tax base and lowering the statutory rate, a country may be able to raise a given amount of corporate tax revenue more efficiently. One reason is that a lower statutory tax rate makes a country less vulnerable to international profit-shifting through transfer-pricing and thin capitalization.8 Also, a low statutory tax rate is particularly beneficial for highly profitable companies, often multinationals earning firm-specific mobile rents from the exploitation of special technologies, brand names, etc. Keeping the statutory tax rate low may thus be a 5

Using European data, Huizinga and Nicodéme (2003) found evidence of a significant positive relationship between average effective corporate tax rates and the share of domestic companies owned by foreigners. 6 See Wildasin (2000). 7 See Zodrow (2006), p. 272.

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way of attracting the type of high-tech investment that gives rise to positive spillovers to the domestic economy. In summary, a perceived political need to raise a certain amount of revenue from the corporation tax combined with the incentives to lower the statutory tax rate in a globalising economy may help to explain the policy of tax-cut cum base-broadening pursued by most OECD governments in recent decades.

2.1. Can taxes on savings actually yield any (net) revenue? While there might be a normative case for a positive residence-based tax on the return to saving, some economists argue that the residence principle cannot be enforced in practice, since governments cannot effectively monitor foreign source income in the absence of systematic international exchange of information among tax authorities. To be sure, bilateral tax treaties do provide for the exchange of information on specific taxpayers upon request by the country of residence, and sometimes treaties also encourage ”spontaneous” provision of specific information by the source country, but it is widely agreed that information exchange on such a limited scale is insufficient to bring all foreign source capital income into the tax net of the country of residence. According to the pessimistic but widely held view expressed by Tanzi and Zee (2001), the basic problem is that source countries seem to have no interest in providing information since this makes them less attractive as a haven for foreign investors. However, some authors have recently tried to identify circumstances in which it would indeed be in the mutual interest of source and residence countries to engage in systematic international information exchange. Keen and Ligthart (2006) show that if the residence country is willing to transfer an appropriate share of its revenue gain from information exchange to the source country, both countries will benefit from systematic information exchange. Recent years have also seen significant progress in international cooperation on information exchange. As part of the OECD initiative to counter ”harmful tax practices”, 30 out of 35 jurisdictions originally identified as international tax havens have now committed themselves to providing information to foreign tax authorities, and under the recent EU agreement on the so-called savings directive, 22 out of 25 EU member states have implemented automatic information exchange starting in July 2005. The remaining three (Austria, Belgium and Luxembourg) will adopt information exchange starting in 2011, relying on withholding taxes (initially

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See Haufler and Schjelderup (2000).

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set at 15 per cent) until then.9 To make the switch to information exchange more attractive to these member states, the EU savings directive contains an innovative clause requiring them to transfer 75 per cent of the revenue from withholding taxes to the residence country. Yet, as long as some jurisdictions refuse to cooperate on information exchange, wealthy investors may be able to escape residence-country tax by hiding their wealth in foreign accounts (perhaps domiciled in offshore financial centres). However, governments may be able to collect some revenue from taxes on savings thanks to the welldocumented “home bias” in investor portfolios, i.e., the fact that financial investors (especially small ones) tend to invest the bulk of their wealth at home rather than abroad.10 Moreover, a large part of household saving is channelled through institutional investors, such as mutual funds, pension funds and life insurance companies, which may hold significant amounts of foreign assets. Because of their limited number and public reporting requirements, the foreign source income of these institutional investors is much easier to monitor than the foreign income of individual households. Thus, it should be technically possible to enforce residence-based taxation of the return to most of private sector saving by collecting the tax from institutional investors.

3. Capital income taxation in the EU Capital income taxation has traditionally been less burdensome in the largest countries of continental Europe (Germany, France and Italy) than in the United States and the United Kingdom, while at the same time consumption and labour taxes have been unambiguously higher.11 In evaluating the impact of these structural differences in tax structure on the economies, let us bear in mind that in 2000 the ratio of tax revenue to GDP in the EU was 42.5 per cent, 13 percentage points higher than in United States (29.4 per cent). This gap has widened significantly over time, as the ratio in the EU increased by 9 percentage points since 1970. Although the total tax ratio has risen sharply, the tax mix has remained remarkably stable (Table 1). 9

The withholding tax rate will be raised to 20 percent in 2008 and to 35 percent in 2011. Home bias may result from (small) investors’ being less well informed about foreign than about domestic investment opportunities (see Gordon and Bovenberg,1996). It may also reflect the fact that returns on domestic equity tend to be negatively correlated with domestic wage rates, giving domestic workers a hedging motive to invest in domestic shares, as argued by Bottazzi et al. (1996). 11 According to Mendoza, Razin and Tesar (1994) estimates of the average effective capital income tax rate in the United States were about 42 per cent and in the United Kingdom 57 per cent in the 1980s; corresponding numbers for France, Germany and Italy lie between 24 and 27 per cent. 10

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Table 1: Tax structure in the EU (1970–2000) and the US (2000) (weighted averages) (Please, insert table 1 here) (a) Including revenues from pre-VAT consumption taxes and retail sales taxes in the US. (b)Taxes on tobacco, alcohol, petrol, motor vehicles and other specific goods and services. (c) Including taxes on labour income imputed to the self-employed and payroll taxes. (d) Taxes on net wealth, immovable property and property transfers. Sources: Cnossen (2002). Updated from Martinez-Mongay (2000). /

The US relies much more than the EU does on taxes on individual income from wages and capital. As far as the taxation of capital is concerned, it is striking how large the income tax component is in the US compared with the EU (15 against 4 per cent). This pronounced difference has been a feature of tax revenues, as far as we know, since at least the 1970s. Measured by the implicit tax rates (tax revenues as a percentage of the potential tax base computed from national accounts), the taxation of income from capital shows a somewhat more similar structure. Interestingly, the implicit tax rate on capital in the US is almost as high as in the EU, but the implicit tax rates on labour and consumption are much lower (Table 2). However, because its tax base is larger relative to GDP, the US has a higher ratio of capital income tax to GDP than Europe. Table 2 Implicit tax rates in the EU (1970–2000) and the US (2000) (weighted averages) (Please, insert table 2 here) Source: Cnossen (2002). Updated from Martinez-Mongay (2000).

Rising capital income effective tax rates have not meant increasing distortions. Indeed, progress towards tax neutrality on capital income accruing from different types of assets has been a hallmark of recent reforms in most EU countries, following in the footsteps of the Nordic countries (Denmark, Finland, Norway and Sweden), which adopted a dual income system in the late 1980s and early 1990s.12 12

For a fuller description of this model, see Cnossen (1997).

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Under this system, a single flat-rate tax applies to net capital income (interest income, dividends and capital gains), while labour income is subject to an additional and progressive tax. Most other EU countries have not adopted a “pure” dual income tax system but increasingly tax interest income and capital gains at flat rates, usually lower than marginal rates which apply to labour income; and these rates are tending to converge (e.g. Austria, France, Germany, Greece, Italy and Spain). The move towards a lower and flat tax on capital income has often reflected the need to remain competitive on the international capital market, especially in the context of free capital movements and the advent of the single currency, and/or the difficulty of securing a proper tax assessment. As economic integration within the EU progresses, the interactions between the tax systems of the ember states are of increasing importance. Member states’ tax policies can have spillover or externality effects, positive or negative, on other member states. Most EU countries grant tax-favoured treatment to specific saving instruments. Typically, retirement schemes and housing investment benefit from the most generous tax breaks, motivated in part by social or economic objectives. Tax breaks for retirement saving typically include allowances for contributions paid to pension funds or life insurance schemes and the absence of (or reduced) tax on income or capital gains earned by the funds. Many EU countries have recently increased tax incentives for retirement saving, albeit from very different starting points. Features of the taxation of capital income maintain significant non-neutralities. First, several large EU countries have fairly sizeable basic allowances against capital income taxation In some cases, these substantially reduce the compliance and administrative burden on taxpayers who make small gains or losses on frequent transactions. Second, some countries grant tax incentives for long holding periods, which may reduce the liquidity of capital markets and limit the financing available for start-ups and dynamic firms. EU countries still apply different tax rules to capital income and often grant preferential tax treatment to non-residents. Moreover, for both residents and non-residents, the tax treatment of income varies substantially across financial assets. Arrangements to undo double taxation exist in most EU countries, but they are still imperfect. Some EU countries grant resident individuals some relief in respect of the taxation at the corporate level by granting them a tax credit corresponding to the tax already paid on corporate profits. This system, which contrasts with those in place in Japan, the United States and some other OECD countries, decreases the tax wedge on distributed profits. However, a lower tax wedge on distributed profits does not imply (almost) tax neutrality on corporate fund-raising, because the tax system still gives firms a strong incentive to use debt funding rather than new equity or retained earnings in most EU countries.

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This is due to the fact that, as in most other OECD countries, corporate interest payments -- as opposed to distributed profits -- are deductible from the corporate tax base, while at the personal level interest income is often taxed at a lower rate than dividends. Several countries have recently adopted measures to reduce this non-neutrality with respect to the choice of finance; in particular, Denmark and Finland have applied a combination of imputation credits and a dual income tax system since the early 1990s. Contrasting with steps to relieve the double taxation at the shareholder level, more recently, two countries have introduced a two-tier system of corporate taxation to reduce the relative cost of financing new investment with equity — Italy in 1997-9813 and Austria in 2000.. Corporate income tax revenues in relation to GDP are low by international standards in most EU countries, despite statutory rates on corporate profits broadly in line with those in other OECD countries. Although this relatively low tax yield, and its large variations across EU countries with similar statutory rates, reflects several factors —among them, large differences in accounting rules and the percentage of incorporated firms — it conceals further distortions related to the extensive use of tax reliefs, as revealed by estimates of effective tax rates in manufacturing based on firms’ financial statements. These estimates suggest that the effective corporate tax rate may be some 10 percentage points lower than the statutory rate in the manufacturing sector at EU level, with large variations across countries in the conditions and generosity of the associated tax allowances.14 The extent to which special regimes are a source of inefficiency distorting the playing field can be gauged with two summary measures of corporate tax regimes. The first is the cost of capital. This is the pre-tax rate of return required from an investment. It is generally assumed that investment projects which earn a rate of return at least as high as the cost of capital will be undertaken. Taxation typically raises the cost of capital, which in turn is likely to depress investment. The second measure is the effective average tax rate (EATR). It too is relevant for investment decisions, although in a different context: where a company is choosing between two or more mutually exclusive projects, circumstances in which it is reasonable to suppose that the firm will undertake the project with the highest post-tax profit. Each of these measures are calculated for a series of hypothetical investment projects, which vary according to the type of asset purchased and the source of funds used to finance the investment.15 The effective average tax rates are summarized in the table below:

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But Italy later backed off from the DIT approach. See Joumard (2001). 15 See European Commission (2001) for further details on the computation of the tax indicators. 14

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Table 3a: Effective average tax rates by country (Please insert table 3a here) Sources: European Commission (2001/ ); Devereux, Lammers and Spengel (2002); 1999 (Germany, 2001), Corporate tax regime

Table 3b: Cost of capital by country (Please insert table 3b here) Source: European Commission (2001); Devereux, Lammers and Spengel (2002); 1999 (Germany, 2001), Corporate tax regime and 5% required return

Dispersion of the cost of capital appears to be limited, since 8 countries display an average cost of capital between 6.3 and 6.5 percent. However, these averages mask a greater variation within specific types of investment, either by type of asset or by source of finance. EATR appears to show more dispersion in the overall average and variation across countries than the cost of capital; the rankings also vary across the two measures. In all, the range of dispersion across the EU in the corporate tax regime appears to be significant, with some impact on the segmentation of the cost of capital in Europe that may be attributed to differential taxation within the EU. The failure of the imputation system to redress in full the distortions in corporate finance decisions, in particular for small and open economies, combined with its bias against foreign investment has led some EU countries to reconsider the taxation of dividends. Overall, at least in a purely domestic perspective, the taxation of capital income is both lower and more neutral towards corporate financing decisions in most EU countries than in Canada, Japan and the United States, largely owing to relief from double taxation of dividends and relatively low and converging tax rates on capital income. The notion of neutrality plays an important role in assessing the tax system’s implication for the financial sector. A tax system is neutral towards corporate financing decisions if a given pre-tax flow of corporate profits produces the same after-tax income for final investors, whether the return in the form of interest payments, dividends or capital gains (i.e. the standard deviation of the rates of return to different sources of finance is nil). This requires that the combined corporate and personal tax burden does not vary across financing instruments.

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Financial market integration is also affected by non-neutrality stemming from different tax regimes. In particular, cross-border securities trading within Europe may be hampered by tax barriers. Securities are liable for taxation in the member state where they are held, creating the potential for problems in the holding and transfer of securities across borders due to unfamiliarity with national tax regimes and the risk of double taxation. According to the Giovannini Report (2001) to the European Commission, much of the difficulty associated with taxation of cross-border securities holdings could be eliminated by allowing investors the freedom to choose the preferred location of their securities. In this way, investors could choose to pay taxes under their preferred regime. However, even with this freedom of choice, it is likely that some investors would still hold their securities in the local market and thus continue to contend with national differences in the relevant tax regimes. Three types of securities taxation have been identified as sources of barriers to cross-border securities trading within the EU: withholding tax, capital gains tax and transaction taxes such as stamp duty. In the majority of cases, these taxes have a general impact on the efficiency of a cross-border transaction. The Giovannini Report (2001) points out more specific cases in which taxation of securities creates barriers to efficient cross-border and settlement16: •

inconsistent and unnecessarily complex national rules and procedures in applying the withholding tax;



national differences in the granting of withholding tax relief. A further problem that can arise is the risk of double taxation in cross-border investments. Although most of the member states

have bilateral treaties to avoid double taxation (mostly harmonised on an OECD model agreed in the early 1960s), there are no common procedures for claiming tax treaty benefits, such as relief from withholding tax. The risk of double taxation often remains even if relief is claimed under domestic tax law provisions; •

onerous capital gains tax reporting requirements on foreign intermediaries. In addition, national

capital gains tax regimes often restrict certain non-trading entities (i.e. entities that hold large numbers of securities long-term) from lending securities, if the domestic tax legislation treats a loan of securities as a sale for tax purposes; •

transaction taxes reducing market liquidity;



national tax authorities are not always focused on the needs of foreign investors.

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4. The integration of European bond markets in the wake of the single currency Many commentators saw Economic and Monetary Union (EMU) as the catalyst that would help elevate euro government bonds in the global financial market to a point where they could challenge the pre-eminence of US Treasury securities as a benchmark. This belief was based on the assumption that the single currency and a unified monetary policy stance under EMU would eliminate the principal factors that had traditionally differentiated the national bond markets. Furthermore, it was expected that the conversion of the entire stock of outstanding issues into euros would increase their collective appeal to investors, attracted by the greater liquidity of a large pool of government bonds. Indeed, as the launch date of the euro approached, yield curves converged across the founding members of EMU as currency risk premiums vanished and monetary policies were fused into a common stance. The so-called “convergence plays”, Italian paper being perhaps the most prominent case in point, proved very rewarding for those investors that had put their faith in the creation of EMU early on and foreseen its broad composition. Yield spreads narrowed from highs in excess of 300 basis points for some maturities to less than 30 basis points across the maturity spectrum over the course of 1997-98, and have remained at low levels since then. The bond market has been the financial market segment where the influence of the single currency has been the quickest and most pronounced In many respects this is because the market in both government and private debt had a fairly international character even before the introduction of the euro. Government debt securities in the euro-area have in the past been the main form of international diversification for institutional investors’ portfolios that were constrained by legal and other prudential restrictions in terms of the size and composition of their foreign exchange and credit risk exposures. Also, the small size of the national markets and the lack of asset managers interested in private credit exposures had obliged private-sector issuers to tap other markets through international bond issuance. The elimination of foreign exchange risk within the euro area since the start of EMU has removed one of the main element that previously differentiated outstanding bonds, increasing the degree of substitutability among securities issued by national treasuries. At the same time, other elements such as credit risk and market liquidity have gained in importance. These changes have affected both pricing and trading activity. As regards pricing, the level and the dynamics of relative yield spreads between different national issuers will no longer reflect foreign exchange factors. The 16

See Box 5.1, pp.52-53 in the Report.

18

portfolio composition and trading strategies of investors have been affected through different channels. In the first place, currency-driven strategies are no longer feasible. Secondly, the scope for risk diversification among national securities has been reduced. And, lastly, the introduction of the euro has removed certain legal barriers to cross-border investment, such as currency matching rules, which traditionally limited the possibility of certain investors — especially pension funds and insurance companies — to invest in foreign currency. Besides these effects, the introduction of the euro has had other, more indirect effects. In particular, the search for market liquidity has fostered competition between issuers to attract investors and has prompted some reorganisation of the market structure. Other institutional changes include the harmonisation of market conventions such as the computation of yields and the existence of a single trading calendar. As far as the organisation of the markets is concerned, one notable development has been the creation of pan-European electronic exchanges for debt securities. So far, the most successful trading platform has been EuroMTS, a screen-based exchange owned by a number of the largest banks active in the European market.17 The issuance policies of the 11 euro area governments had, with few exceptions, traditionally been tailored to the specific needs and institutional demands of a primarily domestic customer base. The introduction of the euro has to some extent affected this equation but has not yet fully eliminated the importance of national institutional structures. These changes are increasingly seen as having created a single market that is comparable in size to those of the United States and Japan.: However, the multiplicity of issuers and differences in credit rating distinguishes the euro-area government bond market from its US and Japanese counterparts. The share of euro-area government securities held by non-residents increased by almost 13 percentage points between 1998 and 2000. This suggests that the introduction of the euro has contributed to a geographical reallocation of portfolios. The removal of certain legal barriers, such as currency matching rules, and greater market integration after the introduction of the euro may have played a part in this process. The impact of the single currency has been even more powerful for private-sector borrowers. One of the more prominent effects of the advent of the euro has been an explosion in the issuance of 17

EuroMTS is an electronic trading platform for euro-denominated bonds of sufficient liquidity, modelled on the successful system for Italian government bonds. It covers government issues larger than €5 billion and private issues of at least €3 billion and has captured an increasingly larger market share. At the beginning of 2000 an estimated 40 per cent of bond transactions were traded through EuroMTS. Currently, government securities of the major euro-area countries and some large highly-rated private bonds are listed on this trading platform (both spot and repo transactions are admitted).

19

euro-denominated corporate bonds from borrowers both within and outside the euro area. This has altered the importance of corporate bond financing in the individual countries. National currencies had been segmenting the corporate bond market in Europe :firms were reluctant to issue large amount of long-term bonds denominated in foreign currencies, because of the exchange risk involved in repayments, while the demand for bonds denominated in national currencies was limited because institutional investors, such as pension funds, had to face exchange risk as well. Before the adoption of the euro, the countries of the nascent area had average total net debt issues of almost zero, while net debt issues averaged about 1 per cent of GDP in the other EU countries. After the introduction of the euro net issues remained at that level in the non-euro area countries but jumped to 2 per cent of GDP per year in the area.

4.1 Reforming the withholding tax regime for fixed income securities: the Italian case Changes in the taxation of income from government bonds played a major role in fostering the development of a large and liquid secondary market in Europe, well in advance of EMU. Italy makes an interesting case-study, as in the early 1990s it went ahead with significant tax reform. Up to 1986 Italian government bonds were exempted from personal income tax; commencing on 16 September of that year newly issued government bonds were subject to a 12.5 per cent withholding tax.18 For retail investors and mutual funds the withholding tax was final; for the corporate sector the amounts withheld were payments on account to be deducted against self-assessed corporate taxes (coupon payments had been exempt, within certain limits, from corporation tax; see Di Majo and Franco, 1987). Since coupon payments were now made net of withholding tax (retained "at source" for transfer to the Treasury), foreign-held government securities also became subject to the withholding tax. Foreign investors could obtain reimbursement upon demand, if a tax treaty against double taxation were in place. In principle, non-residents based in the EU were normally entitled to reimbursement, US residents were not, and Japanese residents had the right to reimbursement up to a tax rate of 10 per cent (set in the Italy-Japan treaty). In practice, however, the lack of an established administrative procedure up to April 199119 made the right to reimbursement purely theoretical. The administrative procedure initially envisaged did not solve the problem, giving rise to long delays because of its complicated 18

Decree Law 556 of 19 September 1986; the 12.5 per cent tax rate was temporarily reduced to 6.25 per cent during the first year (i.e. up to September 1987).

20

paperwork. A new, "fast-track" procedure was set up two and a half years later20 and became fully operational during the summer of 1994, shortening the average waiting time for reimbursement to between 30 and 45 days. In January 1997 the withholding tax "at-source" was replaced by a withholding tax administered by financial intermediaries acting as custodians on behalf of final investors (retail, mutual funds, pension funds and non-profit institutions); companies (including banks) and foreign investors are exempted and therefore receive bonds payments gross of tax. From July 1° 1998 capital gains as well as interest payments became taxable. Non-resident holders were exempted from the 12.5 per cent withholding tax if there was a tax treaty against double taxation between Italy and their country and the treaty allowed the respective tax authorities to exchange information. Securities are held with financial intermediaries in Italy, which are authorised to act as fiscal agent in collecting the withholding tax, or with centralised clearing systems (such as Clearstream and Cedelbank) linked electronically with the Italian tax authorities. In September 2001 the Italian government adopted far-reaching changes to the taxation of government bonds and other securities held by non-residents. The tax regime for non residents was amended as follows: •

the withholding tax exemption was no longer limited to investors resident in a country that had signed a treaty with Italy against double taxation but extended to all non-resident investors, provided their country of residence was not on the list of "tax havens" as defined by Italian legislation;



compulsory certification of the resident status of the investor (Form 116/imp) was replaced by self-certification, prepared according to a decree issued by the Minister of the Economy in October 2001 and legally valid for the Italian authorities, in which the investor declares that he is not resident in a tax haven. More recently, the list of "tax heavens" has been superseded by the OECD code of conduct on

information exchange across tax jurisdictions; countries that comply with the code are no longer classified as "tax heavens". As a result of these changes, exemption of an investor in his home country does not bar his enjoying full exemption from the withholding tax in Italy. The general rule is now exemption from tax

19 20

See Minister of Finance Circular no. 12 of 11 April 1991. Decree Law 377 of 24 September 1993; however, Treasury bills (BOTs) were not covered by the new procedure.

21

in Italy, the exceptions being non resident investors based in countries that the Italian tax authorities defined as tax havens. This measure, which affected interest accruing as of 1 January 1 2002, greatly simplified the administrative requirements for non resident investors. The Italian experience, while apparently arcane, is relevant to three broad sets of issues: •

the impact different mechanisms of levying taxes have on the functioning of financial markets and on the structure and level of interest rates;



the role foreign investors play in the determination of domestic capital costs and the most desirable form of taxation;



the budgetary implications of alternative mechanisms of tax withholding, i.e. under what circumstances net tax revenue would actually be positive. Effective tax rates on yields to maturity were different for three broad categories of investor:

retail investors and mutual funds, corporations (including financial intermediaries) and non-resident holders.21 Retail investors and mutual funds were subject to lower tax rate (12.5 per cent, against more than 47 per cent for corporate corporations), but this was in part because they were exempt from capital gains taxation (until 30 June 30 1998). Foreign investors lacked access to a timely and effective reimbursement procedure for several years, and there were several false starts before a pragmatic and working procedure was put in place. As a result they were taxed twice as long as they would have also been subject to the marginal rate in their own country of residence. Effective yields to maturity differed for different investors according to tax rates, liability and the actual withholding tax reimbursement pattern. We can summarise net-of-tax yield to maturity for bonds held by investors with different tax regimes according to the following formula,

T

P = ∑ [C j (1 − τ ) + Γ j ](1 + r ) − j +[100 − τ (100 − P* )](1 + r ) −T j =1

(1) where P, the current market price of a plain vanilla (fixed) coupon bond (BTP), equals the present value of net coupon Cj(1-τ) periodic payments (taxed at rate τ) and principal repayment (conventionally set at 100) at maturity T, adjusted for taxation of the price discount at issue, τ(100-P*); withholding tax applies to below-par-value bond issues (with P* denoting issue price). Foreign investors’ right to withholding tax reimbursement is captured by a sequence of Γj instalments, accruing at the time of

22

coupon payments (but actually paid a few months late most of the time), including withholding tax on the coupon as well as the accruing issue premium, Γj = δC j + δ (100 − P* )(1 / T ) , δ ∈ [0,τ ], j = 1, T (2) where δ is the withholding rate allowed by the tax treaty for non-resident investors. The very same δ can also capture the financial implications of delay in (or lack of) tax reimbursement due to slow-moving administrative procedures or tax treaty provision, which would lower the actual reimbursement rate below the withholding tax rate level (12.5 per cent). Differentials in effective tax rates were also induced by the heterogeneous tax regime for capital gains generated by trading activity, subject to taxation only for corporate holders, while retail investors and mutual funds were exempt (up to 1998), along with foreign holders. As a result, domestic financial intermediaries, whose corporate tax rate remained close to 50 per cent for most of the 1990s, would take advantage of the ability to offset capital losses on bond trading above par, typically when coupon rates were above market rates. These market conditions were rule for most of the second-half of the 1990s, when Italian interest rates were converging towards lower levels with the launch of EMU. Hence, the tax-adjusted yield to maturity for corporate holders can be obtained from expression (1) by specifying a particular sequence of Γj instalments incorporating tax losses (to be set against corporate tax liabilities) for bonds purchased on the secondary market at a price below par, Pt

Γ j = τ (100 − Pt ) /(T − t ) j = 1, T - t (3) Obviously, only non tax-exhausted financial institutions would be able to take advantage of these tax losses. As remarked in section 1 of the paper, before the abolition of the withholding tax on interbank deposits in 1992, most Italian banks had an excess tax credit position: therefore they were accumulating corporate tax credits vis-à-vis the tax authorities. Interest-free tax loss carry-forwards and, once again, slow tax refunds procedure discouraged this form of bond tax arbitrage by financial institutions. However, beginning in 1993 banks’ improved tax position and significant declines in bond market rates in the wake of the 1992 EMS crisis and lira devaluation stimulated significant bond trading activity aimed at capitalising on the widening dispersion of coupon rates across bonds of similar maturity due to large swings in market rates. This arbitrage activity seems to accord with the evidence 21

See. for example, Penati (1993) and Rizzo (1994) for details.

23

assembled in Penati (1993), who presented several term structure models, estimated conditional upon a range of marginal tax rates between zero and the corporate tax rate (almost 50 percent), that appeared to suggest a prominent role for financial institutions as marginal bondholder in the Italian Treasury market. In his estimates Penati (1993) acknowledged the soaring growth taking place in 1992 on the long bond futures market, where trading activity, had started up a year earlier;, with the EMS crisis looming, domestic financial institutions were very busy taking positions and hedging risks. However, the supposed role of marginal bondholder played by domestic financial institutions can be disputed on two counts. On purely technical grounds, Beltratti (1993) questioned the robustness of the results, pointing out several weaknesses in the econometric identification methodology for the marginal tax rate. And on more factual grounds, one could argue that the abolition of the withholding tax on holdings of non-residents should have left the bond yield unchanged if domestic financial institutions were the marginal bondholder. Interestingly, in a later commentary Penati and Alworth (1995) suggested that, all in all, exempting non resident holders the withholding tax would most likely imply a sufficient decline in bond yield, so that the net cost for Italian Budget might well turn out to be lower than before (i.e. Treasury net interest payments would be reduced); as we shall see in a moment, this prediction happened to be essentially correct. To reconcile the empirical evidence from the early 1990s concerning the marginal investor question, it is necessary to bear in mind the market developments and regulatory changes that occurred in the late 1990s. As documented in Rizzo and Marseglia (1997), the estimated regression residuals of BTPs typical yield curve gross of tax widened substantially during the period of declining interest rates (January 1993-August 1994), while yield curve estimates net of tax, where capital gains tax effects are properly accounted for, did not worsen. The trend reversal of market rates from mid-1994 up to 1995 brought about the opposite situation: gross-of-tax yield to maturity became more aligned to the estimated (theoretical) term structure than the net-of-tax yield curve. From 1996 to mid-1998, when the withholding tax reform was completed with the introduction of a capital gains tax on accrual for retail investors and mutual funds, the net yield curve gradually lost its information content, while gross yield curves gained ground among market participants as the benchmark for pricing and trading. Indeed, tax arbitrage and market segmentation based on high-vs.-low coupon rate bonds, partly motivated by the standard accounting practice at financial institutions of measuring profit and loss on trading activity according to the LIFO method (Cherubini, Esposito and Hamaui, 1993), had become much less attractive. The revision of tax rules sin the direction of market neutrality and equal treatment of coupon

24

and capital gains income made it possible for investors to agree on the relative price of Italian bonds by converging towards a single term structure based on gross interest rates.

4.2 Separating tax from liquidity and credit effects for government bond spreads Along with exchange rate risk and credit default risk, taxation has been an important factor driving interest rate spreads during Italy's convergence towards EMU. Favero, Spaventa and Giavazzi (FSG, 1996), in one of the few studies investigating the Italian bond spread dynamics in Europe by taking explicitly into account domestic withholding tax distortions, argue that a correct measure of the effective yield to maturity should incorporate a time-varying parameter capturing market confidence on in the reimbursement of withholding tax. Clearly the importance of this parameter should be gauged against the potential role of non-resident investors as marginal bondholders. Based on the price series of derivatives contracts issued by several investment banks22 guaranteeing reimbursement of withholding tax up-front, a measure of the size of the deviation from the full reimbursement case is quoted as

β t = 1 − δ t / τ δ t ∈ [0,τ ] (4) measuring the financial loss at time t as a fraction of the full tax reimbursement due at rate τ (12.5 per cent). According to the FGS data, in 1992 almost 70 per cent of the full reimbursement value was priced by the market as lost value due to the frictions in the reimbursement procedure and rules; these fraction gradually declined to 20 per cent by 1995. The implied adjusted credit spread on 10-year BTP-Bund rates would be significantly reduced as a result of the estimated tax distortion, /by some 90 basis points in 1992, declining to about 25 by 1994 onwards. The latter measure is likely to have remained fairly constant up until the announcement of the abolition of withholding tax on foreign holding in 1996. Since net interest payments in the government budget changed only marginally after the abolition, we can estimate the impact on the gross yield to maturity by defining the break-even value for a decline in the yield to maturity following the abolition, such that the net cost for the Treasury remains unchanged

(τ − δ )(1 − α ) Gross r0 1 − τα (5) 22

Morgan Stanley quotes only were reported in the FGS paper.

25

where (1-α) denotes the fraction of foreign investors holding Italian Treasury paper, and r0Gross and δ denote respectively the gross yield to maturity and the actual rate of reimbursement before the abolition of withholding tax. The tax-induced spread implied by equation (5) is calculated as r0Gross −

(τ − δ )(1 − α ) Gross r0 1 − τα (6)

i.e. modelled in terms of the (gross) short-term (riskless) rate, rGross, along the lines of Elton et al. (2001). Hence, we can rewrite equation (6) for a T maturity bond as:   1 1−τ * log   * T 1 − τ exp(−rT ) 

τ* =

(τ − δ )(1 − α ) 1 − τα (7)

Formulas (6) and (7) hold for any (fixed-income) bond, as long as capital gains and losses are treated symmetrically. Notice that the tax-induced spread (7) does not depend on the riskiness of the bond or the coupon rate. In addition it shows that the size of the tax distortion is proportional (in a linear fashion) to the interest rate level as well as, non-linearly , to the tax rate. . The fraction appearing in equation (5) should be in the range of 1.5-2 percent to shave off some 15-20 basis points on the 10-year BTP gross yield to maturity. These estimates assume 10-15 per cent foreign holding, an actual reimbursement rate of around 10 percent and 9.5 per cent gross yield to maturity. Even after the abolition of the withholding tax on foreign holding, Italian government bonds still traded at a premium against swaps of the same maturity, in contrast with the discount normally found in other developed countries . The premium, reflecting liquidity and credit risk effects, was still as high as over 20 basis points in 1996:

Table 4— Asset Swap Spreads: 5 and 10-year maturities (basis points; annual averages) 1995

Italy

1996

1998

5-year

10-year

5-year

10-year

5-year

10-year

69

77

20

23

-15

-18

26

France

-16

-16

-19

-20

-30

-25

Germany

-42

-30

-49

-30

-39

-41

Spain

-7

-8

-24

-2

-27

-21

US

-31

-41

-34

-45

-41

-55

It worth noticing that in 1998, as the convergence process was virtually completed for long interest rates with the launch of EMU EMU, the asset swap spread turned negative and has remained so since then, as in other major countries in the EU and in the US. However, EMU has not ironed out bond spreads altogether, as shown in Table 5:

27

Table 5 — 10-year yield spreads before and after the EMU. Breakdown by factors (a) Basis points

Before EMU

Austria Belgium Finland France Ireland Italy Netherlands Spain

After EMU

Spread

Foreign exchange factor (b)

Other

Spread

9.7 19.0 46.2 3.8 45.4 154.4 -2.2 114.9

1.3 4.5 40.9 -2.9 36.6 132.2 -3.8 96.4

8.4 14.5 5.3 6.8 8.9 22.2 1.6 18.6

26.2 31.0 22.8 13.1 23.1 31.5 14.8 27.0

(a) Spread over German bonds. (b) Approximated as the spread beween the swap rate in the currency of denomination of the bond and the swap rate in DM.

Comparing government bond spreads vis-à-vis Germany adjusted for foreign exchange risk (e.g. subtracting swap rate differentials) before and after EMU, it appears that credit and/or liquidity risk have increased across the board significantly in the euro area since the launch of the single currency. The repricing of various risks after 1 January 1999 may have revealed subtler structural factors, perhaps including tax differentials, segmenting European government bond markets. As far as Italy is concerned, government bond spreads adjusted for exchange-rate risk, a measure of credit and liquidity risk, have been significantly affected by the withholding tax. Figure 3 reports this measure, along with the spread on the Republic of Italy’s international bond in denominated in US dollar vis-à-vis those of international institutions (an indicator of credit risk suggested in Giovannini and Piga, (1993), for the decade:

28

Figure 3 — MAIN INTEREST RATE DIFFERENTIALS (1) (weekly data; percentage points)

1.0

8.5 between Bunds and euro swaps (left scale) (2) between Italian bonds and those of international institutions (left scale) (3) between Italian and German bonds (right scale) (4)

0.5

6.5

0.0

4.5

-0.5

2.5

-1.0

0.5

-1.5

-1.5

12/31/90

12/31/91

12/31/92

12/31/93

12/31/94

12/31/95

12/31/96

12/31/97

12/31/98

12/31/99

12/31/00

(1) Source: BIS and Bank of Italy. -(2) Differentials between 10-year Bunds and 10-year euro swaps. -(3) Simple average of yield differentials between Republic of Italy issues and IBRD bond with similar caracteristics. -(4) Differentials between 10-year BTPs and Bunds.

We can see that the gradual reduction of the effective withholding tax rate and its eventual abolition drove the domestically issued (taxed) bond spreads towards the levels of the "withholding-taxfree" internationally issued bond spreads.

4.3. The EU corporate debt market under the single currency

One of the economic effects of EMU was to render investment strategies based on crosscurrency yield arbitrage and directional bets on national interest rates obsolete. It has thus encouraged bond investors to focus more closely on the assessment and pricing of credit risk. European institutional portfolio managers have begun to educate themselves in the evaluation and management of credit risk, and have gradually developed an increased appetite for it. The progressive expansion of the market towards lower credit ratings bears witness to this process. What used to be a market limited to borrowers rated AA or higher has been able to accommodate a broadening array of ratings.

29

Table 6 — International bond issues by the private sector: details of euro credit spreads (*) (14 July, 1998 to 24 July 24 2001) Descriptive statistics of credit spread in per cent

Distribution according rating in per cent Number of bonds

AAA

AA

A

BBB

High yield

Not rated

Median

Max

Min

Std. Dev.

Industrials

473

7.3

14.9

41.6

25.1

3.2

7.9

0.53

1.17

0.17

0.30

Financials

505

19.5

43.8

31.3

0.8

0.8

3.8

0.32

0.77

-0.01

0.21

0.46

0.73

0.28

0.11

Swaps (*) Relative to the yield on the benchmark 10 year Bund. Source: J.P. Morgan

Convergence of government bond yields across the euro area suggests that taxation is unlikely to play a significant role in determining the size of the credit spread. An indicator measuring the impact of tax distortion on the credit spread can be expressed as23   −T −T  1 1 − (1 + zT ) 1 − (1 + fT ) p  1+ fs + p  T  , zs ≡ rCB − rG = − T −G , 1− t  1− p  1− p −s −s (1 + z s ) (1 + f s ) ∑  ∑  s =1 s =1 G ≡ RR + (1 - RR)t ; RR ≡ Recovery Rate ; t ≡ tax rate (8) where p indicates the probability of default, T the maturity of the bond and fs the government bond spot rate. Low taxes — or small differences in the tax rates across jurisdictions — generate a modest impact on the credit spread (8). Assuming that the annual default probability, p, is within a standard range, say [0.1% ; 1.0%], the recovery rate (given default), RR, around 40-50% of the principal value and government bond spot rates, fs, set at 4% with a 5-year maturity, the impact of taxation would amount to few basis points when cross-country differences in tax rates are within a reasonable range, [0;10%]. The differences in tax rates determine the percentages of the spread attributable to the grossing up of corporate bond yields caused by their taxable status. As far as we know, there is no empirical evidence on tax effects obtained by modelling European corporate bond spreads along the lines suggested by Elton et al. (2001) for US corporate bonds.

23

Stock (1994), eq. 3, provides the foundation for our equation (8).

30

5. Integration of European equity markets: structural factors, regulation and taxation

By the early 1990s many regulatory barriers to the free movement of capital had been lifted in Europe. However, there remained a significant ”home bias” in investors’ portfolios, suggesting that cross-border investment in European equities still differs from investment in domestic shares. Take the case of pension funds and life insurance companies. In most countries national regulations impose limits on the percentage of foreign assets in their portfolios. For example, French pension funds must have have / a 95 per cent currency match between assets and liabilities. In Germany the corresponding minimum is 80 per cent. In addition to these regulations, currency habitats mean that all investors faced a cost of hedging exchange rate fluctuations on cross-border EU asset allocation. These costs (ignoring transaction costs), as measured by the interest rate differentials, were at times quite large. Hence, during the 1990s the pricing of European stocks ought to reflect both local and EU-wide risk. The introduction of the euro eliminated currency composition constraints and the costs of hedging intra-European currency fluctuations. However, even before the introduction of the euro the effects should have been felt on the pricing of stocks, since investors were expected to adjust (albeit gradually) their probability assessment of the single currency as the convergence process unfolded.24 Evidence exists with regard to the extent of the impact of the anticipated introduction of the euro on cross-border equity flows. Relative to the early 1990s, by mid 1998 cross-border equity flows had nearly tripled, to between $120 billion and $140 billion. Estimates of the total rebalancing of equity portfolios from domestic to pan-European portfolios are on the order of $1.5 trillion, more than one third of market capitalisation.25 Two surveys taken on the eve of EMU found that over one quarter of fund managers had already implemented some change in their equity portfolios, over half were already well ahead in their preparations for the single currency and three quarters indicated that they would be reconsidering their assets allocation as a direct result of EMU.26 The advent of the single currency has important implications for market participants, regulators and tax policy. For corporate managers, a lower cost of capital will affect investment decisions; for public policy, a falling cost of capital indicates higher national wealth and can be thought of as social24

Interest rates convergence in the euro area mirrored this adjustment process (see Angeloni and Violi, 1999) . Euromoney, August (1998). 26 Dresdner Klenworth Benson (March/April 1998) and Goldman Sachs and Watson Wyatt (March 1998). 25

31

welfare-enhancing. Furthermore, cross-border convergence of the cost of capital affects corporate policy regarding cross listings and mergers and acquisitions. As regards asset allocation by institutional investors, convergence towards a ”uniform” cost of equity capital at EU level implies that the (domestic) “‘country-effect” may be (gradually) disappearing, while the ”sector-effect” should gain prominence as a fundamental risk factor, with a consequent rebalancing of equity portfolios from the typical crosscountry mandates to cross-sectoral mandates. Changes in corporate valuations induced by the EMU appear to be significant. According to Bris, Koskinen and Nilsson, (2003), corporate-level data show that the introduction of the euro has increased Tobin's Q-ratios in EMU countries by 7.4 per cent. The effects prevail even if the decrease in long-term interest rates is accounted for. The increases in Tobin's Q are larger for firms that are ex-ante expected to benefit more, i.e. firms from countries that had weak currencies and firms that had been exposed to intra-European currency risks. The evidence provided by increased valuations of companies located in the euro area supports the view that the introduction of the euro has lowered firms' cost of capital in EMU countries. In addition, Hardouvelis et al. (1999) confirm that globalisation has led to a significant reduction in the cost of equity in the vast majority of EU stock market sectors. According to the recent econometric evidence presented in Cappiello et al. (2003), EMU has increased the correlation among national assets. As a result of monetary integration and the euro area’s becoming more and more a unified economic/financial bloc, investors move capital that had been allocated within the euro area towards other regions beyond European borders.27 These changes are likely to have had a significant impact on expected returns, capital flows and exchange rates both within and outside the euro area.28 All in all, the introduction of the euro appears to have given a significant boost to intra-euro-area capital flows, though more strongly to the fixed-income segment of the capital market, where the single currency’s impact on expected return is greater. Intra-European stock holdings do not appear to have changed dramatically since the launch of the euro; similarly, demand for euro-area stocks by foreign investors has not led to major portfolio shifts. However, European investors have diversified their stock

27

Since the introduction of the euro significant evidence of a structural break is found in the level of conditional correlation but not in the levels of the conditional volatilities. According to Cappiello et al (2003), conditional equity correlation has increased for the major markets of Europe, i.e. France, Germany and Italy (which are in the euro area ) and UK (which is not). eIn addition, there is also evidence of a similar increase in correlation across other markets and between them and euroarea countries, possibly signalling stronger worldwide economic ties (“globalisation effect”). 28 Guazzarotti and Violi (1999) estimate the portfolio adjustments associated with the introduction of the single currency.

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holdings towards non European stocks, likely in response to the investment opportunities that have opened up outside the euro-area with increasing financial globalisation. An important methodological question arises in relation to the measurement of capital markets integration (in Europe and beyond). A definition of financial market integration can be based upon the "law-of-one-price": assets with the same risk-return profile (“fundamentals”) should fetch the same price in a perfectly integrated markets, even when they are traded in distinct "locations" and by different market participants. If markets are (sufficiently) "complete", efficient portfolio choice would dictate that only common risk factors should determine asset prices in a perfectly integrated market, because idiosyncratic risk (including country-specific risk) would be fully diversified. On the contrary, in partially integrated markets both common and idiosyncratic risk are priced. Such pricing of "geographical" risk, over and above ”sectoral” risk, would show up in the construction of the efficient mean-variance frontier for determining the composition of benchmark portfolios. Taxation systematically affects asset prices as a result of non-neutrality (heterogeneity) in tax rates (and bases) across sources of income, identity of investors and type of assets and can therefore be an obstacle to full market integration. In the wake of the introduction of the single currency, the majority of institutional investors, investment banks and asset managers started to disband their country desks and reorganise their equity analysis and trading operations on an area-wide basis around units with a sectoral focus. This reorganisation is in line with a number of factors that have diminished the relative importance of country-specific macroeconomic factors affecting euro-area equity prices. As economic conditions have become more synchronised across countries, the pricing of equity risk focuses increasingly on factors that are specific to industrial sectors from a pan-European perspective. Surveys of market participants indicate that about 75 per cent of managers of European equities currently believe in the superiority of portfolio allocation strategies based on industrial sectors, while only 10 per cent think that country factors are still dominant. Indicative of the importance of the euro in ushering in this shift is the fact that these proportions were 20 and 50 per cent respectively as recently as 1997. According to the empirical evidence provided by Galati and Tsatsaronis (2001), the sectoral factor had come to outweigh the country factor even before the formal introduction of the single currency. Moreover, its importance

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relative to the country increased after 1999.29 Nevertheless, the influence of the (idiosyncratic) countryfactor on European equity prices did not disappear altogether after the introduction of the euro. Distortionary capital income taxes across European jurisdiction may be the most important determinant of the country-factor impact on European equity pricing. A country-based proxy measure for the implied tax distortions extracted from EU (along with US and Japan) equity returns is suggested by Violi (2003). Based on a sample of (monthly) country panel data (January-1974-April-2003) measured capital income tax distortions appear to be statistically significant within the EU. More specifically, for Italy, France and UK these distortion account on average for some 2 percentage points of the required (expected) return to hold the country portfolio vis-à-vis the corresponding benchmark portfolio;30 for Germany, the estimated tax distortion amounts to only 1 percentage point. According to the sign of the distortion, (effective) tax rates on stock dividends would appear to be higher (on average) than those on capital gains. 6. Conclusion

Taxation of capital income and the integration of European capital markets are posing new challenges to national policy-makers after the introduction of the euro. Substantial improvements in the efficiency of the European markets for fixed-income securities (government and corporate bond)s were achieved in the 1990s, but the convergence of bond yields is largely ascribable to the successful unification of monetary policy in Europe. Capital income tax reform has caught up only partially with the rapid changes in the European financial markets. The granting of tax-exempt status to foreign investment in virtually all European countries proved to be an important factor in fostering a level playing field by removing the distortion generated by double taxation on interest income. Tax wedges implicit in bond yields and spreads appear now to be quantitatively very small (if present at all) in Europe. The integration of European stock markets has proceeded at a relatively slow pace by comparison with the rapid convergence of money and bond markets. Different corporate tax regimes and cross-country disparities of tax treatment for dividends and capital gains are still a factor 29

The decreasing importance of country factors in Europe is also highlighted by a more formal (mean-variance spanning) test performed by Ehling and Ramos (2003), according to whom under the euro monetary regime country and industry (optimal) portfolios cannot be (statistically) distinguished, at least for the component attributable to the "tangency portfolio" which is an essential ingredient for the risk-return trade-off. 30 An EMU-wide index return is used for Italy and France; a world-wide index for the UK.

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segmenting European bourses. Differences in capital income taxation across borders and investors are still driving a non-negligible wedge across stock market returns and valuations within the euro area and between it and other currency areas (UK, US and Japan). Needless to say, other impediments, some of which may be related to the structure of regulation and markets organisation, are still at work in preventing full European stock market integration and unhampered cross-border trading of equities. Hence a broad agenda for policy action promoting (jointly) capital income tax efficiency and European financial integration may well be more necessary than ever.

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