Europe appears to be moving toward increased integration, leading to new investment opportunities. The opening up of markets in Central and Eastern Europe and closer cooperation within Western Europe could result in an unprecedented expansion of the European market. More integrated financial markets in Europe make the allocation of resources more sensitive to differences in national tax rates. Taxation of income from business activities, as well as taxation of financial flows across countries, is therefore receiving much more attention now than it did only a few years ago. In particular, initiatives are under way to harmonize indirect taxation, especially value-added taxes, and capital income taxation in the European Community (EC),1 with possible extension to European Free Trade Association (EFTA) member countries.
This paper compares the effective rate of taxation faced by a “representative” investor located in a major capital exporting country on a marginal investment in Hungary and Poland with an investment in seven other European countries: Austria, Finland, Greece, Ireland, Portugal, Spain, and Turkey.2 The paper assesses the need for tax reform in Poland and Hungary to achieve a more efficient allocation of resources and a more competitive tax system. By combining several different taxes and by incorporating tax provisions in a consistent way, the paper develops a framework that permits evaluation of the overall impact of taxes on the required rate of return on the last unit of fixed capital. An attempt is made to capture the effect of the tax system without incorporating the effect of other potential factors in the investment decision, such as the availability of a suitable labor force or the quality of infrastructure, or more important, the effect of differential risk. However, one section considers the broad interaction of the tax system with the macroeconomic environment.
The focus is on portfolio investment (undertaken by individuals or institutions), which is likely to be more sensitive to the after-tax rate of return than direct investment.3 The study examines the minimum gross rate of return necessary for an investment to yield a given uniform after-tax rate of return, and alternatively, the after-tax rate of return required by the investor under the actual interest rates and expected inflation rates prevailing in each host country. The corresponding tax wedges for both an equity-financed and a debt-financed investment are also presented. All calculations are performed separately for investment in machinery and buildings.
Three different scenarios are discussed. The first scenario assumes that nominal interest rates and expected rates of inflation are equal across countries. The focus is thereby entirely on the countries’ tax systems and not on the economic environment in which each system operates. In this case, the net real rate of return for the investor will vary across countries only on account of differences in the tax treatment in the host country. The second scenario retains the assumption that the expected rate of inflation is equal across countries, while making the nominal interest rate endogenous, so as to accommodate effective tax rate differentials. Thus, the nominal interest rate is calculated so that investments yield the same after-tax real rate of return to the investor irrespective of the country in which he or she invests. This assumption makes it possible to highlight differences in the required gross rate of return to yield a given real net rate of return.4
A third scenario stresses the interaction between the economic environment and the tax system by using actual interest rates and by making an approximation of the expected rate of inflation in each country. In all scenarios, the investor is assumed to receive the same after-tax real rate of return on a debt-financed investment as on an equity-financed investment, thus ignoring the presumed higher risk associated with equity financing. Furthermore, expectations about exchange rate changes are assumed to coincide with inflationary expectations.