TAXATION.

Taxes are a fundamental element of all modern societies. They are levied in almost every country of the world to raise revenue for government expenditure and to provide the financial basis for public services. Taxes are compulsory levies. They are unreciprocated, which means that they are not paid in exchange for specific benefits conferred on the payer.

However, in all political systems, governments have to justify why they raise taxes. Conflicts over taxation have thus been a common phenomenon throughout modern history. Taxes play a central role in defining the complex and contentious relationship between state and civil society, and they are intertwined with economic and social development in general. The institutional practices of taxation have been a matter of continuous renegotiations in relation to the changing forms and functions of the society that they help to constitute. Already in 1918 the Austrian economist Joseph Schumpeter (1883–1950), one of the founding fathers of fiscal sociology, underlined the significance of taxation for the analysis of social change:

The public finances are one of the best starting points for an investigation of society, especially, though not exclusively of its political life. The full fruitfulness of this approach is seen particularly at those turning points, or better epochs, during which existing forms begin to die off and to change into something new, and which always involve a crisis of the old fiscal methods. (Schumpeter, p. 7)

According to Schumpeter, World War I represented one of the key turning points in modern fiscal history. Just as the "domain state" of feudalism was succeeded by the tax state of the Industrial Revolution, the deep changes of World War I paved the way for the modern fiscal state that became one of the most powerful institutions of the twentieth century.

Several features characterize the development of the modern fiscal state. First, tax revenues grew at a greater rate relative to the general development of the economy. Taxation was gradually extended to all economic activities, including personal and corporate income, property, sales, and consumption. Second, beyond their purely fiscal goals, taxes became a powerful instrument of economic and social policy in general. In modern societies, taxes are used to redistribute wealth and income and to compensate for negative external effects such as the free use of natural resources. Fiscal interventions aim to stabilize economic fluctuations and stimulate economic growth. The proactive form of government, with its stress on social intervention and public service, is unthinkable without an elaborate tax system.

However, rising public debts, globalization, and the process of European integration are imposing a new set of constraints on tax policy makers. There has been a general trend toward containing taxation and to reducing the scale of government and public services. Even though there are still marked differences between national tax systems in Europe, a general process of convergence has taken place during the past decades.

GROWTH AND STRUCTURE OF TAXATION IN THE TWENTIETH CENTURY

Until World War I, a considerable share of state revenues came from public domains and import duties. In Prussia, for example, domains accounted for 60 percent of state revenues in 1914. Half a century later, more than 90 percent of public revenue in Europe was provided by taxes. Whereas during the nineteenth century taxes had been levied mainly on property, higher income, and specific consumption goods, taxation was now extended to all spheres of economic activity. This extension was based on three principles that gained influence on tax legislation in most European states since World War I: first, the benefit principle, that is, the idea that there should be some equivalence between what the individual pays and the benefits obtained from governmental activities; second, the principle of horizontal equity requires that persons in the same or similar positions are subject to the same tax liability; and third, the principle of vertical equity, which means that the total tax burden should be shared in accordance with taxpayers' respective ability to pay.

All three principles implied a broadening as well as a differentiation of taxation. Although it is difficult to generalize, certain patterns can be detected in the changes of tax structures over the twentieth century: while customs duties and excises lost importance or were completely abolished, most countries increasingly relied on sales taxes and other general consumption taxes. Almost everywhere, turnover taxes were replaced with value-added taxes, especially after the European Community decided to reform indirect taxes in 1967. Taxes on the privilege of doing business and on real estate have lost ground and are significant in the early twenty-first century mainly as revenue sources for local governments. The absolute and relative weight of direct personal taxation has been rising in most countries, and greater attention has been given to payroll and value-added taxes. In general, there has been a shift from indirect to direct taxes. In most countries

direct taxes (including social security taxes) account for more than 60 percent of the overall revenue, while before World War I, indirect taxes were the most important source of state income. Taking the euro area as a whole, taxes on incomes and profits contributed 33.2 percent of all revenues in 2003, while social security and payroll taxes were 29.8 percent, taxes on property 5.2 percent, and taxes on services 30.4 percent.

As is shown in tables 1 and 2, tax revenues grew both in absolute and in relative terms. While tax ratios were significantly below 10 percent before World War I, they ranged between 15 and 20 percent in the years of the economic depression. World War II and the prosperous postwar era saw a massive increase of tax ratios all over Europe. In 2000 taxation as a percentage of gross domestic product (GDP) was 37.4 percent in the United Kingdom, 37.9 percent in Germany, 45.3 percent in France, 54.2 percent in Sweden, and 41.6 percent in the euro area (calculated on an unweighted average). As taxes have become the main revenue of state budgets, this growth is closely related to the overproportional rise of government expenditure.

THEORIES OF FISCAL GROWTH

In the 1880s, the German economist Adolph Wagner (1835–1917) predicted that in modern societies, government expenditure would increase at a faster rate than economic output. According to Wagner, this was due to three forms of state activity that characterize all industrial societies: the upholding of external and internal order; the emergence of public enterprise; and the provision of public goods such as education, infrastructures, and social security. Wagner's "law of expanding state activity" was empirically confirmed by a number of investigations, observing the statistical significance of the income elasticity of public expenditures. However, the reasons for the overproportional increase of public expenditure are controversial. The British economists Alan Peacock and Jack Wiseman (1961) argue that external factors significantly impact the growth of government expenditure. While in calm times the government fiscal budget grows steadily, in times of crisis, for example, war, famine, or economic recession, government expenditure will expand rapidly, creating a "step" in the otherwise smooth growth process. Peacock and Wiseman name this the "displacement effect." The basic idea is that governments are forced to react to the challenges posed by such shocks, that is, the commitments related to public debts, war pensions, and social programs. When this period of "sudden change" is over, expenditure will fall to some extent but will not return to previous levels. Moreover, the experience of war often implies a higher public tolerance for taxation.

The twentieth century provides evidence of such sudden changes: World Wars I and II induced massive ruptures both in the structure and the level of taxes. Many taxes, in particular the income tax and the turnover or purchase tax (Germany, 1918; Great Britain, 1940) were introduced as "temporary" war measures. Likewise, the withholding method of income tax collection began as a wartime innovation in France, the United States, and Britain. World War II transformed the income taxes of many nations from upper-class taxes to mass taxes.

Yet wars and other crises do not account for all increases of taxes during the twentieth century. For example, they cannot explain the massive expansion of tax ratios that occurred in almost all European countries during the "Golden Age" of economic growth, that is, in the decades between postwar reconstruction and the oil crisis of 1973–1974. Mancur Olson (1965) attributes government (and tax) growth to interest-group behavior and private rent-seeking that occurs in many democratic systems. By contrast, William J. Baumol argues that the overproportional growth of public expenditure relates to the fact that the productivity growth is substantially higher in the private than in the public sector. As relative prices change, costs of public services rise faster and induce an increase of public expenditure. Other authors such as Carolyn Webber and Aaron Wildavsky hold that rising taxes are a consequence of the growing commitment of governments to equality. They argue that governments spend more on social programs when they have surpluses but rarely cut expenditure in periods of slow economic growth and falling tax revenues.

TAXATION AND THE RISE OF THE REGULATORY STATE

While until the nineteenth century taxes had mainly served to secure state revenues, the modern fiscal state has a much broader scope: governments use taxation for other than merely fiscal purposes. World War I led to massive expansion of the public sector and to rising state interventions in the economy. The idea that taxes should be used to redistribute income and wealth rapidly gained ground and set the political agenda for the postwar era. However, a progressive income tax was not realized immediately in all European countries. While Germany adopted a fairly progressive income tax with the Federal Tax Reform of 1919–1920, Great Britain, Sweden, and France abstained from a progressive tariff.

The Great Depression of 1929 gave birth to new concepts of fiscal policies. John Maynard Keynes (1883–1946) and other economists started to think about the instruments of public revenue and expenditure to control macroeconomic development. Keynesian economists advocated the use of countercyclical tax policy as a way of promoting overall economic stability. As this clashed with the still-prevailing balanced-budget concept, most European governments were reluctant to adopt a forceful policy of deficit spending during the slump. However, the economic crisis marked a watershed between traditional politics of laissez-faire and more systematic state interventions in the economy. This was particularly the case in Germany, where after the rise of National Socialism, the government stimulated the economy with massive expenditure for rearmament, infrastructure, and industrial investments. Even though these programs were mainly financed by public debts, they also led to a rise of tax rates. Moreover, the Third Reich used taxes systematically to discriminate against Jews and other religious or ethnic minorities. For example, Jews were excluded from all forms of tax deduction and tax exemption, and they had to pay a high tax when they left Germany (Reichsfluchtsteuer).

After World War II, tax policy was integrated into a broader concept of proactive macroeconomic management. The postwar period was the heyday of Keynesian theories, which shaped economic sciences and policies alike. Still, as growth rates remained high and unemployment fell during the postwar decades, countercyclical demand policies were not adopted in the same way by all European governments. While fiscal demand management became a powerful instrument of economic policy especially in Great Britain, France, and the Scandinavian countries, West Germany pursued a more supply-oriented direction in economic policy that was not compatible with Keynesian prescriptions. However, the German government also relied heavily on tax policy to realize overall economic goals, in particular to create incentives for higher savings and investments in order to stimulate economic growth. Income redistribution and social equality became a central feature of all tax systems in Europe during the postwar era. It was mainly achieved through property taxes as well as highly progressive income tariffs. Finally, taxes were increasingly used to compensate for market failures. Since the early 1970s, there was a growing awareness that natural resources were scarce and therefore should be consumed at lower levels. By internalizing environmental costs into prices, taxes were used to signal the structural economic changes needed to move to a more sustainable economy.

The expansion of the fiscal state in Europe after 1945 has been highly disputed. Tax evasion and avoidance has emerged as a major problem of fiscal administration in all European countries. In 1953 the French right-wing politician Pierre Poujade founded an antitax movement that mobilized small shopkeepers, artisans, and peasants against the government. Since the middle of the 1970s, antifiscalism and protest against taxation has gained momentum in most industrialized countries. The rise of Thatcherism in Great Britain was largely due to the fact that many people considered the level of taxation unsustainable. Moreover, tax systems were criticized as incoherent, highly bureaucratic, and unfair, as they left many possibilities of legal evasion.

Since the late 1970s, most tax reforms aim to reduce the overall tax burden and to make tax systems more transparent and simple. This change in the tax policy agendas also reflects a general shift from demand to supply-side policies. According to this view, low tax rates should generate incentives for higher investments and, in the long run, help to create higher economic growth. At the same time, the spread of monetarism as the leading economic doctrine questioned the capacity of fiscal fine-tuning of economic parameters. Finally, international developments had a growing impact on national tax policies.

EUROPEAN INTEGRATION, GLOBALIZATION, AND INTERNATIONAL TAX COMPETITION

The process of European integration has had substantial effects on national tax systems. As one of the main goals of the Treaty of Rome (1957) was the creation of a single European market, all taxes that distorted free trade of goods and services had to be abolished. An important step toward tax harmonization was the introduction of a Value Added Tax (VAT) in the European Community in 1967. Within two decades, the VAT has become the general consumption tax in almost all European countries. Major efforts have been made to harmonize the rates of VAT as well as tax rates on specific goods such as alcohol, tobacco, and more recently, the taxation of energy products and vehicles. Even though direct taxation is left entirely to the discretion of the member states, there are enduring efforts to harmonize personal and income tax rates as well as the corporate tax base. These efforts reflect the rising concerns of European governments that international integration of capital and labor markets increases tax competition between nation-states and erode the basis of tax revenue.

Indeed, globalization has posed major threats to national fiscal sovereignty. The liberalization of capital, labor, and commodity markets and the emergence of multinational corporations have seriously challenged national tax policies. In particular, the taxation of highly mobile factors such as capital, technology, and a trained workforce is becoming more and more difficult. Taxpayers can often avoid high domestic taxes by shifting their tax base to another country with lower burdens. There are indications that competition for mobile tax bases will inevitably lead to a fiscally ruinous race to the bottom, with serious implications for welfare policy and income distribution. Even though tax revenues have developed fairly steadily in the European Union until the late 1990s, there is evidence that globalization undermines the ability of countries to collect taxes. Between 2000 and 2003, the average tax ratio has declined from 41.7 to 40.5 percent in the euro area, which means that there was an inversion of a secular trend of increasing tax ratios. Moreover, structure of direct tax revenue changes according to the mobility of factors: while taxation of labor has been increasing, the taxation of other production factors has shown an overall decrease. Finally, the enlargement of the EU is likely to intensify tax competition in Europe, as most of the new member states have fiscal systems with relatively low direct tax rates.

By 2006 international cooperation to coordinate tax systems had proved ineffective for the most part. The plan for an excise tax on cross-border currency transactions (Tobin Tax) had not found consent among the industrialized nations. More serious efforts to contain harmful tax competition have been made by the EU but with only limited results. The future will show whether the fiscal state of the twentieth century is obsolete and will be replaced by a new system of public finance.

See alsoEuropean Free Trade Association; European Union; Keynes, J. M.

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Alexander NÜtzenadel