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European Tax War Could Spark a Major Depression

By Martin Armstrong
© December 18th, 1998
Princeton Economic Institute

The true colors have now appeared on EMU. Like a pirate ship that disguised its true intentions until it came within striking distance of its prey, the EMU has adopted the same tactics. The EMU policies of "keep it simple stupid" and "never tell the truth" is perhaps a legacy of Bill Clinton. Nonetheless, Clinton style politics has certainly taken hold within the EMU. We have been warning about the coming federalization of Europe and how Euroland would NOT offer this new age of economic reform and booming investment prospects. Instead, all the dirty little insights we have been given by some high officials in Europe have been born out in recent weeks. EMU is nothing more than an attempt to take over Europe on the part of both France and Germany by imposing the worst of regulation and taxation upon the whole continent.

Instead of looking to the US and the UK to learn from the lessons of deregulation, Europe has dug in its heels to forge ahead in the creation of a new Social Europe". At last the truth has begun to surface as arguments over taxation emerge. The failure to lower unemployment and increase economic growth rates in Germany and France is now openly being blamed on "unfair tax competition" in Europe that must be stopped "as soon as possible" according to Germany's finance minister, Oskar Lafontaine. 
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Germany 's recent attack upon Britain illustrates the true direction of EMU and the Euro. We will NOT see a new utopia of economic growth that will displace the United States, but instead we are about to witness the collapse in economic growth for the 11 members of EMU. Taxes are going to rise within EMU to the highest and most uncompetitive levels among the industrialized world and economic growth rates will collapse by one- third if not by 50%. The highest growth areas within the EMU-11 will now be strangled as their advantages of lower tax rates will be forced higher. Panic selling of German businesses is also taking place ahead of January 1st due to a jump in tax rates from 28% to 50% with the birth of the Euro. EMU may have been a success had a compromise been achieved that would have led to a general lowering of tax rates in Germany and France through equalization. However, the new socialist governments in both France and Germany see things differently. They hope to improve their own uncompetiveness by destroying the economies of their neighbors through forced tax increases and blocking any tax incentives to attract business into their economies.

In an interview with the Financial Times, Mr. Lafontaine has insisted that Britain and Germany have agreed upon the need for tax co- ordination. "When we get rid of tax oases, we will have made a first step towards co-operation within the European Union," he said. Tony Blair could face the greatest challenge of his life and remains on the brink of either destroying the British economy or allowing its progress to blossom. The philosophy of the British people is much closer to their American brethren than to their European neighbors. Britain suffered greatly under the fanatics of socialism to the point that they too were once an IMF bailout case. Today, Britain has risen to become the financial center of Europe and on the eve of EMU, its long-term survival may now hang in the delicate balance of negotiations with Germany. Based upon sheer economic correlations, it would make better sense for Britain to join NAFTA than it would to remain within the EU or move into EMU.

Effectively, this latest row over taxation comes on the eve of Germany taking the chair at EU next year. The German and French have stated their goals to push through "majority voting" on EU tax policies. This means, that the majority will clearly reside among the members of EMU. The EMU will not merely be dominated by Germany and France, it will also seek to dictate tax policy even to non-EMU members. In reality, Germany is particularly keen on closing down all the tax advantages that Britain currently holds relative to Europe. The reason why Britain has attracted nearly 70% of all overseas business seeking to get a foothold within the EU boils down to nearly a 20% savings in corporate taxes and a 40% savings in employee social taxes compared to Germany. Instead of Germany realizing that it has been its own tax code that has driven jobs out of its own economy by its own corporations, the German approach prefers to blame those economies to which business has fled. For this reason, Britain is now under attack to raise its taxes to equal that of Germany, end any tax incentives to attract jobs and shut down the Channel Islands as well as the Cayman Islands that serve as offshore havens for capital.

This latest attack on tax havens is also being silently coordinated by G7 members that are intent upon going after the hedge funds. Some claim that even illegal activities have been taking place involving kickbacks, payoffs and outright bribes of some government officials in third world nations. The danger here is not whether or not these accusations are true or not. The core issue is that there appears to be an effort underway to use the hedge fund debacle as an excuse to usher in new exchange rate controls and restrictions upon global investment. While the dollar collapse against the yen has now endangered the Japanese economy by wiping out all profits, which in turn is likely to start sending unemployment in Japan much higher next year, the introduction of the Euro is also feared by G7 members privately. The concern about the Euro is that speculation could lead to the collapse of the Euro due to the fact that the economies within EMU have not converged. Consequently, speculation could undo the Euro by exploiting the basket as some economies begin to slip away from the stated criteria.

Therefore, we must consider the reality of the situation that is now closing in very rapidly. A new aggressive policy against the hedge funds will have a serious impact upon the global economy. The reason we say this is due to the fact that in order to cut-off the supply of offshore capital that is invested within the hedge fund community, they are attempting to close down the tax havens. This will shrink the global expansion of capital markets and risk increasing the liquidity crisis. 
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Mr. Lafontaine's words are serious indeed: "We stand for fair competition on corporate taxes. But in Europe the trend has been going in the wrong way. Taxes on mobile factors - assets, capital and company profits - are always going down. Taxes on immobile factors - that means on labour, wages and consumption and social security contributions - are always going up. That is a development a social democrat cannot accept." This is in effect an assault upon capitalism and the free markets. If Germany is too stupid to realize that it has been its own over- regulation and high taxes that have caused record high unemployment and a net flight of jobs from its domestic shores, then we are on the verge of a very serious tax war that could easily spill over into net capital movements. Even if Britain were to capitulate in the new assault from EMU, capital from both Britain and Europe will merely jump on any boat and head straight for the dollar. Will Germany then complain about the high growth rates and low tax rates of the US as "unfair competition"?

On July 20th, something very serious happened. It was not only the peak in our global business cycle known as the Princeton Economic Confidence Model, it was also a major shift in capital investment flows and strategy. July 20th represented the PEAK in corporate profits in Germany, but it also represented new record highs in German unemployment. The German economic experience of cutting workweeks and reducing productivity in order to create more jobs is simply the work of an economic madman. Germany does NOT have a free market economy. No NORMAL economic model in history would support the current situation. Traditionally, when corporate profits reach a record high, unemployment should also be at a record low. The question that now faces us is simple. What will happen when the economy turns down in German taking corporate profits with it? Will this reduce unemployment or prove to be a base from which new historical highs unfold over the next few years? We suspect that the latter will prove to be the correct long-term forecast. This warns that EMU will become more aggressive in taxation and regulation as the socialists of Europe desperately try to hold on to what they have. In other words, the EMU outlook is extremely DEFLATIONARY into 2000 and perhaps highly INFLATIONARY as they seek to find a solution to rising social unrest beyond 2000.

In conclusion, as we approach the eve of the birth of the Euro, beware. Just as investors were warned during the 19th century "all that glitters is not gold" we must learn that there is no free lunch either. The new Social Europe cannot continue to hold on to unrealistic economic dreams for much longer. They too must learn the lessons of Russia and China that ultimate economic control does not translate into economic success. The US and UK labor forces had to learn that militant left wing unions lowered productivity, economic growth and living standards as a whole. It is time that Germany and France also face their economic shortcomings once and for all.

In the end, we could face a surge in capital flight from Europe to the dollar. The S&P 500 nearest futures have now just exceeded their July 20th high as the European markets begin to totter once again. While we had hoped for a sideways pattern into 2000 with a maximum downside of 30%, we fear that the capital flows could shift once the Euro begins. There remains a serious risk that the US economy could come under a significant capital inflow from Japan and Europe. Such a capital shift could send the US market up another 20% on the S&P 500 raising the stakes considerably for a major bubble top formation as early as April 8th. There is nothing that moves capital faster than sharp tax increases and more regulation. With a proposed 20% tax withholding on Euro denominated bonds, we must question just how long the hype can hide from the realities of the day. A tax war in Europe will merely perpetuate deflation and raise the risks of a major economic debacle in the years ahead. Just how will the new "Social Europe" cope with a collapse in tax revenues as currently forecast by our global computer models?
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