Tax Policies in an Integrated Europe
The fiscal environment in Europe will change dramatically after 1992, and free capital mobility will make it harder to collect taxes on capital. Though generally lower than in the United States, capital taxation within the EC varies considerably, being relatively high in Luxemburg and the United Kingdom and lower in Germany. In `Capital Flight and Tax Competition: A Viable Solution to Both Problems?', Alberto Giovannini (Columbia University and CEPR) and James Hines (Princeton University) argued that this environment distorts investment decisions by multinational firms. To avoid taxes, they make inefficient investments and manipulate the prices used between subsidiaries in different countries. These distortions will worsen after 1992, because cross-border trade will increase.
The EC had an excellent opportunity to complete its internal market for capital by instituting a system of residence-based capital income taxation, according to the authors. They advocated a uniform 50% withholding tax on corporations' income. Taxes would be due to the government of the country where the income is earned, with no distinction between local branches of a foreign corporation and separately incorporated entities. EC governments should then be able to set their own tax rates on corporate income by applying rebates to owners of corporate shares for the difference between 50% and the local rate. The only constraints should be that the rebates be less than the 50% EC rate and based on a common definition of taxable corporate income.
In this system host governments would be permitted to subsidize firms, industries and particular investments, but the subsidies would be included in the corporate tax base. Foreign income outside Europe would be taxed at the full 50% rate, but with a credit for foreign income taxes paid. Europe should also establish a `clearing system' to allocate corporate income from source countries to the countries of shareholder residence. In such a system, the authors noted, governments could no longer retain corporate tax revenue from foreign shareholders, but they would gain the right to tax in full their own citizens' non-domestic corporate income. Giovannini and Hines estimated that the new system would initially increase tax revenue in countries which were net capital-exporters to the rest of Europe, such as Germany, the Netherlands and the United Kingdom, and reduce revenues for France, Italy and Spain. A transitional arrangement could be set up to persuade the losers to accept the new system.
The Delors Report viewed fiscal policy as a constraint on monetary policy and proposed fiscal rules to accompany EMU. Arguments for fiscal coordination frequently relate to spillovers when government debts are traded internationally. One country could engage in a spending spree, the cost of which would be borne in rising interest rates and reduced value of government bonds across the whole union. Without rules against such behaviour, this could lead to excessive deficits in all countries. In the first of two papers, on `Fiscal Policy, Interdependence and Efficiency', Willem Buiter (Yale University and CEPR) and Kenneth Kletzer (Yale University) analysed this externality using a two-country, overlapping-generations model with a neo-classical production function.
They showed how, with no distortions and only non-distortionary fiscal instruments, such behaviour would not in fact lead to any loss of economic efficiency. The world interest rate played a key role in determining the distribution of gains from international lending and borrowing and from increases in one country's public debt. In the absence of a non-distortionary mechanism for international redistribution, social welfare could be enhanced, at the expense of efficiency, by distortionary instruments such as source- or residence-based taxes on income from capital. If there are other distortions, such as worldwide public goods or international externalities in production or consumption, then non-lump-sum instruments need not involve efficiency loss.
In `The Welfare Economics of Cooperative and Noncooperative Fiscal Policy', Buiter and Kletzer analysed the use of intergenerational transfers to alter the pattern of national saving and consumption and so gain a welfare advantage for domestic residents. Fiscal coordination in general optimized the governments' objectives, but optimization of global objectives required international lump-sum transfers. If none are available, a second-best involved lump-sum redistribution between generations within each country, influencing the world rate of interest and hence the distribution of income between debtors and creditors. The introduction of both distortionary and lump-sum fiscal instruments and of worldwide public goods created an efficiency case for fiscal coordination in Buiter and Kletzer's model.

Monetary Integration
The macroeconomic effects of monetary union, with perfect capital mobility and irrevocably fixed exchange rates, will in large part depend on how increased currency substitution will affect money markets. Michael Woodford (University of Chicago) investigated `Does Competition Between Currencies Lead to Price Level and Exchange Rate Stability?', using a multiple currency, cash-in-advance model similar to that used by Lucas and Stokey to consider substitution between cash and credit. The model treated transactions using different currencies as different types of goods. The degree of substitutability between these commodities represented substitutability between currencies. Analysis of the model suggested that, contrary to widespread opinion, the degree of currency substitutability had little effect on equilibrium price levels and exchange rates except in the case of perfect substitutability. But, by raising the likelihood of indeterminacy, increased currency substitution could make management of fixed exchange rates more difficult.
Woodford argued that this cast considerable doubt on the wisdom of evolutionary approaches towards fixed exchange rates such as that advocated by the UK Treasury. Markedly increased currency substitution would increase the scope for speculative instabilities in exchange rates and corresponding fluctuations in price levels. If currency competition resulted in lower rates of monetary growth, as the UK government argues, this itself could make exchange rates and prices more unstable, owing to greater scope for indeterminacy when monetary policy is contractionary. Woodford concluded that, rather than allowing a natural evolution towards fixed exchange rates, as the UK Treasury argues, too much currency substitution would make fixed exchange rates harder and perhaps impossible to manage. If Stage One of the Delors process leads to a substantial increase in currency substitution, a single currency may then become essential to preserve even the degree of monetary stability achieved under the current EMS.
In `Problems of European Monetary Integration', Rudiger Dornbusch (MIT and CEPR) argued that the EMS is now in limbo, frustrating policy-makers in many countries. First, Germany has no way to avoid importing inflation. If domestic spending were restrained, the resulting gain in cost competitiveness would increase the external surplus, becoming a further source of demand and inflation. Or German restraint could lead to an offsetting expansion abroad, leaving demand for German goods and services and hence inflation virtually unchanged. Second, high nominal interest rates in some countries reflect the possibility of exchange rate changes, but governments are committed against realignments. This is the worst of all worlds, according to Dornbusch: high nominal rates without realignments mean high realized real interest rates, especially painful for high-debt countries. Third, unsustainably high external deficits are a further indication of monetary problems.
A strong drive for monetary integration is therefore essential, Dornbusch argued. With capital movements fully liberalized and margins in financial markets reduced, monetary policy will bear an even greater bur den, with even higher costs for public finance. Though monetary integration is often interpreted in terms of lost independence, for most EMS members monetary policy is already just an instrument for managing the balance of payments. `Independent' monetary policy is also expensive, in exchange rate uncertainty and debt service. Reform should be designed to reduce the exchange risk premia in real interest rates and to reduce fiscal deficits. It is because governments retain the option of devaluation that the capital markets retain the risk premium. To remove it, exchange rate fixity must become more credible. The more governments put at stake, the more credible their policy.
Dornbusch advocated that the `core' countries (the present EMS members less Spain) totally abandon exchange rate margins against the Deutschmark. This could be achieved in a year, with no need yet for joint institutions. France and Italy would experience incipient capital inflows. To offset the demand expansion they should sharply tighten their fiscal stances, providing an excellent opportunity to retire public debt. The transition should also be used to break inflation inertia, introducing a temporary wage freeze not to cut real wages, but to ensure the step to fully fixed rates does not go astray at the start.
But not all EC members should be included in this process. In the United Kingdom a real depreciation would be needed, but the response would be wage pressure and inflation which would only be checked at the cost of unemployment. Sterling could not fit into a European monetary arrangement while UK wage- and price-setting differs so radically from what is now accepted on the Continent, Dornbusch maintained. Second, the new entrants to the EC would be better adopting a crawling peg to achieve fixed real exchange rates. As Latin American experience shows, fixed nominal rates are not a lasting measure against high home-made inflation.

Conclusions
The conference ended with a public panel discussion on `Problems of Financial Integration in Europe', chaired by Mario Sarcinelli, Director General of the Ministero del Tesoro in Rome. A major difficulty that will arise in a European financial area, he suggested, is that a `level playing field' with separate national currencies will make possible large-scale tax and regulatory arbitrage. One solution is for the Commission to be responsible for taxing the income from services, but this is unlikely to be politically acceptable. An alternative is to shift responsibility for supervising intermediaries from the host to home countries.
Luigi Spaventa (Università di Roma and CEPR) warned that the new freedom to import financial services will mean that the present high reserve requirements and taxes on deposits will penalize the Italian financial sector. Due to a long history of political involvement, Italy also has too many banks. A simple merger spree to create fewer, larger banks was not the solution, according to Spaventa. More appropriate would be cross-border alliances enabling Italian banks to continue to exploit their comparative advantage in local knowledge, while importing expertise.
Niels Thygesen (Kobenhavn Universitet) criticized the UK Treasury's `competing currencies' proposal, which involved advanced financial competition with no steps on the monetary front. This may well be destabilizing and leaves unresolved the setting of overall EC monetary policy. Thygesen argued that the full gains from financial integration would only be attained with further monetary integration. A single currency would remove the risk premium in interest rates, eliminate transactions and information costs of exchange uncertainty, and allow deeper specialization and superior allocation of saving and investment.
Charles Wyplosz (INSEAD and CEPR) emphasized the distributional consequences of integration. Though he commended Giovannini and Hines's proposal for a tax regime that removed incentives for capital flight within the EC, it would not prevent wholesale capital flight outside the Community. As tax receipts on capital income fall, governments will respond with a combination of higher taxes on less mobile factors, i.e. labour, and reduced spending on social programmes and public investments. Similarly, he was concerned about the overall effect of such a huge increase in competition. The result would be to reduce economic rents, but while capital can move elsewhere, labour is less mobile and so will lose out. We should beware, Wyplosz concluded, the prospect that 1992 will turn out as a capitalist paradise.

European Financial Integration edited by Colin Mayer.
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