For the last decade, the high-tax countries of the European continent have been engaged in an aggressive and largely unknown war against low tax-rate countries around the world. This is not just a war of rhetoric, but one in which Continental governments are trying to destroy the economic livelihood and prospects of many smaller and poorer countries. The war has the goal of stemming the flow of savings and investment to low-tax entitiesfrom the high-tax countries.

These governments are using two basic strategies. The first is to try to force low-tax countries to raise their tax rates, particularly on capital--that is, taxes on individual and corporate income, including taxes on interest, dividends and capital gains. They argue that low-tax countries are economic free-riders, enjoying the protections of the welfare state paid for by higher-tax countries while avoiding taxing their own citizens at high rates. The second strategy is to make it difficult for savers and investors to move their capital freely around the world to its best use. To do so, high-tax countries are attempting to force their capital-friendly neighbors to report what funds they receive from citizens and companies of high-tax countries so they can be "properly" taxed--in their home countries.

Economists have long known that taxing capital is economically destructive. Nobel Prize-winning economist Robert Lucas, after carefully reviewing relevant economic studies, concluded in 2003 that reducing capital-income taxation from its current level to zero (using other taxes to support an unchanged rate of government spending) would result in overall welfare gains of "perhaps 2 to 4 percent of annual consumption in perpetuity." As a result of the accumulation of this and other economic evidence of the destructive effects of taxes on capital, countries around the world have been reducing their tax rates for the last couple of decades. The tax revolution started with Prime Minister Thatcher and President Reagan. Now, a quarter of a century later, some of the most aggressive tax-cutting states can be found in eastern Europe, where low-rate flat taxes have taken hold. The best economic performance the world has ever experienced has occurred during this period, in large part because of the global reduction in destructive tax rates. But France and Germany, with their high-tax, statist economic policies, have been trying to stop and reverse the tax revolution.

Europe is losing the economic race to the United States and Southeast Asia. Since 1982, the U.S. economy has been growing at a rate about 50 percent higher than Europe's. The French and Germans, having made great economic progress in the 1950s, 1960s and 1970s, are now keenly aware that they have been getting poorer in relation to Americans since the time of Ronald Reagan. Parts of Europe, most notably Ireland and to a lesser extent Britain, have pulled ahead of euro-zone countries like Germany, France and Italy.

Twenty years ago, the Irish were one of the poorest people in Europe. Now they have a per capita income that is higher than all of the major European countries. The British, as a result of Margaret Thatcher's economic reforms, have also done relatively well. In 1980 the per capita income in Britain was below that of the Germany and France. Now it is higher, making Britain (on a per capita basis) the wealthiest major European country. The Irish and the British succeeded by cutting tax rates and deregulating their economies. The supply-side revolution that changed America, Britain and Ireland for the better barely breached the shores of the Continent.

It is often said that demographics drive history and, to a considerable extent, the lower-than-replacement birth rates on the Continent are at the root of the tax-rate war. Starting in the 1960s, these countries built welfare states with generous retirement systems. Such systems are barely sustainable, even with rapidly growing populations. "Defined-benefit" systems are in essence Ponzi schemes that require the number of new workers to grow as fast, if not faster, than the retirees, because it is the taxes of the working population, not any sort of savings, that are used to finance the payments to retired workers. Europe is plagued with stagnant or falling populations, which means that the proportion of the elderly is increasing rapidly.

Many countries are moving to a "defined-contribution" system, much as Chile did a quarter of a century ago (and as President Bush is now advocating for the United States). In such a system, workers are required to invest a giv en percentage of their incomes in relatively safe investments, such as government bonds or high-grade corporate bonds and stocks. The Europeans have waited too long, however, to make the necessary changes without going through considerable pain. They cannot get out of the dilemma by raising taxes, because their current tax rates are already above the revenue maximizing point. Hence, any tax increase will further reduce economic growth. Because present growth is so low, tax increases will actually lead to less tax revenue over the long run. The European governments are then left with no alternative but to begin reducing real benefits. But the public is not yet willing to support politicians who tell them the unpleasant truth. As a result, reducing benefits is constantly postponed by the politicians.

Individually, most Europeans understand the reality they are facing. Thus, we find that Europeans save much of their income. The problem is that Europeans have few profitable domestic investment alternatives available to them--given that tax rates on capital income often approach or even exceed 100 percent when an adjustment for inflation is made. (For example, if you are a French investor who received 4 percent on a capital investment before taxes, but are subject to a 50-percent-plus tax rate on that investment, while the inflation rate is 3 percent, the actual after-tax return is negative 1 percent.)

What do rational people do when faced with confiscatory tax rates on saving? They cease saving and increase their consumption, or reduce their incomes by working less, or move their savings out of the country to places where investment income is better treated. Many Europeans (both individual citizens and businesses) have chosen the last alternative--moving much of their capital out of high-tax countries.

In the view of much of the political class in these countries, if they could somehow force productive capital to remain at home rather than flee, they would have more money for both domestic investment and funding the welfare state and pensions. Thus, politicians ignore the inconvenient fact that if individuals and businesses cannot get acceptable returns on their savings and investment, they will choose not to save and invest, and consume all of their income instead.

Following the initial successes of Reagan and Thatcher's tax reforms, the Continental governments were left in the difficult position of trying to resist tax cuts as tax-cutting fever swept the globe. Politicians in individual high-tax countries realized that they were almost powerless to stop tax competition by themselves. They needed collective action. The Paris-based Organization for Economic Cooperation and Development (OECD) seemed to be the ideal vehicle. It had originally been set up by the thirty major industrial countries to promote economic cooperation and trade and to collect statistical data. The OECD had a reputation for reliable work, and it was viewed as non-political. But the French and their allies convinced the other members of the OECD in May 1996 to utilize the Fiscal Affairs Committee to "develop measures to counter the distorting effects of harmful tax competition on investment and financing decisions and the consequences for national tax bases." In April 1998 the OECD issued a report entitled, "Harmful Tax Competition: An Emerging Global Issue." In the report, the OECD argued that it was necessary for collective action to stop "harmful tax competition." A country was considered engaged in "harmful tax competition" if it had low or zero income taxes, allowed foreigners investing in the country to do so at favorable rates, or afforded financial privacy to investors or citizens.

The OECD identified 41 countries (mostly in the developing world) as having "harmful tax regimes" and demanded that they either raise taxes and engage in routine and comprehensive disclosure of individual citizens' confidential financial information, or be blacklisted. Blacklisted countries would be punished by a variety of economic and financial measures, incl uding termination of tax treaties and corresponding banking relationships.

To reinforce the efforts of the OECD, UN Secretary General Kofi Annan appointed a panel in December 2000 to look at "Financing for Development." The panel published its report in 2001. The report called for the establishment of an International Tax Organization (ITO). This body would allow every UN member government to have unqualified access to the financial information of all citizens of UN member states. It would also, among other things, provide for the taxation of emigrants, prohibit "unfair tax competition", and tax carbon emissions. Not surprisingly, the proceeds of the various taxes would go directly to the UN, bypassing national governments.

Similar steps were taken by the European Union. From the time of the formation of the EU, a debate had been ongoing about how much information the members should share about movements of capital between the associated states. The capital-exporting countries, such as France and Germany, desired more information in order to tax their citizens on income earned on capital beyond their borders. Capital-importing countries that had a tradition of financial privacy, such as Luxembourg and Austria, resisted information-sharing. In 2000 the EU proposed the European Savings Tax Directive, which would require countries to automatically exchange information on the investment earnings of foreign investors. For the measure to have its desired effect of reducing capital outflow (particularly non-taxed capital outflow), it was obvious that not only would the EU members and their off-shore dependencies need to be included, but also at least the United States, Switzerland, Liechtenstein, Andorra, Monaco and San Marino. This was clearly not in the cards. But it was agreed that, at least temporarily, Austria, Belgium and Luxembourg could apply a withholding tax on savings held by residents of the member states, eventually rising to a 35 percent withholding rate. The European Savings Tax Directive has been in an almost constant state of revision since it was first proposed, and a greatly watered-down version is now supposed to go into effect in July. This is at least a partial victory for the high-tax countries.

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