Finans

Finanshus: Søndagsnote om spillet bag EU’s mia. store redningsfond

Morten W. Langer

søndag 19. juli 2020 kl. 17:49

Fra Unicredit, skrevet af cheføkonom Erik F. Nielsen:

Happy Sunday, As I’m starting to write this, the European leaders are getting up in Brussels after two bruising days of negotiations on the biggest and most consequential European initiative since the introduction of the Single Market almost 30 years ago. This morning they’ll be having a number of bilateral meetings before reconvening at noon for what will surely be a long afternoon and (probably) evening of negotiations.

I remain optimistic that we’ll get an agreement, if not today, then before the end of the month. My biggest concern is the attempts to water it down both in terms of size and focus. Indeed, my key point in today’s note is that there is so much more at stake than just the details of the proposed mega-sized fund to help Europe recover from the lock-down.

Maybe even more important is the underlying vision of creating an environmentally sustainable economy with a level of “home grown” digitalization that will make it possible for Europe to navigate the now rapidly escalating conflict between the US and China, particularly in the area of technology. Of course, money is needed for this, but it seems that a number of political leaders may be missing the view of the forest here as they focus not only on the trees, but even on the branches on the trees.

In a nutshell, with the help of Council President Michel, the co-authors of the all-important vision, French President Macron and German Chancellor Merkel, are trying to find a way between (roughly speaking) the North, who want to de-fund the effort to the extent possible, and the South and East (CEE) who want mostly unconditional money in the form of grants.

So, in today’s note: ■ I’ll first briefly reflect on the outstanding issues and how the “branches on the trees” seem to have taken over. ■ I’ll then remind you of the most burning of the two key issues at stake here – digitalization – and how tensions between the US and China have accelerated in recent weeks to a degree where Europe now needs to take side… ■ … and for that to happen, corporate taxation, and particularly the practice of aggressive tax havens inside the EU, which are particularly heavily used by US tech companies, needs to be addressed.

That has been brought to the forefront by Wednesday’s court ruling in favour of Ireland and Apple, and against the European Commission (and common sense.)

1. The outstanding issues and the confusion. According to media reports, the European leaders broke up late yesterday when, after two days, they still couldn’t bridge the gaps between the various sides on issues ranging from the size of the fund, to the split between loans and grants, to the issue of conditionality for receiving money.

Reportedly, Council President Michel has proposed to cut the grant component to EUR 400bn (from EUR 450bn), which has frustrated Germany and France, as well as most of Southern and Eastern Europe, but EUR 400bn is still seen as way too big for the four frugals and Finland. Michel has also proposed to cut the incentives for private investment from EUR 30bn to EUR 11bn. This is one of the usual casualties when – and I apologise in advance for the following description – political leaders turn into accountants, rather than leaders or visionaries.

I’ll bet you that the cost to growth of that EUR 19bn cut in incentives will be much greater than the cut of EUR 50bn in grants to governments. Fundamental disagreement also remains on conditionality (for lack of a better word). The “North” wants conditionality in terms of commitments to economic reforms and adherence to fundamental liberal values, and the ability for any one country to stop disbursements (via requirement of unanimous agreement in the Council for disbursements), if such “conditionality” is being 19 July 2020

Broadly speaking, the “South” opposes policy conditionality; the “East” opposes “values” conditionality – and both the “South” and the “East” opposes the requirement of unanimity in the approval of payments. I have lots of sympathy for a requirement of some sort of conditionality. This is about “the vision” and not about debt relief or some other general-purpose spending, and of course, there is also the issue of “Real-Politik”. How can any political leader sell to his or her own taxpayers the financial responsibility for a massive borrowing program with “no strings attached” disbursements to another country?

Yet, the debate has gone off on a bizarrely simplistic populist path in most countries, which surely serves no serious purpose: First, the public narrative in most Northern European countries is one of sending huge amounts of money to Southern Europe, particularly Italy. Yet, the real story is different. For years, Italy has been a financial net contributor to the EU, while Spain and Portugal have been relatively small net beneficiaries.

The big net beneficiaries are all in Central Europe. As the UK’s roughly EUR 15bn in annual net financial contributions end, this picture would be more extreme in relative terms – and that as Southern Europe has suffered much more severely from the pandemic than Central Europe. Still, the proposed mega-plan (which would borrowing EUR 750bn at near zero interest rates, if not negative rates) would make Italy a (relative small) net financial beneficiary, and the rest of Southern Europe slightly bigger beneficiaries – while ploughing still more money into Central Europe.

What would Northern Europe get in return? European growth and stability and (hopefully) a shared vision of liberal values and unity in a world where conflicts between the US and China roam. Second, these politically important and much-quoted numbers, calculated to tell countries whether they are net contributor or beneficiary, tell only a small part of the real financial story; i.e. before we start talking about the benefits of the Single Market and the common currency. For example, according to the Commission’s calculations, the Netherlands was a net contributor to the EU of EUR 2.4bn in 2018.

Meanwhile, according to the Tax Justice Network, that same year, the Netherlands’ tax haven structures helped them grab EUR 6.7bn in tax receipts from Germany, France, Italy and Spain (ht Algebris’ Alberto Gallo.)

Third, in most Northern European countries, including my native Denmark and in the Netherlands, the media – driven by key politicians, labor union leaders and others – is focusing on statements by e.g. Italian Finance Minister Gualtieri of the possibility of tax cuts and on the Italian government’s recent reversal of the pension reforms to (under certain circumstances) lower the pension age.

So, the story goes, why should we help finance that? My view is that Italy – and the rest of Europe – should indeed follow Germany’s lead and provide further tax incentives, particularly temporary cuts in the VAT, to stimulate the recovery (which indeed was what Gualtieri was referring to). And before anyone gets too excited about pensions they should accept that it’s a rather complex issue, and comparisons are far from straight-forward.

If interested, see this OECD piece from last year comparing Italian and other pension systems: https://www.oecd.org/italy/PAG2019-ITA.pdf. That all said, all of Europe should continue the drive to raise the pension age, but that’s for another day.

2. The most burning of the two key issues at stake here – digitalization – and how tensions between the US and China have accelerated in recent weeks to a degree where Europe now needs to take side… These past couple of weeks have made it clear (if it wasn’t before) that Europe urgently needs a strategy for how to navigate the rapidly accelerating conflict between the US and China with respect to technology. Coming late to the tech-game, Germany and France identified digitalization as a top priority (along with the green agenda) in the Macron-Merkel plan, hoping – in German Economics Minister Peter Altmaier’s words – to turn Europe into a “digital powerhouse”.

Any hope of doing so will require a massive, and well targeted, public investment program along with a set of incentives for the private sector to invest and develop this space. Unfortunately, judged by the negotiations now going on in Brussels, Germany and France have problems convincing their fellow Europeans, particularly the Four Frugals, of the necessity of this vision.

And it’s urgent now. US-Chinese relations are fast descending into a state in which third party countries will be forced to choose sides, with, it seems, broader negative consequences for future relations with the other party. Particularly since May, when the US placed Huawei on its “Entity List” (which means that any sale or transfer of US technology to Huawei now requires specific permission by the US Bureau of Industry and Security), US authorities have been leaning heavily on Europe to ban the company from participating in the forthcoming roll-out of 5G.

Just last week, the US national security advisor was touring Europe to make that case. And, voila, this past week, the UK completed its labored U-turn and fell in line with US demands when Boris Johnson announced that Huawei will be excluded from the UK’s 5G network, triggering the expected further threats of retaliation from Beijing (a relationship already tortured by China’s handling of Hong Kong and the UK’s reaction).

Meanwhile, Peter Almaier and several other key Germans have been emphasizing Europe’s commercial relationship with China, but as Brooking’s “Germany explainer” and foreign and security expert, Constanze Stelzenmueller, argued in her piece in the FT this past week, it really isn’t a matter of “choosing the US”, but rather of “not choosing” Huawei – and China. If not clear before, recent weeks have demonstrated China’s foreign policy ambitions and its lack of respect for international treaties in its pursuit of broader global influence.

And believing Huawei’s claim of independence from the state seems just a tad too naïve. Stelzenmueller’s very read-worthy piece is here: Europe faces a fateful choice on Huawei. Yet, choosing (also if by default) US companies for the next generation technology comes with a number of serious issues as well, which reach far into the present negotiations in Brussels – and into the functioning of the EU’s Single Market because these are companies which – with the blessing, and now explicit defense, of the US government – have exploited more than anyone the vastly distortive tax haven opportunities offered by a small number of EU members, most noticeably Ireland, Luxembourg, the Netherlands and Belgium.

3. Corporate taxation, and particularly the practice of aggressive tax havens inside the EU, which are particularly heavily used by US tech companies, needs to be addressed. That has been brought to the forefront by Wednesday’s court ruling in favour of Ireland and Apple. As I’m sure you know, the European Commission has been worried about these tax structures for a long time, while Berlin, Paris, Rome and Madrid have been strangely quiet on the issue. Of course, tax policies are solidly anchored as a national competency (maybe explaining part of the reason for the silence in major capitals), even though the effects are felt far beyond the national borders when they are applied to international companies.

Therefore, the Commission has been circling the wagons for quite a while, shooting a few timid test arrows (read: claims of hidden subsidies which violate competition policies) into the compound to see what might start the desired fire, from where the battle could then begin. And, after winning (and losing) a few such minor attempts (with low double-digit million euros at stake), Commissioner Vestager and her Competition Directorate thought they had their big and obvious case.

Ireland had handed Apple a truly extraordinary tax deal. To remind you, Apple had based its European business in Ireland, but had been allowed – under Irish law – to establish an entity with no tax domicile or employees between the US parent and its Irish branch, to which a huge chunk of Apple’s profits from its businesses around Europe was allocated. That this is acceptable to other countries is already peculiar to me, but the Commission’s bone was much more limited in scope than that.

It simply claimed that by allowing this structure, cutting Apple’s tax liabilities by some EUR 13bn (and dropping Apple’s tax rate to something like 1%), Ireland had violated EU’s rules on state aid. (Ireland has since changed the law so that they no longer allow this specific structure for tax avoidance.) Yet, as I’m sure you noticed, just this past Wednesday, Europe’s second highest court ruled that the Commission had not demonstrated sufficiently that this absurdly advantageous tax deal handed out by Ireland to Apple constitutes a subsidy which would have distorted competition in the EU.

I have a ton of respect for Apple and its products (and design), but wow! – if their dominant position, enormous profits and matching share price (or price/earnings) do not hint at subsidies and/or near-monopoly status, and hence distortions, I don’t know what does In any case, the US has threatened retaliation if Europe were to crack down on these tax avoidance schemes exploited by US companies operating in Europe – and if France, and other Europeans, carry through with their planned taxation of digital businesses.

I’ll get back to this. Wednesday’s court ruling in favor of Ireland and Apple – and, more broadly, the corporate tax haven structures being operated inside the EU – are relevant for the European mega-package and broader vision because it relates to European growth across 19 July 2020 Macro Research Chief Economist´s Comment UniCredit Research page 4 See last pages for disclaimer. a level playing field (the Single Market), the European vision of becoming more self-reliant in technology, and because of the relative responsibilities for the future servicing of the common debt now being planned.

I have written about the deeply troublesome tax haven structures inside the eurozone before, quoting OECD data and academic research which clearly illustrate the huge shifts in multinational corporates’ profits away from a number of countries with “normal” tax regimes, including Germany France, Italy and Spain, and to, particularly, Ireland, Luxembourg, the Netherlands and Belgium.

Today, I’ll just throw one more statistic at you to illustrate the absurdity of what’s being offered by some EU countries to divert multinational companies’ taxes to places without any even remotely comparable share of their production or sales, thereby fueling the politically troublesome developments in income distribution (capital has gained about five percentage points over labor during the past 15-20 years) and preventing the development of a comparable European tech industry:

According to the CIA World Factbook, the world’s greatest host of FDI investment (i.e. the “stock” of FDI) at the end of 2017 (latest available data) was the Netherlands with an eyewatering USD 4.9 trillion of foreign investments “invested” in the country (taking in no less than USD 58bn in 2017 alone, according to, not entirely comparable, UN data), surpassing such major (also business friendly) countries like the US (USD4.1 trillion) and the UK (USD 2.0 trillion). Ireland is the fifth biggest host of FDI, at USD 1.5 trillion, at par with, e.g., China and Germany.

Belgium is the 9th biggest host for FDI at USD 1.1 trillion. May I suggest that even if just a fraction of these FDIs in the Netherlands, Ireland and Belgium were “real” foreign direct investment in terms of producing goods and services, as opposed to tax-convenient mailboxes, every building in those rather small countries would have to be tens of stories high to house all these activities!

Let’s be real and say it as it is: This involves European governments facilitating massive tax avoidance schemes at the cost of others: Other European countries and European citizens in other countries. And the effects of these bizarre schemes are clear. They include an overall taxation of the participating multinationals’ profits which are completely out of proportion with other companies’ tax burden which surely distorts competition in their favor – call it a subsidy or not. It also contributes to a massive scale of redirection of tax revenue away from countries where the companies’ actual activity takes place, be it production or sales. How this is acceptable between partner countries which share a Single Market, the currency and now [soon] a meaningful amount of debt, is simply beyond me.

Returning to the case of the day, this past week’s court ruling in favor of Ireland and Apple, I’ll make three points in conclusion of today’s note: First, there is probably a strong case why the Commission should appeal the decision to the highest court, even if the issue is much greater than this case: In an excellent piece in the FT, Martin Sandbu notes that the court did not dispute the possibility that special tax arrangements may constitute illegal state aid, but they ruled that the Commission had not established that this arrangement was specifically for Apple, and it could, therefore, not be called “state aid”.

As noted above, even though it may be right that this truly bizarre arrangement was available to other companies, it surely could only be used by huge global companies with lots of profits generated by intellectual property, and not by smaller start-ups; so while it may not have been exactly like state aid, it surely distorted competition. The court also ruled that while it was unclear (and maybe erroneous) how the Irish authorities allowed the exact portions of Apple’s European profits to be assigned to this ghost-unit, the Commission had not proven that these unclear decisions always had been made to the advantage of Apple (to which I say “wow”, and nothing else).

As Sandbu writes, “if the law really allows this, the law is an ass and should indeed be changed”, but he also concludes that it’s not entirely clear that that’s what the law says. So, he concludes, the Commission should appeal … and do a better job preparing the case. Martin Sandbu’s piece, which is highly recommended, is here: The EU’s economic case against Apple and Ireland Second, while saying that they’ll study the ruling (obviously with a view to possible appeal), the Commission used the date of the ruling to publish a major initiative to harmonize corporate taxation.

This has obviously been in the oven for a long time, but 19 July 2020 Macro Research Chief Economist´s Comment UniCredit Research page 5 See last pages for disclaimer. accelerated after the Macron-Merkel plan talked about it as well. And rather than keep pursuing these crazy tax avoidance deals along the “competition” avenue, as their weapon of choice, they now say they’ll activate (for the first time) Article 116 of the Treaty, which – in a broader sense – prohibits policies that “distort the Single Market”.

This would be a laborious process under which the Commission first has to identify the distortion caused by the differences in a member state’s “law, regulation or administrative action” from others, then argue that such distortion “needs to be eliminated”, and then it needs to go and consult with the member state in this case. If this then does not lead to an acceptable outcome, the European Parliament and Council can agree with a qualified majority (i.e. with at least 55% of the member states representing at least 65% of the population) on directives which would address the issue.

The neat thing here is, supposedly, that decisions can be taken with qualified majority, thereby bringing distortive taxation practices away from national parliaments and on to the European level. What I am not clear about, however, is the type of consequences the EU would – or could – impose on a country that “plays games” by fiddling the tax regime a bit in order to simply start this multi-year process again. In conclusion, my third point is the following broader one:

Whether the Commission appeals or not, and whether it pursues these arrangements via Art 116 or not, the tax haven issue is greater than a matter of policing. Rather, it is one of policy – and of attitude. Without a common fiscal authority – obviously anchored in a democratic process – there really is no simple solution to some countries’ belligerent tax policies, even if they impair European growth, cohesion and – potentially – political stability. Ultimately, the great distortions and unfairness brought about by these tax deals are rooted in the inherent conflict between global businesses and free capital movements versus national policies.

I’ll argue – maybe another day in more detail – that this conflict played a major role in the undoing of the globalization process we now witness, at potentially huge cost to growth and living standards around the world, precisely because of the lack of a functioning global governance structure. Maybe that was (sadly) inevitable on the global level, but it ought not be the case in the EU. While far from perfect, one of the least appreciated (by many in the market) strengths of the EU is the peer pressure and power of persuasion among ministers in the councils.

We saw this in abundance during the financial crisis, the sovereign crisis and specifically the Greek crisis. But while the major countries, including Germany and France, along with the Northern countries “happily” and effectively teamed up and put their collective persuasive powers to good work back then, why the same big countries, and everyone else, apart from the four key offenders, don’t do the same towards these four outliers beats me. But one thing is clear. As long as European corporate taxation is not broadly harmonized, leaving huge benefits to multinationals’ – including US tech firms’ – operations in Europe, there is a real need to impose a different type of taxation on those companies’ activities, e.g. at point of sales, or user level.

France has opened this avenue, and the US administration has raised all sorts of retaliatory threats if they carry through. To me, however, these are threats well worthwhile dealing with. First, there is a rather good chance that the present US administration won’t be around much longer, although while a Biden administration will surely address the general deficiencies in US corporate taxation, it’s not clear it’ll take a more cooperative stance towards Europe.

But then again, that’ll be a matter of money, rather than of national security, which is what the Chinese route to 5G would imply. I know what I would prefer – until Europe gets its act together on its own digitalization. 19 July 2020 Macro Research Chief Economist´s Comment UniCredit Research page 6 See last pages for disclaimer. And on that note, I’ll wrap it up for today with the hope that common sense and an understanding of the bigger issues for Europe will prevail in Brussels today.

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