A revealing report by Swedish think tank Timbro entitled "EU versus USA" garnered considerable international economic and media attention when it was released in June 2004. It is essential reading for anyone looking at overseas investments, especially in the Euro region.

The Effects of High Taxes, Big Government and Regulation
The authors of the study, Dr. Fredrik Bergström, President of The Swedish Research Institute of Trade, and Mr. Robert Gidehag, formerly the Chief Economist of the same institute, painted a disturbing picture of the cumulative effects that high taxes, burgeoning government size and escalating regulations have had on EU nations in the last three decades of the twentieth century.

According to the study, if the European Union (comprised of 15 nations) were a state in the United States, the EU's gross domestic product (GDP) per capita - an important measure of economic well-being - would rank fifth from the bottom, slightly ahead of Arkansas. When compared to the U.S., the nations of France, Germany, Italy and the UK were found to have GDP per capita rates lower than all but four of the poorest U.S. states, and below that of Oklahoma.

The report also went a long way in dispelling the myth that, thanks to the social safety net provided through high tax rates, Europe's poor are better off. Data showed that the poor in the U.S. were in fact considerably better off than their European counterparts. For example, 40% of Swedish households (where overall tax rates have consistently been among the highest in Europe) would have been below the poverty line if they lived in the U.S. In 2000, 12% of the U.S. population was below the poverty line.

Figure 1: Total GDP of the 15 nations of the European Union has declined against the U.S. GDP since the 1980s. The trend shows no sign of ending, although it did level off somewhat during the 2000-2002 recession.

The Economic Impact of EU and U.S. Difference on International Investment
The report was enough to prompt a closer examination of what implications the economic differences between the U.S. and EU might have on an international investment strategy. Here are some more pertinent facts revealed in further research:

1. There is an almost direct linear correlation between overall taxes as a percentage of GDP and productivity. The higher the tax burden, the lower the productivity. No real surprise here, but the Timbro study showed the seriousness of the impact and how much the prosperity of the EU nation states and that of the U.S. had diverged.

2. In the 36 years between 1960 and 1996, taxes as a percentage of GDP in the U.S. increased from 28.4% to 34.6%. In 1960, taxes per GDP in the 'EU-15' were actually lower than the U.S. at 28.2%, but by 1996 had grown to a whopping 52.4% of the average of GDP, which means that over the span of 36 years since 1960, governments increased what they were taking out of the economy by 85% (see table 1).

3. In May 2004, there were 10 new additions to the EU. Without exception, each new member had a GDP per capita well below the EU-15 average. If, again, the EU-15 GDP per capita is set at 100, the 2001 data shows that the 10 new members average GDP/capita was less than 53. The U.S. scored 141.

4. As a percentage of GDP, the EU-15 spent 1.95% of GDP on research and development in 2001, versus the U.S. expenditure of 2.7%. In the same year, the overall EU economy was less than 90% of the size of the U.S. economy. In 2004, the gap in research and development (R&D) expenditure continued to widen.


Global Investment Returns – A Comparison
Determining the impact of an event such as the addition of 10 more 'have-not' states to the EU should be of great immediate concern to the global investor. If taxes have a negative effect on economic productivity and growth, what is the impact on investment returns? And can it be measured?

Figure 2 compares the relationships between tax rates of four nations as a percentage of GDP and the average annual return in those nations' stock market indexes over the 11-year period from 1990 to 2000. Indexes used were the French CAC-40, German SE XTRA DAX, U.S. Dow Jones Industrial Average (DJIA) and Hong Kong Hang Seng Index.

Figure 2: Chart comparing the French CAC-40, Germany SE XTRA DAX, U.S. Dow Jones Industrial Average, and Hong Kong Hang Seng Index buy-and-hold annual rates of returns from 1990 through 2000 versus average percentage of taxes as percent of GDP from 1990-2000. Market data provided by http://www.pring.com/ and http://www.metastock.com.

It appears there was an almost linear relationship between tax burden and index returns (see dashed dark red and green lines). If the rates of return in figure 2 continued for 20 years starting in 2004, the international investor would earn the returns represented in figure 3 if he or she were to invest $10,000 in each of the four national indexes.

Figure 3: Differences in 20-year returns for a $10,000 investment in the four national indexes assuming rates of returns in figure 2.

Differences in index performances between nations were found to be significant. Over a 20-year period, an investment in Hong Kong's Hang Seng Index, for example, would have returned more than double the same investment in France's CAC-40 and nearly double an investment in Germany's SE XTRA DAX Index.

Star Euro Performers
It is important to point out that, as of 2004, not all European Union members were experiencing declining economic prosperity. Luxembourg and Ireland - both listed as low-tax jurisdictions in Walter and Dorothy Diamond's three-volume tax reference entitled "Tax Havens Of The World" - are notable exceptions. Comparisons using the EU-15 GDP per capita of 100 in 2001 show that Luxembourg scored an impressive 194, while Ireland outperformed most other nations in Europe with a score of 118. Ireland was also the only member of the EU-15 to experience a decline in taxes per GDP between 1970 and 1996.

It is no surprise that the Irish SE ISEQ Overall Index outperformed the French, German, Canadian (TSX Composite Index) and UK (FTSE 100 Index) markets in the 14 years preceding 2004. Ireland took an aggressive approach to getting its economy going in the early 1990s by slashing corporate tax rates, much to the consternation of Europe's tax-and-spend bureaucrats. The policy worked, and the Irish economy is now a model of how cutting tax rates and government spending is the right answer to viable long-term economic prosperity.

Tax Rates and Your Portfolio
While it may be difficult to say that there is always a direct linear relationship between tax treatment and investment returns, the data shows a strong correlation over the long haul. Are taxes completely to blame, or could there be other factors? Generally, there are a variety of considerations when making an investment. But the evidence of a link between taxes, regulation and red tape, and economic performance is clear. And these factors exhibit significant bearing on all aspects of the economy, including investment returns.

The Canadian Slide
There is also evidence to indicate a correlation between taxation policies and currency performance. In the mid-1970s, the Canadian dollar was worth $1.10 U.S. By the early 1990s the "loonie" had fallen to 62 cents. An investment by a U.S. investor in Canadian markets over this period would have resulted in a loss of nearly 50% thanks to the devaluation in the currency.

What caused the drop? In 1960 (see table 1) tax rates in the U.S. and Canada were nearly identical. By 1990, the overall tax burden in Canada had increased by 70% to 47.8% of GDP while the U.S. increase was a more manageable 22.5%. Both Canada's corporate tax rate and personal income tax rate were also significantly higher. Taxes were certainly a factor at the root of the problem.

The Canadian TSX Composite Index significantly under-performed both the S&P 500 and the DJIA thanks in part to the tax differential between the two countries. This gives investors one more good reason to be careful when investing in any country with excessive tax rates. (For further reading see, Going International and Using Tax Lots: A Way To Minimize Taxes.)

The Competition Cartel
Interestingly, instead of recognizing and addressing the fatal link between declining economic prosperity and increases in taxation, EU governments, under the auspices of the Organization for Economic Cooperation and Development (OECD), initiated a program in 1998 called The Harmful Tax Competition Initiative. The initiative targeted nations around the world with low-tax policies, including countries in the Caribbean, Eastern Europe and the Pacific region. Many of the nations with such policies were poor and desperate to attract international investment dollars. Since the initiative began, a number of countries have been singled out and systematically blacklisted by the OECD. Explaining its actions, the OECD declared that it wanted to stop practices it labeled "unfair tax competition" and halt "a [tax] race to the bottom."

This is ironic because the European Commission has a competition agency headed by Competition Commissioner Mario Monte, who, in the name of protecting the public, has the job of assiduously seeking out monopolistic practices and enforcing competition among corporations operating in the EU. There seems to be a contradiction if, on the one hand, competition between corporations is desirable and corporate cartels are undesirable, but, on the other hand, competition among states to offer more attractive tax rates is wrong and a tax cartel is considered beneficial. The moral of the story is that investors should take note of such contradictions.

For more information on tax rates in OECD countries, please refer to the OECD website (http://www.oecd.org/)

Forewarned is forearmed!

Related Articles
  1. Investing

    What a Fed Delay Means for the ECB & BoJ

    The Fed’s continued delay has repercussions for more than just the U.S. economy and markets. The ECB and the BoJ may support the case for stocks in Europe.
  2. Investing

    How Worried Should We Be About China?

    An economic slowdown, a freezing up in trade and plunging markets and currencies are casting a shadow across Asia—and the globe. How worried should we be?
  3. Economics

    Keep an Eye on These Emerging Economies

    Emerging markets have been hammered lately, but these three countries (and their large and young populations) are worth monitoring.
  4. Investing

    Latin America’s Economic Forecast

    After a ten-year run, the economies of Latin America are in a decline. For sustainable, long-term growth, the region needs structural reforms.
  5. Mutual Funds & ETFs

    Top 3 Japanese Bond ETFs

    Learn about the top three exchange-traded funds (ETFs) that invest in sovereign and corporate bonds issued by developed countries, including Japan.
  6. Stock Analysis

    The 5 Biggest Russian Oil Companies

    Discover the top Russian oil companies by production volume and find out more about their domestic and international business operations.
  7. Stock Analysis

    Who Are Delta Airlines’ Main Competitors?

    Compare the top competitors of Delta Air Lines, Inc. Take a deeper look into the key drivers of competition in the airline industry.
  8. Investing

    Impact Investing Funds: What are the Risks?

    Impact investing funds can carry risks unique to this asset class, including political risk, currency risk and exit risk.
  9. Mutual Funds & ETFs

    Top 3 German Bonds ETFs

    Learn about the top three exchange-traded funds (ETFs) that invest in sovereign and private bonds issued by Germany with different duration yields.
  10. Investing

    China's Top Trading Partners

    A slowdown in China, the largest trading nation in the world, will have significant impacts on major trading partners: the U.S., Hong Kong, and Japan.
  1. Do financial advisors prepare tax returns for clients?

    Financial advisors engage in a wide variety of financial areas, including tax return preparation and tax planning for their ... Read Full Answer >>
  2. What is the difference between comprehensive income and gross income?

    Comprehensive income and gross income are similar, but comprehensive income is a specific term used on a company's financial ... Read Full Answer >>
  3. What is the difference between a greenfield investment and a regular investment?

    A greenfield investment is a particular type of investment where an international company begins a new operation in a foreign ... Read Full Answer >>
  4. What tax breaks are afforded to a qualifying widow?

    The tax breaks accorded to qualifying widows or widowers include being able to use a tax filing status that allows for a ... Read Full Answer >>
  5. What are the benefits for a company investing in a greenfield investment?

    Advantages of greenfield investments include increased control, the ability to form marketing partnerships and the avoidance ... Read Full Answer >>
  6. How is income taxed on prorated salary?

    Since yearly income is viewed by the Internal Revenue Service (IRS) as the total amount of income a person has made over ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Purchasing Power

    The value of a currency expressed in terms of the amount of goods or services that one unit of money can buy. Purchasing ...
  2. Real Estate Investment Trust - REIT

    A REIT is a type of security that invests in real estate through property or mortgages and often trades on major exchanges ...
  3. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  4. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  5. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  6. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!