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Tax-cut war widens in Europe

A tax-cut war is spreading across Europe as leaders of the Continent's biggest economies give up criticizing smaller neighbors for cutting business-tax rates and decide to join them instead.

The move toward lower levies on corporate profits in Spain, Germany, France and Britain is aimed at attracting companies and reinforcing the strongest economic expansion in six years. It comes after Ireland and new European Union members from Eastern Europe succeeded in attracting investment, and irking their larger rivals, with tax rates of less than 20%, among the world's lowest. "The gloves are off," said Erik Nielsen, chief European economist with Goldman Sachs in London. "Bigger countries are now competing on taxes. This is very much something that will determine how much and where companies want to invest."

The EU's average corporate tax rate at the end of 2006 was a record low of 26%, and more cuts are in the works this year. Gordon Brown, the British chancellor of the Exchequer and prime minister-in-waiting, in March lopped two%age points off the top rate, which is now 28%. The lower house of the German Parliament last week backed Chancellor Angela Merkel's plan to pare its corporate rate to 30% from 39%. Nicolas Sarkozy, who was elected French president this month, promised to reduce his country's 33% rate by at least five%age points. The Spanish government under Prime Minister José Luis Rodríguez Zapatero is cutting its rate to 30% from 35%; and the prime minister of Italy, Romano Prodi, is considering a reduction in his country's 33% rate. The rush to lower business taxes is a turnaround for the biggest European countries, whose governments once complained that their neighbors were engaging in 'tax dumping' and threatened to cut aid to them. Just three years ago, Sarkozy, then the French finance minister, sought EU support to implement a minimum corporate tax rate throughout the bloc.

Feeding the complaints were business-tax reductions by Poland, Slovakia and Hungary before their EU entry in 2004. Poland cut its levy to 19% from 27%. Slovakia adopted a flat-tax rate of 19%, down from 25%, and Hungary went to 16% from 18%. The lower rates helped lure operations from companies in higher-tax countries. PSA Peugeot Citroën, an automaker based in Paris, and Siemens, an engineering company based in Munich, for example, moved some production to Slovakia. "Corporate tax has been an important part of the story in strengthening growth, balances of payments, fiscal performance and currencies" in Eastern Europe, said Philip Poole, head of emerging-markets research at HSBC in London. Now, falling budget deficits are making it easier for Sarkozy and other leaders to join the tax-cutting competition. JPMorgan Chase forecasts the budget shortfall in the 13 nations that share the euro will shrink to 1% of GDP this year from 2.5% in 2005.

Supporters of lower corporate taxes point to the success of Ireland, whose 12.5% rate, the lowest in the developed world, is down from 47% in 1988. That proved a magnet for such US-based technology companies as Microsoft, Intel and Dell and helped Ireland's economy grow more than three times the rate of the euro area in the past decade, while still running a budget surplus in nine of the 10 years. Nielsen at Goldman Sachs is betting that lower corporate taxes, by making businesses more competitive, will help euro-zone economies grow at a faster rate without heating up inflation. An improved business climate has helped raise that rate, the so-called speed limit, to as much as 2.5% for the bloc's economies, from 2%, he said. That's consistent with the findings in a study of 86 countries last year by KPMG International, which showed corporate tax cuts allowed countries to attract and retain business investment with little loss of revenue. While governments collect less from companies, the difference is offset by new revenue stimulated by expanded hiring and spending, the study found. "It's not just a free gift to companies; it's a way to improve the overall economy," said Loughlin Hickey in London, head of KPMG's global tax practice.

How much corporate tax cuts encourage growth remains a subject of debate. Stefano Scarpetta, an economist at the Organization for Economic Cooperation and Development, said, "Evidence on the links between taxes and investment is not fully conclusive." The OECD, based in Paris, plans to finish a research project on the question by March. Taxes are also only one factor companies consider when deciding where to locate. Employment regulations, work force skills, wage levels and infrastructure are also decisive. Poland, for example, lures investment because its labor costs average €3.80, or $5.10, an hour, compared with €27.87, or $37.50, an hour in western Germany, according to the IW institute, an economic research organization in Cologne. Governments may also make up for lost corporate tax revenue by raising taxes elsewhere. As Brown reduced Britain's main rate of corporate tax in March, he also pared allowances on plant depreciation. Merkel plans to limit corporate tax breaks on interest payments and lease contracts. (