The Swiss taxation system: Federalism in action
Bern, 18.01.2007 - Position paper by Federal Councillor Hans-Rudolf Merz on international tax competition; 18 January 2007
The Swiss tax system and its particular features are currently the subject of a good deal of discussion. For Federal Councillor Merz the system reflects our society’s understanding of the State and thus our cultural identity. The element of tax competition which is anchored in the country’s political system of direct democracy means that ultimately, the most efficient and fairest tax systems will prevail.
As a continent, Europe could scarcely be more diverse. Historically this has not been much of a disadvantage. Quite the opposite, in fact. In his well-known book „The European Miracle", for instance, Eric Jones argues that it was no coincidence that Europe formed the epicentre of the Industrial Revolution. European diversity, coupled with a healthy dose of competition, proved fertile ground for huge strides to be made in politics, religion, art and culture. It was precisely the differences in basic institutional assumptions within a confined geographical space that ensured and inspired the development of social innovation and unorthodox ideas. A wide range of political and social models engendered a rivalry of ideas, challenging each other to maximise productivity as well as creative initiative. Even the Renaissance, according to historians and economists, brought wealth and prosperity to Germany, for instance, as political fragmentation tore down the constraints of organised guilds. Political rivals outside of the major cities gave merchants and artists greater individual space, thereby attracting an influx of migrants. New towns evolved, traditional conventions were abolished, and political experiments put to the test.
Times have changed, of course. The question nowadays is whether such diversity within a small geographical area actually makes sense in an increasingly integrated world with global legal rules. There are numerous answers to this. Just as there are in the matter of fiscal policy and tax competition. How much competition is healthy, and how much coordination is necessary? The potential and limitations of tax competition were hotly debated as part of the OECD's project on harmful tax practices, and Switzerland was a constructive participant in the discussions. According to the OECD study, our taxation systems are fully compliant with the rules. In fact, just recently the OECD - an international organisation representing no fewer than 30 member states - categorised our taxation practices as adhering to the principles of fair competition. Now that's something worth noting.
Country comparisons are always fascinating as well as problematic. Fascinating because diversity enriches such a study, allowing us to draw conclusions for our own situation. Problematic because the differences that exist often elicit a lack of understanding. I will therefore explain a little about the Swiss taxation system and what makes it different. Knowing the facts helps to prevent misunderstandings.
Based on the rule of law, the Swiss taxation system reflects our understanding of the state and society and therefore our cultural identity. It is truly an example of federalism in action, with a maximum of direct democratic participation. Swiss-style federalism is committed to the concept of subsidiarity. Authority and power are developed from the bottom up. Justification for the higher state communities must come from below. Only then can the higher instance intervene in a manner that is balanced and „subsidiary". Alexis de Tocqueville aptly defined this over 170 years ago as a combination of different advantages resulting from both how big and how small states are.
What this means in our context is that Switzerland's original fiscal sovereignty lies in the hands of the cantons. The federal government may only levy taxes of a subsidiary nature, which means wherever and to the extent that this is permitted under the Constitution. And such constitutional powers can only be authorised directly by the people and a majority of the cantons. Thus, the federal government's own fiscal powers are limited. In the past, the federal government has generally only wrested fiscal powers from the cantons after several failed attempts. Even today, the federal government's authority to levy direct federal taxes and value added tax is granted for only a limited period of time. These two taxes combined make up 60% of the Confederation's income. Nonetheless, this authority is subject to renewal by the people and the cantons. The last time the electorate voted on this issue was in 2004. And in 2020 my successor will once again have to fight for renewal of our taxation powers.
The cantons' autonomy in respect of fiscal policy is something that is firmly anchored in Switzerland. And this autonomy is guaranteed by direct political rights. Consequently, the cantons end up competing against each other in terms of fiscal policy. Tax competition among the cantons is based on three pillars: the cantons' autonomy of revenue in their tax laws, the cantons' autonomy of expenditure in their budget, and a financial equalisation at federal level to even out the differences between the cantons. In the individual cantons, it is the people, the parliament and the government who decide how much their authorities should tax and how much they should spend. The foundation of direct democracy on which this financial policy is based forms a central role. A quotation from Alexis de Tocqueville accurately reflects the thinking behind this decentralised and direct-democratic approach to fiscal policy: „A democratic government is the only one in which those who vote for a tax can escape the obligation to pay it".
The impact of tax competition within Switzerland can be seen as something positive. There has been no ruinous „race to the bottom" with tax rates, as is occasionally feared. We provide a high-quality infrastructure, on which the people decide, as they do on the taxes needed to fund it. Tax competition ensures diversity, choice, efficiency and innovation. Why? When people and companies are free to choose their place of residence or domicile, this forces the politicians and governments of competing locations to raise their game and offer an attractive combination of efficient public services and a fiscal burden that is as low as possible.
Another benefit of tax competition is the fact that it offers a welcome benchmark. Citizens can measure the success of a particular government and of the parliament in relation to other governments and parliaments and keep this in mind when they later go to the polls. In this respect, tax competition brings democracy to life.
The cantons are also competing against each other in terms of quality. In my opinion, the beauty of tax competition lies in its potential for innovation and experimentation with new solutions. Raymond Broger, a former member of the Council of States (from Appenzell) was not too far off the mark when he said, „There's almost nothing that the federal government thought up by itself. Almost everything has been learnt from watching the cantons experiment in practice".
In this respect, tax competition acts as an open arena for social experiments. As these progress, better solutions are singled out and imitated, and weaker solutions abandoned. Advantageous political rules and regulations are not simply derived from plans and foresight but from trial and error. Even with the best will in the world, one can never be sure in politics of having found the best solution. As in all walks of life, politics is also dependent on the potential of competitive processes to unearth new ideas and solutions.
Historically, this possibility of opting out has played an important role in the emergence of a free society. In the Middle Ages many peasants could only shake off the feudal yoke by fleeing to the free cities. Thus, as a democratic state can protect itself against anarchy, tax competition protects us against the loss of individual free space.
Nonetheless, the cantons' autonomy in matters of fiscal policy is not without its bounds. The Tax Harmonisation Act at federal level formally aligns the tax assessment basis among the cantons. This basis is centred on a constitutional provision that was approved by the people and the cantons in 1977. In material terms, the constitutional provisions do not curb the cantons' fiscal autonomy in setting tax rates and the level of social deductions. However, this does prevent cantonal and communal legislators from introducing harmful tax practices.
The same applies for the special tax assessment rules for legal entities (holding, domiciliary and mixed companies) in the cantonal tax laws, which have recently come under fire. These are based on Article 28 of the Tax Harmonisation Act, which governs the special cases in calculating cantonal tax on earnings. Thus, contrary to what is sometimes claimed, the cantonal rules are actually based on federal legislation. Such rules have been in existence since the first half of the 20th century; at that time, however, the cantons had complete autonomy in this respect, as there was not yet a Tax Harmonisation Act to impose limits.
Under this rule, companies with a holding status are not subject to cantonal tax on earnings, but to tax on capital. The non-taxation of dividend income in the case of holding companies is used to avoid multiple taxation of corporate earnings in economic terms. This is in keeping with an internationally recognised principle of fiscal policy. Thus, in Switzerland all companies with holding status are subject to the same legal treatment, whether they are under Swiss or foreign control. So there is clearly no preferential treatment of foreign-controlled firms in certain cantons. No discrimination occurs. The tax regulations are not selective, they are open to all economic players - regardless of their nationality or their area of business or production. Moreover, holding companies are also subject to full taxation of earnings at federal level, although here too, the multiple taxation of dividends is eliminated through the granting of a participation deduction comparable with Germany's participation exemption rules.
In the case of domiciliary companies and mixed companies, no or very little business is actually conducted in Switzerland. This means that their business activity and income structure is predominantly foreign-based. Such firms use less of Switzerland's infrastructure than companies whose activities are predominantly domestic-based. The Swiss taxation system takes this into account on the basis of the requirements set out in the Tax Harmonisation Act. This prevents it from veering too far from the concept of source-based taxation. In other words, we should also expect fair value for money when it comes to taxes. In all cases, however, the cantons have no means of discriminating or granting preferential treatment in favour of foreign or foreign-controlled companies. This stems from the Tax Harmonisation Act, with which the cantons are bound to comply.
Quite another topic currently under discussion is the issue of lump-sum taxation for individuals. This is a Swiss speciality, an auxiliary construction, so to speak. This makes it possible to assess taxes in certain difficult cases with an administratively justifiable expense. It is quite common around the world to use discretionary rules to determine the tax burden in difficult tax assessments. In Switzerland we call this lump-sum taxation. In the UK, the closest equivalent would be the non-domiciled tax status. Other countries have such discretionary rules too. Lump-sum taxation is available to individuals who are coming to stay or take up residence in Switzerland for the first time or after an absence of at least ten years. Individuals with lump-sum taxation status are not permitted to work in Switzerland. If such individuals make use of a double taxation agreement, the income in question must always be included in the basis for assessing the lump-sum taxation, based on our domestic law. Thus, in this respect, they are treated the same as individuals subject to normal income tax. Certain double taxation agreements, such as those with Germany and France, generally deny the benefits of their agreement to those with lump-sum taxation status. Furthermore, it should be noted that such residents pay value-added tax in full.
In this whole debate we must ultimately not forget that competition in terms of location is a fact. Just like any other country, Switzerland also strives to offer an attractive business location with advantageous conditions. A country's prosperity and the state of its labour market are directly dependent upon the economic framework it is able to put in place. Clearly, different countries benefit by pursuing different strategies, all seeking to carve out their own areas of specialisation. Given the small size of our domestic market, the lack of natural resources, our landlocked nature and topographic limitations, Switzerland is forced to seek its niche elsewhere, such as in an attractive taxation policy.
Corporate taxation is an important factor, but by no means the only one in explaining Switzerland's appeal. Modern infrastructure, a flexible, multilingual and highly qualified labour force; strong R&D capacities; a harmonious social partnership; flexible labour law; moderate taxation of individuals; double taxation agreements with our main economic partners; proximity between the government and the people, and a pragmatic and consensus-oriented political environment are also important factors when it comes to investment and location decisions.
Let there be no misunderstanding. Those who welcome competition, as we do, must accept the fact that location decisions will not always go their favour. We in Switzerland have also seen firms such as US pharmaceuticals giant Amgen favour Ireland over Switzerland for taxation reasons, or Lego Switzerland shift its production facilities from Switzerland to eastern Europe. We have to accept these things. Ultimately, they actually spur us on and motivate us to examine why Switzerland loses out in location decisions, draw lessons from the experience and optimise our own framework conditions.
And so, to conclude. Switzerland's taxation policy adheres to the international rules of the game. Switzerland is a constitutional state and has no arbitrary or discriminatory forms of taxation. This has also been confirmed by the OECD. In international comparison, our fiscal landscape has some specialities, which stem from our fiscal federalism. This has developed in a bottom-up fashion, reinforcing the subsidiary fiscal autonomy of the regional authorities downstream, with maximum opportunities for taxpayers to have their say. A country that places great stead by the fiscal autonomy of its constituent states must also accept that a range of different tax systems will exist side-by-side, and that various innovations will be tested and at times replicated. Switzerland can thus be seen as a testbed for different taxation systems. It is our intention to keep this testbed up and running so that, through a mechanism of competition and direct democracy, the fairest and most efficient tax system will ultimately prevail.
Publisher
Federal Department of Finance
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