Outlook: Withholding tax

IN THEORY there is nothing wrong in withholding taxes, a form of anti-tax avoidance which most countries use in some way or other. Those inclined to "forget" to meet their tax obligations are thwarted through the simple device of taking it off them at source. This is why bank and building society statements show interest on savings net of basic-rate income tax, and it is also why dividends are paid net. Better to get at least some of the money owing than none, goes the thinking.

So far, so good. But apply it across national boundaries - as the European Commission seeks to do in the interests of "harmonisation and level playing fields" - and problems appear.

One of the most worrying of these is the amount of red tape and bureaucracy it would impose on member countries and their investors. To set a minimum withholding tax rate on interest earned on savings and investments would create a quite unnecessary degree of paper work and complexity, given that European countries have differing bilateral tax agreements with each other.

Worse, it would create an incentive for investors to put their money in places where they receive their interest gross - as indeed it has done in countries such as Germany and Austria, with high levels of withholding tax on investment income. Nobody suggests that such people are seeking to evade tax, but given the choice investors do like to pay their taxes on their own terms and in their own time. As a consequence, the effect of a withholding tax is all too often to shift investment business offshore.

A study by Professor Richard Dale of Southampton University, commissioned by the Corporation of London and published this week, makes the case that much of the City of London's strength is founded on just such a distortion.

According to Professor Dale, regulations and taxes imposed on lenders in the United States up to 1984 encouraged investment business to flee the country. The result was the Eurodollar bond market, which to this day is centred on London. More importantly, it encouraged many to establish a base in London as an alternative to New York. This position would obviously be threatened by a Europe-wide withholding tax. Investment business would seek out an alternative without such a tax - the Bahamas, perhaps. It wouldn't benefit Frankfurt or Paris as financial centres, but it would harm the City.

Tony Blair has gone on the record to say that he would use his veto to block any measure "that will harm the City of London". Unfortunately the proposal is gathering support at an alarming pace, and all because the Germans believe certain of their citizens are salting away their savings in Luxembourg, where there is no such tax.

There are no obvious solutions to this problem. No government is going to abandon tax on savings altogether - the most obvious course of action - as it yields so much revenue. Nor are they going to forgo the cash flow and anti-tax avoidance benefit they get out of withholding taxes. On the other hand, if we have to harmonise at all, it should as a matter of principle surely be towards the country with the most progressive tax regime for savings, not the least. That country happens to be Britain.