The positive global role of jurisdictional competition and international financial centres

In the midst of an international recession, it hardly seems that this is an appropriate moment to express optimism. It also appears to be a poor time to give a pat on the back to legislators, especially since government mistakes such as misguided monetary policy and housing subsidies are responsible for much of the world’s current financial turmoil.

Yet a bit of cheer is warranted. Consider the state of the global economy 30 years ago: Monetary policy was a huge problem thanks to inflation. Industries in many nations were nationalised. Tax rates were at confiscatory levels. Regulatory burdens were stifling and protectionism was ubiquitous. Not surprisingly, this was a time of economic chaos, falling livings standards, and politicians fixated on how to re-slice a shrinking pie.

Thanks to pro-growth reforms, however, many of these problems have been either solved or ameliorated. Marginal tax rates on productive behaviour have significantly fallen. Trade barriers have been reduced. Regulatory burdens have been rationalised, and markets have been liberalised. All of these reforms helped restore the global economy, increasing world GDP to record levels and substantially reducing poverty.

The valuable role of diversity among nations

One of the largely-unrecognised factors that contributed to this renaissance is jurisdictional diversity. There are two specific reasons why the existence of many nations (and territories with independent economic policies) has helped resuscitate the world economy. First, the world is a laboratory and when different jurisdictions adopt different policies, they generate different results. This means real-world evidence that has a significant impact on the public policy debate.

During the 1970s, for instance, it became increasingly apparent that the command-and-control communist model was an economic failure. It also became equally obvious that the socialist model of Western Europe (which was adopted by much of what was then referred to as the developing world) did not work very well. These examples helped to convince policy makers that market-based reforms were necessary – especially since jurisdictions that focused more on capitalism, such as Hong Kong, routinely enjoyed strong growth.

Jurisdictional diversity continues to play a role today. There are more than 30 nations with personal retirement accounts and these systems have been remarkably successful, even during a global recession. These nations are examples of how governments can ensure adequate retirement income without bankrupting national economies with tax-and-transfer entitlement schemes. Similarly, there are now 27 flat tax nations, and these systems have been quite successful, helping to demonstrate for lawmakers that single-rate tax regimes generate more prosperity.

Competition between nations: A race to better policy

The second benefit of jurisdictional diversity is that there is a market-feedback mechanism that rewards nations that adopt pro-growth policy. This is what is known as the ‘tax competition’ issue, but it also applies to other areas such as regulatory policy, trade policy, monetary policy, and labour policy. Simply stated, globalisation makes it easier for labour and capital to cross national borders, and this means that nations that adopt good policy not only get more growth from internal sources, but also attract investment and jobs from other nations.

Tax competition became a big issue following the Ronald Reagan and Margaret Thatcher income tax rate reductions about three decades ago. President Reagan slashed the top personal tax rate in the United States from 70 per cent to 28 per cent, and Prime Minister Thatcher dropped the top tax rate in the United Kingdom from 83 per cent to 40 per cent. Those lower tax rates helped rescue the US and UK economies, of course, but what is most noteworthy is that these lower tax rates began to attract productive resources from other nations and this forced politicians from those nations to mimic the ‘supply-side’ policies of Reagan and Thatcher.

Every major country has cut its top individual income tax rate in recent decades. The average top income tax rate for the nations of the Organization for Economic Cooperation and Development, which is an international bureaucracy comprised of 30 industrial economies, used to be nearly 68 per cent in 1980. Thanks to tax competition, nations have been racing in the right direction, and the top tax rate today is about 42 per cent. The politicians understand that the geese that lay the golden eggs can fly across the border and this is leading them to lower tax rates even though that is contrary to the usual instinct of the ruling class.

Global reductions in corporate tax rates have been almost as dramatic as cuts to individual tax rates. The rate-cutting revolution began in the 1980s with cuts by Britain and the United States. Britain cut its corporate tax rate from 52 per cent to 35 per cent between 1982 and 1986. The United States followed with a cut to its federal rate from 46 per cent to 34 per cent in 1986. Major rate cuts followed quickly in Australia, Canada, France, Germany, Japan and other countries. More recently, Ireland slashed its corporate tax rate from 50 per cent to 12.5 per cent, triggering another wave of corporate tax rate reductions as other nations responded to competitive pressure. As a result of these pro-growth reforms, the average corporate tax rate in major industrial countries, which at one point had averaged about 48 per cent, began to fall rapidly and now averages less than 27 per cent.

Interestingly, corporate tax rates have been dropping most rapidly in the European Union. The average corporate tax rate in the EU fell from 38 per cent in 1996 to 24 per cent in 2007, which is 16 points lower than the US rate. The growing economic integration of the EU has put strong competitive pressures on its 27 member nations. A European Parliament report noted that “a wind of tax reforms has been blowing through the European Union . . . most reforms can be seen as supply-side oriented1.”

The last sentence of that quote is especially important. Supply-side tax reforms are those that reduce the costs of productive activities such as working, investing and starting businesses. If the costs of production are reduced, output will increase and wages and incomes will rise. In other words, tax competition spurs the types of tax cuts that boost standards of living worldwide.

Remarkably, even OECD economists understand that tax competition is a pro-growth force in the world economy. They have admitted that, “…the ability to choose the location of economic activity offsets shortcomings in government budgeting processes, limiting a tendency to spend and tax excessively2.” Another OECD study acknowledged that, “…decentralisation can make governments more accountable… It may also introduce competition across jurisdictions and thus raise public sector efficiency3.” These are astounding confessions since the OECD is leading the attack against low-tax jurisdictions.

The positive role of international financial centres

Low-tax nations and territories, sometimes referred to (often with pejorative intent) as ‘tax havens’, have been especially helpful in convincing politicians to reduce the double taxation of income that is saved and invested. Many nations have lowered or eliminated death taxes and wealth taxes because the politicians have finally figured out that oppressive tax laws simply lead taxpayers to move their money to nations such as Luxembourg or Panama. Likewise, nations have reduced double taxation of dividends, interest, and capital gains. The politicians figure it’s better to have a low rate and collect some money rather than have a high rate and drive investment somewhere such as Switzerland or Singapore. As a German economist noted:

The level of total taxation would indeed be higher in a world without tax competition… Financial assets such as bank accounts, bonds, or equity are highly mobile and easy to relocate. …Tax competition has largely prevented politicians from tapping into this revenue source. … tax rates were cut practically everywhere.

From an economic perspective, these lower tax rates are critical because they reduce the tax bias against saving and investment. Many large nations, including the United States, tend to impose a heavier tax burden on saving and investment compared to consumption. This is a foolish policy since saving and investment are the ways that people set aside more of today’s income to finance tomorrow’s growth – and even socialist economists agree that capital formation is the key to long-run prosperity and rising living standards. To cite a negative example, it is possible in America for a dollar of income that is saved and invested to be taxed as many as four different times, thanks to the combination of capital gains taxes, corporate income taxes, dividend taxes, and death taxes.

But thanks to tax competition, this pernicious form of double taxation is slowly being reduced, both in America and elsewhere. Wealth taxes, which were once popular in Europe, are a good example. These levies are a tax on capital, resulting in the confiscation of a share of the net assets of individuals above an exemption amount. Thus in France, the ‘solidarity tax on wealth’, imposes an annual tax with graduated rates from 0.55 per cent to 1.8 per cent on net financial assets and real estate, including primary residences, above an exemption of €760,000 (about US$1m).

Rising tax competition has convinced many countries to cut or eliminate these taxes. A survey of 19 countries found that the average wealth tax fell 40 per cent during the 1980s and 1990s4. Many countries have completely abolished their wealth taxes in recent years including Austria, Denmark, Finland, Germany, Iceland, Luxembourg, the Netherlands, and Sweden5.

The empire strikes back?

Unfortunately, some nations are resisting the pressure for economic liberalisation. Indeed, a few of them have suborned international bureaucracies into trying to undermine tax and regulatory competition. The OECD, for instance, has a ‘harmful tax competition’ project. The European Commission has numerous anti-tax competition initiatives and international bureaucracies such as the International Organization of Securities Commissions are seeking regulatory harmonisation. Moreover, the recent G20 meeting included a major push to undermine tax and regulatory competition.

If successful, these efforts would be a setback for the global economy. Forcing a one-size-fits-all approach on the world necessarily kills off the diversity that is so helpful in providing good and bad examples for the world’s policy makers. Moreover, even though tax and regulatory harmonisation does not necessarily mean excessive taxation and regulation, it is rather revealing that the politicians pushing for this approach are the ones who favour a bigger burden of government.

Nor surprisingly, so-called tax havens are in the crosshairs of the international bureaucracies. International financial centres have been successful in large part because of sensible tax laws and prudent regulatory structures. These policies have attracted economic activity, much to the chagrin of politicians from nations with more punitive tax and regulatory policies. And rather than compete, these politicians want to set up global cartels on tax and regulation – sort of akin to an ‘OPEC’ for politicians.

Conclusion

To close on a pessimistic note, the shift to statism in many nations suggests that the world may be sliding back to the economic turmoil of the 1970s. Poor monetary policy, especially in the United States, is one indication of this worrisome trend. Many nations now want to also raise tax rates and increase regulatory burdens. But because of globalisation, they understand such policies will be self-destructive unless they somehow can coerce other nations and territories into jumping off the same cliff.

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