The economics of international tax competition

Read the article in the Cayman Financial Review Magazine 

Globalisation has significantly reduced the cost of cross-border economic activity. This has led to big increases in worldwide commerce and also a dramatic expansion of international capital flows. These developments have been good for consumers and the overall global economy, but they also have yielded important indirect benefits.

Governments, for instance, now must compete to attract jobs and capital (or to keep jobs and capital from fleeing to jurisdictions with better policy), and this is encouraging politicians to lower tax rates and reform tax systems.

This process, known as tax competition, has encouraged sweeping changes in tax policy. Personal income tax rates have dropped, corporate tax rates have plummeted, and more than 25 governments have adopted flat tax systems.

The economic analysis of this process is very straightforward: Monopolies are bad, competition is good. This is well understood in the private sector. Consumers benefit when banks compete for their business. They benefit when grocery stores compete for their business. And they benefit when pet stores compete for their business. The notion of tax competition simply extends the analysis to political decision making when there is more than one government.

The liberalising impact of jurisdictional competition is particularly important since there is a tendency among politicians – in the absence of any constraints – to raise tax rates beyond their optimal level because it is in their self-interest to have bigger government. The expansion of the public sector and the concomitant rising tax rates during most of the 20th Century certainly is consistent with this “public choice” view of political behaviour, which focuses on incentives to accumulate power and use public funds to seek votes.

The policy impact of tax competition

Globalisation has imposed constraints on politicians, however, and the process became especially important following the elections of Margaret Thatcher and Ronald Reagan. In 1979, when Margaret Thatcher became prime minister of England, the top tax rate was 83 per cent and England was in terrible shape. During her tenure, she reduced the top tax rate to 40 per cent and implemented other free-market reforms. The UK economy, not surprisingly, recovered and her nation prospered.

Likewise, in 1980, Ronald Reagan was elected president in America. The top tax rate was then 70 per cent and America was suffering from stagflation – a debilitating combination of inflation, stagnation and unemployment. To restore America’s economy, President Reagan slashed the top tax rate down to 28 per cent. Along with other reforms to reduce the burden of government, this helped to restore America’s economy.

But what’s really noteworthy about the Thatcher and Reagan tax cuts is that nations all over the world were forced to play follow the leader. Top tax rates in the developed world dropped from more than 65 per cent down to about 40 per cent. This is a dramatic shift toward better tax policy, and it explains, at least in part, why the global economy – even with the recent financial crisis – is much stronger today than it was in the 1970s.

The key thing to realise is that politicians in other nations almost invariably cut their tax rates because of competitive pressure, not because of a philosophical belief in smaller government or lower tax rates. This is why tax competition is such an important force for good policy. Even statist policymakers are compelled to do the right thing when they fear that the geese that lay the golden eggs will fly across the border.

And it’s not just the personal tax rate. Corporate tax rates have dropped by more than 20 percentage points since Thatcher and Reagan took office. Ireland really deserves the lion’s share of the credit. By slashing the corporate rate from 50 per cent to 12.5 per cent, Irish leaders turned their economy from the sick man of Europe into the Celtic Tiger during the 1990s. But the global effect is even bigger. In order to compete, nations all over Europe and around the globe felt pressure to lower their corporate tax rates.

Tax competition is also playing a role in the global flat tax revolution. Twenty years ago, the only flat tax jurisdictions were the little British territories of Hong Kong, Jersey and Guernsey. Today, there are nearly two-dozen flat tax jurisdictions, including many of the former Soviet Bloc.

The economics of tax competition

Tax competition issues have been addressed in the academic sphere. Charles Tiebout published a famous article in 1956 that introduced what became known as the Tiebout Hypothesis, which explains that tax competition is desirable since it allows people to choose jurisdictions that best match their preferences for spending and taxes.

And many public finance economists instinctively support tax competition on a “results” basis. They recognise that lower tax rates are good for economic performance, so that makes them sympathetic to a process that compels policymakers to keep rates modest. Similarly, public finance economists generally dislike laws that require “double taxation” on income that is saved and invested, giving them another reason to like the liberalising impact of tax competition.

But there also has been a strain of academic thought hostile to tax competition. It’s called “capital export neutrality” and advocates of the “CEN” approach assert that tax competition creates damaging economic distortions.

They start with the theoretical assumption of a world with no taxes. They then hypothesize, quite plausibly, that people will allocate resources in that world in ways that maximise economic output.

They then introduce “real world” considerations to the theory, such as the existence of different jurisdictions with different tax rates. In this more plausible world, advocates of CEN argue that the existence of different tax rates will lead some taxpayers to allocate at least some resources for tax considerations rather than based on the underlying economic merit of various options. In other words, people make less efficient choices in a world with multiple tax regimes when compared to the hypothetical world with no taxes.

To maximise economic efficiency, CEN proponents believe taxpayers should face the same tax rates, regardless of where they work, save, shop or invest.

This may sound radical, but there’s some overlap between the CEN theory and traditional public finance analysis. Most tax economists, for instance, want to eliminate the plethora of deductions, credits, preferences, exclusions and distortions in the tax code. Why? Because they want people to make decisions based on economic merits rather than tax consideration. Yet that’s the same argument put forward by CEN advocates.

So we have to dig deeper to understand the different attitudes toward tax competition.

Defining tax harmonisation

Not surprisingly, politicians from high-tax nations don’t like tax competition. They resent being forced to lower tax rates. Much like the owner of a town’s only gas station, they want captive customers who have no choices. They prefer “tax harmonisation” policies so that taxpayers no longer are able to benefit from better tax policy in other jurisdictions. There are two forms of tax harmonisation:
 

  • Explicit tax harmonisation occurs when nations agree to set minimum tax rates or decide to tax at the same rate. The European Union, for instance, requires that member nations impose a value-added tax (VAT) of at least 15 per cent. The EU also has harmonised tax rates for fuel, alcohol and tobacco, and there have been many proposals to harmonise the taxation of personal and corporate income.
  • Under this direct form of tax harmonisation, taxpayers are unable to benefit from better tax policy in other nations, and governments are insulated from market discipline.
  • Implicit tax harmonisation occurs when governments tax the income their citizens earn in other jurisdictions. This policy of “worldwide taxation” requires governments to collect financial information on non-resident investors and to share that information with tax collectors from foreign governments. This “information exchange” system tends to be a one-way street since jobs and capital generally flow from high-tax nations to low-tax nations.
  • Under this indirect form of tax harmonisation, taxpayers are unable to benefit from better tax policy in other nations, and governments are insulated from market discipline.

Working through the Organisation for Economic Cooperation and Development, an international bureaucracy based in Paris, statist politicians want to hinder the flow of jobs and investment from high-tax nations to low-tax nations. Indeed, the OECD has a “harmful tax competition” project. It even put together a blacklist of low-tax jurisdictions and threatened them with financial protectionism if they didn’t help high-tax nations enforce their bad tax laws.

While parts of the OECD are more market-oriented, the bureaucrats in charge of the anti-tax competition project have an openly statist orientation. In its 2000 report, it said the “low” or “zero” taxes is the number one reason for blacklisting so-called tax havens. The OECD also complained that
Low-tax policies “unfairly erode the tax bases of other countries”.

It said that tax competition is “re-shaping the desired level and mix of taxes and public spending”.

The OECD even admitted it doesn’t like tax competition because it “may hamper the application of progressive tax rates and the achievement of redistributive goals”.

The OECD’s anti-tax competition project is bad policy. It is designed to facilitate higher tax rates and more double taxation of income that is saved and invested. These policies are at odds with the consensus in the public finance literature about the ideal tax system.

To proponents of CEN, evasion and avoidance are equally bad

One of the remarkable implications of capital export neutrality is that tax avoidance and tax evasion are equally undesirable. Indeed, the theory is based on the notion that all forms of tax planning are harmful and presumably should be eliminated.

The OECD, for instance, is now pushing a global pact known as the Multilateral Convention on Mutual Administrative Assistance in Tax Matters. This MCMAATM (an acronym that doesn’t quite roll off the tongue) has existed for a couple of decades but was dramatically expanded a couple of year ago and the OECD now wants all nations to participate in order to give high-tax governments sweeping new powers to impose bad tax law on an extraterritorial basis.

But most notably, the MCMAATM process is explicitly designed to deal with issues beyond tax evasion. The OECD has a judge-jury-execution role in interpreting and enforcing the pact and unambiguously asserts that one of the goals is “combating tax avoidance”.
The Paris-based bureaucracy also has launched an initiative targeting multinational companies. This project on “base erosion and profit shifting” openly acknowledges that corporations are acting legally when they minimise tax burdens. But since tax avoidance supposedly is illegitimate, the OECD is seeking to develop global rules to restrict tax planning opportunities.

It’s unclear at this point where this project will lead, but the rhetoric in the OECD “BEPS” report suggests that the long-run goal is global formula apportionment, a system that basically would require companies to calculate their worldwide income and then divide that income on the basis of sales. So if a certain nation accounted for 4.3 per cent of a firm’s sales, the government of that country would have the right to tax 4.3 per cent of the company’s worldwide income – regardless of how much or how little income actually was earned in that nation.

Why CEN is misguided

As a practical matter, the previous sections show that proponents of CEN are interested in tax harmonisation policies in order to hinder both tax evasion and tax avoidance. And they clearly want to make it easier for governments to increase the tax burden.

Is this what makes CEN a bad theory? Perhaps, at least if one is a libertarian, classical liberal or small government conservative.

But the CEN is flawed for reasons completely independent from preferences about the size of government.

Critics point out that capital export neutrality is based on several highly implausible assumptions. The CEN model, for instance, assumes that taxes are exogenous – meaning that they are independently determined. Yet the real-world experience of tax competition shows that tax rates are very dependent on what is happening in other jurisdictions.

Another glaring mistake is the assumption that the global stock of capital is fixed – and, more specifically, the assumption that the capital stock is independent of the tax treatment of saving and investment. Needless to say, these are remarkably unrealistic conditions.

So in order to determine whether CEN is a good theory, we have to develop the estimates needed to complete this equation: 

Dan_Mitchellgraph.jpg 

Needless to say, this is the challenging part of the discussion. If you ask five economists to fill out this equation, you’ll probably get nine different answers.

Ironically, statists generally support tax harmonization and CEN because they think tax rates and tax burdens don’t have much impact on economic behaviour, but they simultaneously think that differences in tax rates will lead to large amounts of economically inefficient tax planning and tax evasion.
So even though there is a logical inconsistency to their views, they can assert that their policies will be good for the economy.

Most research in public finance, however, finds that there are significant negative effects of high tax rates and double taxation. Moreover, there’s considerable evidence that all developed nations have public sectors that are far beyond the growth-maximising level. As such, anything (such as tax competition) that encourage lower tax rates, less double taxation and smaller government will improve economic performance.

Finally, it is worth noting that a world of vigorous tax competition presumably will encourage some level of convergence of tax rates. Governments with above-average tax rates will face pressure to lower tax burdens for competitive reasons, yet policy makers also will discover that there’s not much benefit to lowering tax rates beyond a certain point, particularly since investors and entrepreneurs will value the services – such as infrastructure, property rights, and education – provided by an efficient state.

In other words, the very thing that proponents of CEN favour – tax policies that are similar – is the likely long-run outcome in a world with vigorous tax competition.

Conclusion

In the real world, tax competition has played a critical role in promoting more efficient tax policy. Not only has it stimulated reductions in personal income tax rates and corporate income tax rates, but it also has encouraged nations to reduce capital gains tax rates, death tax rates, wealth tax rates and tax rates on capital income. These reforms have significantly improved incentives for productive behaviour.

This does not mean that competing tax systems automatically generate economically efficient choices. Indeed, there are even some forms of tax competition – such as special tax breaks for specific companies and specific behaviours – that almost certainly encourage sub-optimal decisions. But tax competition generally encourages the right kind of tax reforms, which is an additional reason why multilateral bureaucracies such as the OECD (and also the European Commission and United Nations) should not be permitted to hinder this liberalising process.

Politicians from high-tax nations resent tax competition, but competition between governments has been good for taxpayers and the global economy. Tax rates have been reduced, tax reforms have been implemented, and global commerce has expanded. Along with indirect benefits such as providing individual protection against venal or incompetent governments, low-tax jurisdictions play a valuable and desirable role. 
 

 

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Margaret Thatcher and Ronald Reagan
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Daniel J. Mitchell

Daniel J. Mitchell specialises in fiscal policy issues. He also is a co-founder of the Center for Freedom and Prosperity, an organisation created to preserve and protect tax competition, fiscal sovereignty, and financial privacy.

As a member of the Editorial Board of the Cayman Financial Review, Daniel’s biography can be seen on the Editorial Board details page.

Daniel J. Mitchell
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