Taxation in the global economy: Balancing competitiveness and solvency

It seems the Administration is using economic growth like magic beans – the cheap solution to all our problems. But there is no golden goose at the top of the tax cut beanstalk, just mountains of debt,” reads a statement released from Maya MacGuineas, president of the nonpartisan Committee for a Responsible Federal Budget. “Instead of banking on fantasy growth rates to offset debt-financed tax cuts, we should be pursuing sustainable economic growth to lift incomes and reduce budget deficits.”

According to Bloomberg’s ‘Tracking Tax Runaways’ report, 57 corporations left the U.S. for more tax-friendly jurisdictions in the last 20 years1. Ireland, with a corporate income tax rate of 12.5 percent, tops the list of recipient countries for U.S. companies that shift their place of incorporation to another country. President Trump’s proposal to slash the corporate income tax to 15 percent aims to reverse this trend by making America competitive again.

The rest of the developed world anxiously awaits what will happen to America’s corporate tax structure, because the highest corporate tax rate in the developed world has been benefitting other nations’ economies for years. Since the mid-1990s, while some OECD (Organization for Economic Co-operation and Development) countries gradually reduced their corporate tax rates, America’s corporate rates remained relatively unchanged. As a result, large American employers left America for lower-tax jurisdictions2 – average corporate taxes in the rest of the OECD are nearly 10 percent lower.3 Table 1 documents that five corporations with a total net income of $2.3 billion shifted their place of incorporation to another country in 2016 alone.

Table 1

Unlike Maya MacGuineas, most economists – myself included – recognize that U.S. President Donald Trump’s proposed sharp decrease in the overall tax burden would increase U.S. competitiveness and grow the size of the U.S. economy. This is because competitive tax cuts would trigger large inflows of capital that would boost productivity. However, most experts are reluctant to publicly support the plan due to worries about fiscal solvency. One concern is that slashing the corporate tax rate to 15 percent would boost the deficit so much that the tax cut would be short-lived.

On April 25, the Washington D.C.-based Tax Foundation estimated that in order for the proposed corporate income tax cut to be self-financing, it would have to raise the U.S. average growth rate from 1.9 percent to 2.8 percent.

Most experts believe this type of growth is unlikely since productivity has sharply declined in most industrialized economies. In the United States, per-person gross domestic product rose by an average of 2.2 percent a year from 1947 through 2000, but growth has been much lower since. While weak productivity and fewer workers are hits to the “supply” side of the economy, former Secretary of the U.S. Treasury Lawrence Summers4, who re-introduced the world to the concept of secular stagnation, provided evidence that a shortage of demand is also a major part of the problem.

Regardless, when confronted with low productivity, the case against expansionary policy does not seem logical. Whether supply will create new demand or demand will lead to a supply boost – as Secretary Summers suggests – one thing remains certain: productivity growth will not return to its golden age with tax rates that penalize both supply and demand.

Tax policy, such as cutting the corporate tax rate, influences saving and investment decisions which in turn affect labor market outcomes – employment, wages, and aggregate welfare. In increasingly interconnected markets, the effects of policies in one country can have implications for the rest of the world. Globalization, reductions in institutional barriers to international investment, and trade agreements have contributed to increased levels of capital mobility across countries with large differences in factor taxes. One example was the creation of a unified financial market in Europe that caused a large increase in international capital mobility across countries with uneven tax structures. It soon became clear to Europe’s political class – concerned about fiscal solvency – that containing capital flight had to become a priority.

Capital flight refers to a large-scale exodus of financial assets and capital. Corporations and high-income individuals often move their assets to countries with a lower tax burden when the benefit from moving assets abroad exceeds its cost. The flow of mobile factors of production from a high-tax to a low-tax state directly reduces the tax base in the high-tax jurisdiction. In addition, the relocation of mobile factors – labor and capital – can also reduce overall factor income in the high-tax country, thus further eroding its tax base.

For most countries, curbing capital flight implies either a tax race to the bottom or tax harmonization. Tax competition exists when governments are encouraged to lower the fiscal burden to either encourage the inflow or discourage the exodus of production factors.

Tax harmonization refers to making the tax burden identical across borders, usually by increasing tax rates in all jurisdictions.

When capital is perfectly mobile and there are no tax differentials, investors will continue to shift capital between sectors of the world economy until the marginal productivity of capital in each sector is equal to the world return. At equilibrium, the international allocation of capital is efficient because resources are directed towards the location where they create the most value.

However, if tax differentials exist between countries, resources will continue to be shifted only to the point where after-tax rates of return are equalized to the world return. Pre-tax rates of return will remain un-equalized, and thus so too will the marginal productivity of capital in different sectors of the world economy. Tax differentials thus disrupt the optimal allocation of resources, and reduce economic efficiency. Through lower and converging tax rates, tax competition represents an opportunity to enhance global productivity and aggregate welfare.

For example, in the 1980s, the United Kingdom (U.K.) – which previously had higher taxes on capital income and lower income tax rates on labor than France – lowered its tax rates on capital income and barely changed its labor income tax due to concerns about competitiveness. On the other hand, countries in Continental Europe (CE) barely changed their taxes on capital income and increased labor income taxes sharply because of concerns about fiscal solvency. These changes led to productivity gains and an amelioration of living standards in the U.K. relative to CE. (Mendoza and Tesar, 2005)5.

The U.K. clearly benefited from the capital tax cuts. Capital flows from CE to U.K. made labor more productive in the U.K., grew its tax base, thus explaining why fiscal solvency in the U.K. did not require large increases in other taxes. On the other hand, capital flight from CE made labor less productive in CE, shrinking its tax base. Large increases in labor income tax rates only exacerbated the problem since labor supply responded negatively to higher effective tax rates. While tax competition proved to be welfare-improving for the U.K., it was immiserating for CE.

By the late 1980’s Britain’s average growth rate had reached 5 percent. For the general election of 1987 Margaret Thatcher’s party boasted that “Britain’s Great Again. Don’t let Labour wreck it.” Although the share of real gross domestic product (GDP) paid in taxes – a measure of the tax burden – decreased in the U.K. (see, Figure 1), yearly tax revenues per capita grew faster in the U.K. (see, Figure 2), averaging 8 percent annual growth in the 80s and 90s compared to 6 percent in France.

Figure 1
Figure 2

In OECD countries, the expected decline in tax revenues never occurred in countries that cut taxes on capital income.6 Instead, a significant increase was recorded. (Simmons, 2006)7. In the U.S., Mertens and Ravn (2013)8 provides more evidence of the dynamic effects of capital and corporate tax cuts. The authors of this study find that personal income tax cuts lowered tax revenues while corporate income tax cuts did not, because of a very elastic response of the tax base.

Economists Andrew Mountford and Harald Uhlig investigate the effect of unexpected fiscal policy changes, such as tax cuts and spending hikes, in a paper entitled: “What are the Effects of Fiscal Policy Shocks?”9 Mountford and Uhlig analyze how changes in government tax revenues and spending affect important economic indicators like GDP, consumption and private investment. They use U.S. data from 1955 to 2000 and control for business cycles, which are normal, reoccurring fluctuations in economic activity.

Mountford and Uhlig find that deficit-financed tax cuts outperform both balanced-budget and deficit-spending approaches in improving GDP. Deficit-financed-tax-cuts deliver up to five dollars of additional GDP per 1 dollar of decline in government revenue caused by the tax cuts. Deficit-financed-tax-cuts stimulate output, consumption and investment significantly, with the effect peaking three to five years after the policy change. While some tax cuts may not immediately pay for themselves, growth effects coupled with government spending restraint are guaranteed to deliver solvency.

Unfortunately, fallacious claims suggesting that a tax race to the bottom leads to insolvency still dominate the policy debate. Competitive tax cuts grow the tax base, which in turn reduces the marginal cost of public funds. (Razin and Sadka, 1989)10. As a result, funding for government programs can increase via non-distortionary means in a more competitive low tax regime.

Fiscal solvency is a symptom of tax competitiveness while insolvency indicates a lack thereof. The bulk of evidence suggests that corporate tax cuts grow the tax base and improve aggregate welfare. This is precisely why good tax policy in a global economy begins with improving competitiveness. Mark Twain famously said: “history does not repeat itself but it often rhymes,” and a corporate income tax cut – one that rhymes with the Thatcher tax cuts – should foster an economic environment conducive to fiscal solvency – ceteris paribus.

The author can be reached for comments at orphe@buckeyeinstitute.org. The views presented here are solely those of the author. They may or may not reflect the views of The Buckeye Institute.

ENDNOTES

  1. https://www.bloomberg.com/graphics/tax-inversion-tracker/
  2. Ibid.
  3. https://taxfoundation.org/benefits-tax-competition/
  4. Gauti B. Eggertsson & Neil R. Mehrotra & Lawrence H. Summers, 2016. “Secular Stagnation in the Open Economy,” American Economic Review, vol 106(5), pages 503-507.
  5. Mendoza, E. and Tesar L. (2005). “Why hasn’t tax competition triggered a race to the bottom? Some quantitative lessons from the EU.” Journal of Monetary Economics, 52, 163-204.
  6. OECD (2017), Tax revenue (indicator). doi: 10.1787/d98b8cf5-en (Accessed on 02 May 2017)
  7. Simmons, R. (2006). “Does recent empirical evidence support the existence of international corporate tax competition?” Journal of International Accounting, Auditing and Taxation. 16-31.
  8. Mertens, K. and Ravn M. (2013). “The Dynamic Effects of Personal and Corporate Income Tax Changes in the United States.” American Economic Review, 103(4): 1212-47.
  9. Mountford, A. and Uhlig, H. (2009). “What are the effects of fiscal policy shocks?” Journal of Applied Econometrics, 24: 960–992. doi:10.1002/jae.1079
  10. Razin, A and Sadka, E. (1989). “Integration of the international capital markets: the size of government and tax coordination.” National Bureau of Economic Research, working paper #2863