Chapter 18: Tax competition
What is the role of competition between governments? If competition is the fundamental force of efficient economic performance in the private sector, why should it be different for the public sector? Why cannot the same disciplining effect of competition be applied to the public sector as well? In the private sector competition will promote efficiency because firms which best satisfy consumers’ preferences will survive and prosper, while others will lose customers and fail. Extending this argument to the public sector, competition among governments and jurisdictions should induce them to best serve the will of their residents. If they fail to do so, residents will vote with their feet and leave for other jurisdictions which offer a better deal. The purpose of this chapter is to show that if the private competition analogy has some merit, it also needs to be seriously qualified.
Tax competition refers to the interaction between governments due to inter-jurisdictional mobility of the tax base. Tax competition arises because jurisdictions finance provision of a public good with a tax on locally- employed capital. Capital moves across jurisdictions in response to tax differentials, while residents are typically immobile (or at least less mobile).
In the competitive version of tax competition, jurisdictions are ‘too small’ (relative to the economy) to affect the net return to capital that is determined worldwide. As a result, each jurisdiction sets its tax on locally-employed capital taking as given the net-of-tax price of capital. Tax rates in other jurisdictions do not matter and there is no strategic interaction among jurisdictions when setting their taxes. When jurisdictions are ‘large’ relative to the economy, each jurisdiction can affect the net return to capital by varying its own tax rate. In this case, the tax rate chosen in one jurisdiction varies with the taxes in other jurisdictions. Jurisdictions behave strategically: they set their tax in response to the tax rates in other jurisdictions.
Both the competitive and strategic version of the tax competition model lead to the same important conclusion, namely that public goods are underprovided relative to the efficient Samuelson rule level. The reason is that each jurisdiction perceives the mobility of capital and keeps its tax low
to preserve its tax base.
1. Tax competition results from mobility
2. Tax base relocates to avoid taxation
3. Public goods are underprovided
When two countries engage in tax competition the equilibrium tax rates will be inefficient. This is a consequence of the tax externality between the countries that underlies the strategic interaction.
Each country levies a per-unit tax t i on the capital that is employed within its boundaries. Due to capital mobility, the tax choice of one jurisdiction affects the size of the tax base available to the other country. Given the pair of tax rates, costless mobility implies the equality of the
after-tax return to capital across countries.
Each country sets its tax rate to maximise revenue from the tax. The optimal choice of each country is found by applying the usual Nash assumption: each takes the tax rate of the other as given when
The tax rates are strategic complements: a higher tax in country 1 diverts capital to country 2 which in response raises its own tax rate.
As such, the tax competition argument provides some important reasons for being cautious about the benefits of fiscal federalism that were described in the previous chapter. Giving jurisdictions too much freedom in tax-setting may lead to mutually damaging reductions in taxes - the so- called ‘race to the bottom’.
• Strategic interaction
• Nash equilibrium
• Inefficiently low tax rates
18.2 Tax overlap
A common feature of fiscal federalism is that higher- and lower-levels of government share the same tax base. This tax base overlap gives rise to vertical fiscal externalities. With tax competition between jurisdictions, the horizontal fiscal externality upon other regions is positive - an increase in tax rate by one region raises the tax base of others. In contrast, if different levels of government share the same tax base, then the tax levied by one government will reduce the tax base available to other levels of governments. This introduces a negative vertical externality. Not surprisingly such vertical externalities lead to over-taxation in equilibrium because each level of government neglects the negative effect of its taxation on the other levels of government.
When vertical and horizontal externalities are combined, the noncooperative equilibrium outcome is ambiguous: it would involve excessively low taxes if the horizontal externalities dominate the vertical externalities. Canada provides an important example since most provincial governments levy their personal income tax as a fraction of the federal income tax. On top of this each province levies a surtax on high-income residents. The bias in the perceived marginal cost of taxation caused by tax base overlap may explain why Canadian provinces have introduced high-income surtaxes when tax competition for mobile high-income taxpayers would predict the reverse.
• Two or more levels of government share the same tax base
• A negative externality between levels
• Equilibrium tax rates too high
18.3 Tax exporting
In any country, some commodities that are sold within its borders will be purchased by non-residents. This will be particularly true if the country is especially important in the context of international tourism. It will also be encouraged under fiscal federalism with a single market covering all jurisdictions. Similarly, some of the productive activity carried out in a country will be undertaken by firms that repatriate their profits to another country. Whenever there is such economic activity by non-residents, the possibility for tax exporting arises.
Tax exporting is the levying of taxes that discriminate against nonresidents. A simple example would be the imposition of a higher level of VAT upon restaurants located in centres of tourism. The motive for such tax exporting is to shift some of the burden of revenue collection onto non-residents and lower it on residents.
Another form of tax exporting is the taxation of capital employed in the country but owned by non-residents. The simplest version of this model has capital owners in each country free to invest their capital in their home country or abroad.
Next, note that the initial asymmetry in capital endowments leads the countries to set different tax rates. This non-uniform tax equilibrium has important implications in terms of productive efficiency. Indeed, the efficient allocation of capital requires its marginal product to be equalised across countries. But because one country subsidises capital and the other taxes it, it follows that the marginal product of capital is higher in the country levying a tax. Therefore, in equilibrium, the country subsidising attracts too much capital, and the country taxing too little, relative to what
• Discrimination against non-residents
• Negative tax externalities
• Inefficiently high tax rates
18.4 Efficient tax competition
Tax competition has been seen as producing wasteful competition. There are circumstances however where tax competition may be welfare enhancing:
• Countries may seek to give a competitive advantage to their own firms by offering wasteful subsidies. In equilibrium all countries will do this, so each country’s subsidy cancels out that of others.
• Tax competition may be a commitment device. Inter-governmental competition for capital deters a government from taxing away profits within its borders because it would induce re-allocation of capital between countries in response to differences in tax rates.
• The original insight that tax competition leads to inefficiently low taxes was obtained in a model with benevolent decision-makers. An alternative perspective is that public officials seek to maximise their own welfare and not necessarily that of their constituencies. From this perspective, tax competition may help discipline non-benevolent governments.
• Wasteful subsidies
• Constraint on leviathan
18.5 Income distribution
When the powers for tax setting are devolved to individual jurisdictions, the Tiebout hypothesis asserts that the outcome will be efficient. The Tiebout hypothesis is also silent about how the policy of a jurisdiction emerges. It is possible that equilibrium results in all the residents of each jurisdiction being identical, so that there is no need to resolve different points of view. More generally, though, it is necessary to explore the consequences of political decision making, expressed through elections, on the choice of policy.
The equilibrium has to be symmetric with individuals evenly divided between the two jurisdictions. In other words, perfect mobility leads to harmonisation of tax-transfer schemes, even though agents differ in their preferences. The mobility does not lead to the sorting of types across jurisdictions as Tiebout predicts. The possibility for the rich to detach themselves from the poor to escape redistributive taxation induces jurisdictions either to abandon any taxation or to choose the same tax rate.
Suppose now mobility is imperfect. To simplify assume that consumers have one of two income levels. Those with the higher income level are termed the ‘rich’ and those with the lower income are the ‘poor’. In this case the equilibrium level of redistributive taxation is inversely proportional to the difference in the mobility of the rich and the poor. Higher mobility of the rich reduces taxation but this is partially offset by the mobility of the poor. The reasoning behind this is that in equilibrium the poor chase the rich and so it is not possible for the rich to detach themselves from the poor. The logic of this conclusion also applies in a model with capital and labour mobility. With this extension, it implies that the possibility to tax capital increases with the mobility of labour. So the problem of tax competition is not only the excessive mobility of capital but also the lack of mobility of labour.
In a context where there are no legal barriers to migration, so that the forces of fiscal competition are at work, any attempt at redistribution or the provision of social insurance in a country would be impossible because it would induce emigration of those who were supposed to give (the rich)
and immigration of those who were supposed to receive (the poor). The most extreme predictions of this form imply a ‘race to the bottom’ but receive little theoretical or empirical support. This is probably due to the presence of significant costs and barriers to migration.
• Redistribution limited by mobility
• Sorting may not occur
• Migration and the race to the bottom
18.7 Inter-governmental transfers
An important insight from the analysis of tax competition is that increasing the tax rate in one region benefits other regions by increasing their tax bases. If we take the tax base to be the capital stock and the aggregate supply of capital to be fixed, then the tax-induced outflow of capital from the region taxing more represents an inflow of capital to the other regions.
It follows that if regions were to take into account such external benefits they would no longer perceive capital outflows as a cost and the efficient provision of public good. The central authority can achieve this efficient outcome by means of revenue-matching grants. The idea is to correct the externality by providing a subsidy to the revenue raised by each region. The matching rate to a region is the additional revenue that accrues to other regions when this region raises its tax rate.
Then regions are correctly compensated for the positive externalities of raising their taxes.
Expenditure externalities can also be corrected with expenditure-matching grants. To induce the local government to internalise this vertical expenditure externality, the federal authority can use expenditure-matching grants.
The attraction of matching grants is to internalise expenditure externalities. Self-financing is a
powerful incentive device and it is essential that local governments do not turn to the federal authority to bail them out of fiscal difficulties by resorting to expansible matching grants.
Inter-governmental grants are also used to channel resources from wealthy jurisdictions to poorer ones. Such transfers are based on equalisation formula that measure the fiscal need and fiscal capacity of each jurisdiction. Fiscal equalisation involves higher grants to those jurisdictions with the greatest fiscal need and the least fiscal capacity.
• Matching grants correct externality
• Differentiation to equalise taxes
• Fiscal equalisation contentious
The central result of the tax competition model is that increasing mobility of capital will drive down the equilibrium tax on capital. This result is at the heart of concerns about capital tax competition within the EU. In response to this growing concern, the OECD published a report (OECD,
1998) comprising about 20 recommendations to counter what was perceived as ‘harmful’ tax competition of capital income. Considering the statutory tax rate on capital between 1982 and 2001 for a group of
countries in the EU and G7 show the extent to which it has fallen.
It is natural for economists to think that competition among jurisdictions should stimulate public decision makers to act more efficiently and limit their discretion to pursue objectives that are not congruent with the interest of their constituency.
The evidence supports strongly the conclusion that increased competition tends to restrict government spending. But the fact that spending falls with more competition does not mean that resources are more efficiently allocated as competition increases. Standardised test scores and post-graduating earnings provide performance measures that are easily comparable across districts. Greater competition among school districts has a significant effect both in improving educational performances and reducing expenditure per student.
• Definition of harmful tax competition
• Evidence of reductions in capital taxes
• Evidence that competition reduces spending
READING: Hindriks and Myles, Intermediate Public Economics, 2004
Chapter 20: Fiscal Competition
Tax competition refers to the interaction between governments due to interjurisdictional mobility of the tax base. It does not include fiscal interaction between governments resulting from public good spillovers, where residents of one jurisdiction consume the public goods provided by neighboring jurisdictions. p473
Difference in country size, production technologies, factor endowments or residents’ preferences can be expected to cause the countries to choose different tax rates. An interesting aspect of the ensuing asymmetric tax competition is the so-called benefit of smallness. The idea is that although fiscal competition is inefficient, it can actually benefit small countries. Of course such gain comes at the expense of larger countries. p479
Tax competition has been seen as producing wasteful competition. There are circumstances however where tax competition may be welfare enhancing... where countries seek to give a competitive advantage to their own firms by offering wasteful subsidies. In equilibrium all countries will do this, so each country’s subsidy cancels out with of others. Since they cancel, none gains any advantage and all countries would be better off giving no subsidy. ... he use of tax competition as a commitment device. In the tax competition model, governments independently announce tax rates and
then the owners of capital choose where to invest. A commitment problem arises here because the governments are able to revise their tax rates after investment decisions are made. Tax competition may help to solve this commitment problem. The reason is that inter-governmental competition for capital would deter each government from taxing away profits within its borders because it would induce reallocation of capital between countries in response to difference in tax rates. p484
In a context where there are no legal barriers to migration, so that the forces of fiscal competition are at work, any attempt at redistribution or the provision of social insurance in a country would be impossible because it would induce emigration of those who were supposed to give (the rich) and immigration of those who were supposed to receive (the poor). The most extreme predictions of this form imply a “race to the bottom” but receive little theoretical or empirical support. This is probably due to the presence of significant costs and barriers to migration. p489
A critical insight from the analysis of tax competition is that increasing the tax rate in one region benefits other regions by increasing their tax bases. If we take the tax base to be the capital stock and the aggregate supply of capital to be fixed, then the tax-induced outflow of capital from the region taxing more represents an inflow of capital to the other regions. p489