Tax Competition and the Myth of the ‘Race to the Bottom’

In a world without borders, capital can move where taxes are lowest. In theory, at least, this forces governments to compete for mobile resources by providing business-friendly conditions, such as low or even zero taxes on capital gains and corporate profits. Because of this competitive pressure, taxes on mobile capital ultimately will disappear.

This is precisely the prediction made by most capital tax competition models that have been developed since the early 1960s. Politicians and economists alike expect that international tax competition will impose tough constraints on the ability of policy-makers to tax mobile capital bases, which will eventually erode revenues from taxing capital. As Fritz Scharpf (1997) put it:

“Capital is free to move to locations offering the highest rate of return …. As a consequence, the capacity of national governments … to tax and to regulate domestic capital and business firms is now limited by the fear of capital flight and the relocation of production. Hence all national governments … are now forced to compete against each other in order to attract, or retain, mobile capital and firms.”

Similarly, many politicians in the western hemisphere use tax competition arguments to justify tax cuts for corporations and capital owners. For example, in 2007 the then UK Chancellor of the Exchequer Gordon Brown declared in a budget speech that: 

“Because our goal is and will continue to be the most competitive business tax rate of the major economies, I have decided to cut mainstream corporation tax from April 2008 from 30p down to 28p – at 28p a rate lower than the United States, Germany, France, Japan, and all of our other major competitors – Britain's corporate tax rate, the lowest of all the major economies.”

Today there can be little doubt that history has proven wrong the dire prediction of a complete erosion of capital tax revenue. Comparative data on corporate and capital tax rates demonstrate that governments continue to tax mobile sources of capital, effective capital tax rates have not changed much compared with the mid-1980s, when tax competition was (arguably) triggered by the 1986 US tax act, and tax systems are as varied as countries and political systems themselves, with no visible sign of convergence.

In general, scholarly empirical evidence for tax competition is very limited and offers no support for the dire prediction of the early tax competition models. The lack of empirical underpinning for the ‘race to the bottom’ hypothesis may come as a relief to politicians, but perhaps not to social scientists who saw their pre­dictions proven wrong.

As a result, more recent work in economics and political economy has focused on explaining non-zero capital taxation by arguing that political, institutional and economic restrictions prevent governments from implementing very low or even zero capital tax rates. These models predict non-zero tax rates on mobile assets and a pattern of tax rates that highly co-varies with the pattern of economic[i] , political[ii]  or institutional[iii]  constraints on governments.

Yet, only few scholars have challenged the underlying assumptions of tax competition models. For example if we – more realistically – relax the assumption of perfect capital mobility, predicted equilibrium tax rates will diverge from zero. Moreover, countries are not equal in size, institutional or economic background. Tax competition therefore does not affect all countries in the same way, but it does generate likely winners and losers who implement very different fiscal adjustment strategies.

De facto capital mobility and tax competition

Economic models that predict a ‘race to the bottom’ in capital taxation assume that capital is fully mobile and can move at no cost to jurisdictions that offer lower tax rates. Indeed, during the last 30 years most OECD countries have abolished legal restrictions to capital-account transactions[iv] . International capital flows seem to follow this trend: between the early 1980s and late 1990s the annual flow of outbound foreign direct investment (FDI) increased nominally by more than 1,200 per cent worldwide, rising from less than US$50 billion to more than US$600 billion (Haufler 2001).

The absence of legal capital controls does not necessarily lead to perfect capital mobility. De facto mobility, as opposed to legal restrictions on capital transactions, depicts the actual elasticity with which capital responds to differences in tax rates. Important differences in the institutional environment, such as education and skill levels, wage differences, the wage bargaining and corporate structure, as well as environmental and labour-market regulations, prevent capital from being fully mobile. A large number of companies require a certain skill set in their labour force that is only available in established industrial clusters. Consequently, an individual firm cannot simply leave the country in which it prospers because it may not find a suitable combination of skills elsewhere.

The most obvious reason for a lack of mobility is that many corporations produce non-tradable goods and services. The business activities of these corporations thus depend on their presence in specific markets. This is especially the case for the service sector. The idea is that it would prove hard to “download a haircut”. Unless effective tax rates are prohibitively high and reduce demand for their goods and services to virtually zero, corporations normally stay in these particular markets even if the domestic effective tax rate is higher than in other countries.

Relocating production sites and plants generates relatively high costs since it involves not only a physical move but also a large amount of administrative and bureaucratic effort: firing and hiring employees, rebuilding connections with local infrastructure, transportation, packaging, establishing ties with the local bureaucracy and administration, and so on. In addition, capital owners have to gather information about tax rates, tax credit structures and exemption rules in other countries before deciding on a new destination.

Thus, the ownership structure of domestic capital determines the costs of moving capital through jurisdictions. The higher the concentration of capital, the lower the transaction costs of shifting profits to low-tax countries because owners of capital can benefit from economies of scale. A good example is the possibility for Multinational Enterprises (MNEs) to profit from tax differences by virtually relocating profits and debts through transfer pricing and other measure across subsidiaries in different locations. Small and medium firms instead have to physically relocate in order to benefit from lower taxes.

The most obvious effect of this partial mobility is that governments in countries that have a predominantly immobile capital base can maintain higher tax rates without losing much capital to other countries. This is true of countries with a highly specialised and skilled labour force, such as Germany and Switzerland, and of countries such as Italy in which services and agriculture dominate.

Fairness and tax competition

Governments need revenues to fulfil public tasks such as the redistribution of income to poorer parts of society and to provide important public services like education, health and infrastructure. If the competitive pressure generated by globalisation and capital market integration limits the ability of policy-makers’ to tax mobile factors, they may want to compensate for this by shifting parts of the tax burden toward more immobile factors, such as labour and consumption as this allows them to keep revenues and public good provision relatively stable[v] .

This strategy, while welfare maximising, implies problematic distributional problems for individual wage earners and also generates political costs for incumbents[vi] . The perception of unfairness will prompt a large part of the electorate to withdraw political support when the government attempts to shift large parts of the tax burden onto voters. Therefore, preferences for societal equality can constrain governments in their ability to create a large gap between the tax rates imposed on mobile and immobile taxpayers.

How strongly these attitudes towards fairness and equality are rooted in society largely depends on the political culture of a country and the initial set-up of the welfare state. Long-lasting political practice shapes voters' expectations regarding the equity and symmetry of the tax system, and influences the behaviour of governments. Social democratic welfare states institutionalised income redistribution from rich to poor much more extensively than liberal market economies. Voters in continental and Scandinavian welfare states, therefore, can be expected to demand more fairness and greater tax symmetry than voters in countries with a greater free market tradition.

As a result, the pressure on governments to implement more equal tax rates on capital and labour varies with the strength of egalitarian preferences in a society. The higher the equality expectations of voters, the less likely a government will play the tax competition game very hard. In such cases, governments can often win higher voter support from not reducing capital taxation too strongly or cutting back wage taxation accordingly than they might gain from attracting foreign capital investors.

Winners and Losers of Tax Competition

Just as competition in sports determines win­ners and losers, competition for mobile tax sources increases capital imports in some countries and capital exports in others. As a result, these winners and losers of tax competition are forced to choose different strategies to deal with the consequences of tax competition.

Whether a country wins or loses is largely determined by its size and by the government’s ability to finance deficits for a limited time. In tax competition, being small is beautiful. When countries reduce the effective capital tax rate, revenues from taxing the domestic capital stock decline. This is the tax rate effect. At the same time the country imports capital from nations with higher capital tax rates. The inflowing capital will be taxed at the reduced tax rate. This is the tax base effect. Since small nations can import more capital – relative to their domestic capital stock – from larger countries than the latter can import from smaller ones, the tax base effect is more likely to dominate the tax rate effect when a country is smaller. Hence, if a country is small enough, revenues from taxing capital can increase when the government significantly reduces the effective capital tax rate and thus induces sufficient capital inflow. Countries with a relatively large domestic capital stock also attract capital inflows when they reduce the effective capital tax rates. However, revenues generated from this additional capital are far less likely to compensate for the income losses caused by the reduction in capital tax rates.

Policy-makers in small countries then have more leeway in setting out their economic agenda. Small countries can reduce capital tax rates, hold effective labour taxation at the same level and reduce debt simultaneously – as Ireland has done.

Luxembourg is a good example of a country that has pursued an alternative adjustment strategy whereby the government reduced effective labour taxation and held effective capital tax rates constant at low levels while at the same time slightly increasing social security transfers. Basically, small countries with low initial debt levels are the winners of tax competition; governments in large countries with high initial levels of debt are most likely to have to respond by increasing capital and labour tax rates.

If large countries reduce their capital tax rates, they must deal with a reduction in capital tax revenues. If policy-makers do not counterbalance capital tax cuts with fiscal policy reforms, debt and deficits will surge. Governments, of course, can implement different sets of fiscal policy reforms. With capital being only imperfectly mobile, their first option is to increase effective capital rates to the extent that higher taxes compensate revenue losses from capital exports. Policy-makers usually do so by adopting a strategy that is commonly known as ‘tax-cut-cum-base-broadening’, which implies not necessarily increasing the statutory tax rates but cutting tax exemptions and opportunities for tax avoidance[vii] .

Conclusion

The majority of OECD countries have only experienced minor effects of capital market integration and capital tax competition, but there can be no doubt these competitive pressures created some winners – Luxembourg, Ireland and capital owners in larger liberal market economies – and some losers, especially large continental European welfare states. Yet, the dire predictions of early doom theories have not materialised, welfare states are still welfare states and are likely to persist in the future.

Tax competition affects countries differently and does not lead to a ‘race to the bottom’ since capital remains incompletely mobile.

The competitiveness of a country (size, mobility of capital, initial fiscal conditions, lack of fairness norms) determines countries’ fiscal adjustment strategies. Cutting capital taxes, therefore, will not necessarily have the desired effect of generating more capital inflows, especially not in large countries. And, even if countries succeed in attracting FDI by lowering taxes for large corporations, the additional taxes levied will not offset the loss in income caused by this tax cut. Governments that want to be successful in elections need to consider the trade-off between a small gain in capital tax revenue and possible spending cuts. Slashing the provision of public goods will have far-reaching electoral repercussions because of the distributional consequences. Policy-makers need to focus on other tools than cutting corporate tax rates in order to prompt firms to relocate or attract investments. Such strategies can consist of greater investment in higher education to increase the provision of highly skilled labour, the improvement of infrastructure, and so on.

These findings on tax competition and taxation have much broader implications for the fiscal responses of countries to globalisation, their redistribution efforts and their measures to address income inequality. Given that tax competition affects countries differently, governments will choose diverse strategies to cope with these international pressures. Tax competition will have a more adverse effect on disposable income inequality in countries that predominantly redistribute via the tax system (liberal market economies) than those that historically set up a welfare state by redistributing via social transfers (continental European welfare states).

Therefore, the initial fiscal conditions and the choice of policy adjustment strategies can explain why disposable income inequality has increased more in liberal market economies than in continental welfare states. While the latter had to maintain a high level of social security transfers in order to avoid political costs, the former would have had to cut back on tax-based redistribution and to increase social security transfers in order to fight higher income inequality. Not all governments in liberal market economies were able or willing to do so, and as a result, disposable income inequality rose most in liberal economies whose governments did not increase social security transfers, or where they did so very modestly, notably in the United States and the United Kingdom.

[i] Swank, D. (2006), ‘Tax Policy in an Era of Internationalization: An Assessment of a Conditional Diffusion Model of the Spread of Neoliberalism’, International Organization, 60: 847–82; Rodrik, D. (1998), ‘Why Do More Open Economies Have Bigger Governments?’, Journal of Po­litical Economy, 106: 997–1032; Garrett, G. (1998a), ‘Global Markets and National Politics: Collision Course or Virtuous Circle?’, International Organization, 52: 787–824; Garrett, G. (1998b), ‘Shrinking States? Globalization and National Autonomy in the OECD’, Oxford Development Studies, 26: 71–97, among others.

[ii] Ganghof, S. (2004), ‘Progressive Income Taxation in Advanced OECD Countries. Revisiting the Structural Dependence of the State on Capital’, unpublished manuscript, Max-Planck-Institute, Cologne; Genschel, P. (2002), ‘Globalization, Tax Competition, and the Welfare State’, Politics & Society, 30 (2): 245–75.

[iii] See, for example, Hays, J.C. (2003), ‘Globalization and Capital Taxation in Consensus and Majoritarian Democracies’, World Politics, 56: 79–113; Basinger, S.J. and Hallerberg, M. (2004), ‘Remodeling the Competition for Capital. How Domestic Politics Erases the Race to the Bottom’, American Political Science Review, 98: 261–76.

[iv] see, for example, Janeba, E. (2000), ’Tax Competition When Governments Lack Commitment: Excess Capacity as a Countervailing Threat’, American Economic Review, 90: 1508–19; Ganghof, S. (2000), ‘Adjusting National Tax Policy to Economic Internationalization Strategies and Outcomes’ in Scharpf, F.W. and Schmidt, V.A. (eds), From Vulnerability to Competitiveness: Welfare and Work in the Open Economy (Oxford: Oxford University Press), pp. 597–646.

[v] Sinn, H.-W. (2003),The New Systems Competition (Berlin: Blackwell Publishing Ltd).

; Schulze, G.G. and Ursprung, H.W. (1999), ‘Globalization of the Economy and the Nation State’, The World Economy, 22: 295–352, among others.

[vi] Genschel, P. (2002), ‘Globalization, Tax Competition, and the Welfare State’, Politics & Society, 30 (2): 245–75; Ganghof, S. (2004), ‘Progressive Income Taxation in Advanced OECD Countries. Revisiting the Structural Dependence of the State on Capital’, unpublished manuscript, Max-Planck-Institute, Cologne.

[vii] see, for example, Swank, D. and Steinmo, S. (2002), ‘The New Political Economy of Taxation in Advanced Capitalist Democracies’, American Journal of Political Science, 46: 642–55.