Tax harmonization vs. Tax competition

Tax harmonization vs. Tax competition


Capital taxes are used to finance a public input and public goods, such as mobile[1] skilled workers and immobile unskilled workers. The early literature on fiscal competition claimed that competition for mobile factors would drive down taxes to inefficiently low levels.

If labor is completely immobile, education and health increase the productivity of labor and are, in this sense, public in­puts in production. However, if labor is mobile, then education and health can be consumed in one country with the human capital supplied elsewhere.

From the perspective of an international investor, it may be presumed that public health and education tend to improve a country’s local attractiveness; for instance, mul­tinational firms may locate their production activities where medical care, health prevention or rehabilitation facilities for employees are well-established. On the other hand, a more healthy and well-educated labor force is more expensive in terms of factor compensation, which may impede international investment.

In order to attract international investors, governments tend to increase public expendi­ture directly promoting the productivity of mobile capi­tal (industrial public goods, often summarized as public infrastructure). In contrast, expenditure items intended to benefit immobile residents, notably for social security and welfare, are underprovided. Consequently, fiscal competition between countries may induce a systematic shift from residential and redistributive public goods to production-enhancing public goods.

According to statistical data and report for the last decade and beyond, countries like Albania tends to spend too much on public infrastructure, which attracts mobile capital, and too little on consumption goods, which benefit immobile workers.

Most of the literature shows that governments tend to reduce their capital tax rates as other countries adopt a strategy of tax cuts. Countries with a positive tax rate differential to adjacent economies are faced with a higher pressure from fiscal competition, which, in turn increases the likelihood that they will reduce their capital tax rates in subsequent years. In fact, it is the tax rate differentials from other countries which is the main motive to cut capital tax rates.

A reduction in capital tax rates is associated with an immediate inflow of capital and therefore an increase in the domestic capital tax base. In contrast, other regions are faced with capital outflows and shrinking (capital) tax revenues. Because the government’s objective is to maximize the welfare of its residents, it fails to account for these fiscal externalities’. Reducing the capital tax rate is the dominant strategy in this tax game.

The world capital stock is fixed and perfectly mobile across countries. Fully competitive firms produce a homogeneous output using capital and immobile factors (labor, land). The household sector is given by a representative consumer, who supplies the production factors and is immobile across countries. Governments provide public goods for consumers or firms. They are benevolent and finance a fixed amount of public expenditure by source-based taxes on capital, labor and pure profits (i.e., land rents).

Fiscal competition may, in fact, exert downward pressure on government expenditure, especially for social security items, but this effect may be simply outweighed by other aspects of globalization not considered in this study. For instance, trade liberalization may exert downward pressure on domestic wages and employment, especially for low-skilled workers because fiscal competition (and, from a country’s perspective, its outcome, i.e., tax revenue) is by definition connected with public expenditure via the government’s budget constraint, we treat fiscal competition as endogenous in our empirical analysis.

Fis­cal competition is (i) positively related to expenditure on economic services (transport and communication, as well as research and development), education and health and (ii) negatively associated with public expenditure on social security and welfare, as well as on housing and community amenities.

But, how is the effect of fiscal competition on the composition of spending?

Governments try to attract mo­bile capital not only by reducing capital tax rates but also by providing additional public inputs. Conversely, residential and redistributive public goods are bound to immobile factors, enabling governments to lower the provision of these expenditure types without running at risk of firm or workforce de-location, which would entail revenue losses.

A change in the expenditure structure from residential to production-enhancing public spending creates a capital inflow and a corresponding capital outflow from other countries. This result, in turn, induces three types of externalities on other countries: (i) a decrease of tax revenue from mobile capital; (ii) falling rents, which lower the revenue of land taxes; and (iii) a decline of (gross and net) wage rates and labor supp­ply with corresponding revenue losses from both labor and land taxation.

The problem in this does not only belong to the interaction of government budget in different sectors of country’s economy, but to the interference and interaction of tax and economic models to each other, for example property tax rate is related to the tax rates of neighboring countries.

Fiscal competition among regional governments for mobile factors is one possible explanation for the effects of strategic interaction that we identify. However, it is not yet very clear how much capital is actually lost by countries due to adverse tax rates.

But instead of fiscal competition, why the neighbor countries not interact with each other to complement and harmonize that part of economy and system that lack to the next country?

The main arguments in favor of fiscal harmonization stem from the need to deal with the mobility of capital across national borders and the concomitant problem of capital being hard to attract and hard to tax.

This is a hot discussion in EU member states. Influential voices within the EU are increasingly arguing in favor of better coordination and cooperation between member states in matters of tax policy which go beyond the full harmonization of the VAT.

The Fiscal Compact that came into effect in early 2013 is just the most recent of the relatively more conspicuous steps towards fiscal harmonization of a higher order in the EU.

The OECD launched the harmful tax competition initiative in the 1990s, with the OECD’s Center for Tax Policy providing a list of harmful tax practices, and the UN has called for the creation of an International Tax Organization to curtail tax competition in the global arena.

Why tax harmonization instead of tax competition?

Competition is the natural state and requires no action while harmonization requires a great deal of cooperation and coordination.  Between tax competition and harmonization exist the difference, because of the results each produces, but a bigger difference is given by the nature of the processes by which they are generated.

The strongest case for tax harmonization comes from the potential harmful effects of horizontal tax competition. A considerable share of the tax competition literature has focused on competition for capital via lower tax rates for corporate taxation. Of course, tax competition can also take the form of commodity and other indirect tax competition in countries which share borders and where cross-border shopping is feasible.

Here, it is important to distinguish between origin based and destination based indirect taxes. Residents of a jurisdiction can evade origin based taxes by purchasing from the neighboring jurisdictions provided transport costs are lower than the differential tax bill. This problem of tax avoidance can be controlled if destination based taxes are used with the deployment of border adjustments (with tax collected from domestic firms but rebated for the goods exported, at the same time a tax is collected on imports).

Meanwhile, tax harmonization is the set of rules (e.g., uniform bases, minimum rates, or introducing uniform rates) adopted in a coordinated fashion with the intent of reducing or eliminating the effects of tax competition. Beyond the agreement on bases or rates, tax harmonization at the extreme may involve the shedding of separate tax setting powers to a supra-national authority.

An obstacle in the area of fiscal policy harmonization could be the absence of strong enforcing mechanisms. In this regard, the experience from EU countries tells us that when the process is going to stop or to not function like it was projected then should be in place some mechanism which will trigger the situation to go be resolved in the favor of the future harmonization.

Most papers in the tax competition literature assume that the competing governments whether competing on tax rates and infrastructure or only on tax rates set the policy variables once and for all. In terms of game theory, the tax game lasts only for one period irrespective of whether it is played as a Nash game or a Stackelberg game.

When tax setting powers are distributed at different vertical levels of government, tax bases may be co-occupied or exclusive. The former types of arrangements generally give rise to vertical tax externalities what one level of government decides affects the taxes collected by the other levels. In contrast to the standard result of horizontal tax competition, the literature on vertical tax competition generally predicts that tax rates will be inefficiently high at all levels of government.

Tax harmonization may be desirable, but in specific situations may not produce the desired effects, that is, be welfare improving. For example, if there is tax rate coordination (same tax rate agreed upon by all countries which is higher than the tax rate of the smaller countries) then as a whole the entire region benefits. But if the larger country is too large then the residents of the smaller countries are worse off with harmonized tax rates as their consumption of both the private and the public good is reduced.

In this regard, we should consider the possibility of countries competing in the provision of infrastructure while coordinating their tax rates. Tax cooperation is beneficial and welfare improving if the only policy tool with which the countries compete is the tax rate. However, if countries compete (or cooperate) on tax rate and infrastructure provision, then tax coordination is actually not welfare improving.

Governments of every country tend to adopt fiscal policies in isolation to counter country specific shocks but these policies tend to always have spillover effects (externalities) which individual governments fail to account for. In such conditions, fiscal policy coordination would be expected to help in the face of demand and supply shocks and increase the effectiveness of the fiscal policy policies adopted by the national governments

Even though there is considerable capital mobility, the role of tax policy is somewhat muted by the available avoidance techniques investors can use and other factors. In addition, the evidence is weak that the observed tax policy changes are being driven by competition as opposed to other factors.

[1] workers are able or willing to move between different jobs, occupations, and geographical areas. It is called horizontal mobility if it does not result in a change in the worker’s grading or status, and vertical mobility if it does. Skilled workers have low occupational mobility but high geographical mobility; low-skilled or unskilled workers have high degrees of both types of mobility. Low labor-mobility causes structural unemployment, and governments try to avoid it by worker retraining schemes and by encouraging establishment of new industries in the affected areas. 

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