Globalisation has had positive effects on the development of current tax systems and it has encouraged countries to engage in fiscal reforms that reduce taxation. However, it has also created an environment in which tax havens thrive and governments can be induced to adopt harmful preferential tax regimes to attract investment within their territories.
What Is Tax Competition?
This phenomenon, called tax competition – or tax war by some – is realised with the economic integration of the different tax jurisdictions, thanks to the mobility of production factors and income subject to tax flows. Given these conditions, governments compete with each other in order to increase the level of well-being of their residents.
Tax competition is therefore a process in which states, or even cities, use tax breaks and grants to attract investment, multinational corporations or hot money to create more jobs and higher tax revenues. According to economic theory, jurisdictions that reduce taxation on production factors may increase the level of investment within their economy at the expense of jurisdictions with a higher tax burden. In order to react to the outflow of production factors, the other tax jurisdictions are driven to lower their rates, triggering a downward trend in tax rates.
According to some authors, referring to Cournot Equilibrium and Game Theory, the long-term equilibrium produced by tax competition would be inefficient as the tax burden would become too low. This is referred to as harmful tax competition. Other authors, on the contrary, believe there is beneficial tax competition when the equilibrium produces efficient results as it pushes executive power to pursue collective well-being with the least waste of public resources.
In order to limit the possible negative externalities associated with tax competition, regulators should harmonise tax legislation or devolve their tax sovereignty to a higher level of government. This solution is not always possible because states are reluctant to limit (or lose) their fiscal sovereignty and, secondly, because of the presence of states that do not benefit from tax coordination (so-called free riders). Another problem is that countries with a smaller territorial dimension or population have to support lower public spending and thus have a greater capacity to reduce their rates. In the absence of a central coordination, it is extremely difficult to combat the phenomenon of harmful tax competition. Such considerations also explain the presence and nature of the so-called tax havens.
Horizontal and Vertical Competition
In general, the competition between different tax jurisdictions is called horizontal tax competition because it affects independent and sovereign governments. There is, however, a further form of competition, called vertical tax competition, which affects different levels of the same government. Economic theory considers efficient vertical tax competition, basing this judgment on the model of C.M. Tiebout (1954). According to this model, which takes on the perfect mobility of individuals, citizens who are dissatisfied with the policies implemented by their local governments will reside in other places, thereby creating competition between governments through the mechanism of Albert O. Hirschman known as “Foot Voting”. Local governments, therefore, would be able to better detect citizens’ preferences and offer, with greater efficiency, the public services required by the population.
On the other hand, even the different characteristics of various tax structures can cause alternations on the effects of tax competition. For example, countries such as Denmark and the United Kingdom rely relatively less on direct social charges than countries like France. Factors like this can well explain why tax competition can be classified as “harmful” by a state but not so by another.
Amongst the motivations of tax competition supporters is that tax rates, being lower, encourage investment. It also allows firms to generate more profit that can be used for research and development (R&D) and business investment. On the government side, lower taxation encourages legislators to reduce public spending and increase efficiency.
By doing historical analysis, it can be seen that tax reductions became a major issue in the 1960s and 1970s. Margaret Thatcher rescued the UK economy by reducing taxation from 83% to 40%. Ronald Reagan restored the US economy by cutting the tax rate from 70% to 28%. But the most interesting thing in these tax cuts is that it has seen other nations forced to follow the US and UK: taxes in main industrialised countries have fallen overall by over 65% to about 40%. This leads the competition supporters to say that in this way tax policy has improved and that the global economy is much stronger today than in the 70s.
Similarly, in the plans of Donald Trump’s electoral program, there is the will to cut corporate tax rates from 35% to 15%. This is making governments such as Germany, France and China worry about their own tax regimes.
The Disadvantages of Tax Competition
Some instead argue that tax competition is harmful and argue that there is no gain: ultimately, only a few countries have benefits at the expense of others. In addition, investments prove temporary because multinationals shift their capital every time a country reduces taxation. They are thereby attracted fickle investments that have few productive ties with the real economy.
If corporate tax rates are reduced, other taxes, such as income tax or VAT, will have to rise to face the shortage. This could represent an increase in social inequality and this also means that countries lose the power to choose how to distribute the tax burden on their economy. This, therefore, erodes democracy, reduces productivity and economic growth, promotes capital at the expense of labour, and tightens state budgets.
In this way, those who are against tax competition prefer to call it a “tax war” because it is much more like a trade war or a currency war than a competition in the product market.
Europe, like many other realities, has studied and tried to regulate tax competition. The “Anti-Tax Avoidance Package” adopted on 28 January 2016 is part of the ambitious agenda of the European Commission for a taxation more equitable, simpler and more effective. This package contains concrete measures to prevent aggressive tax planning, increase fiscal transparency and create equal conditions for all EU firms.
Tax competition is not always harmful, but when it is, cooperation between the parties is essential to counteract it. Tax competition has limited the tax-increasing trend in relatively high-rate countries and has produced convergence within the EU Member States. Coordination and cooperation are justified when the degree of competition produces a potential failure to reap the benefits that the single market provides in terms of growth and employment.
It has not yet come to the definition of a range where the tax rate may change. For example, in the field of VAT, a minimum rate of 15% was set by the EU in 1992 but no proposal for a maximum limit of 20% was approved. It seems therefore that EU legislators want to leave the maximum rates to competition and market forces. In any case, there is an upper natural limit since any possible increase in rates may lead to a fall in the aggregate revenues due to the imposition of taxation.
In any case, the balance between competition and cooperation is crucial. Although it is possible to initiate community action to eliminate obviously harmful tax competition, it is preferable to start a cooperative action. Greater cooperation and exchange of information between tax authorities of the origin and residence countries are considered the correct preservation of national sovereignty and of market forces.