Tax Competition

Globalization has significantly reduced the cost of cross-​border economic activity. This cost reduction has been responsible for large increases in worldwide commerce and also a dramatic expansion of international capital flows. These developments have greatly benefited consumers and the overall global economy, but they also have yielded important indirect advantages. Governments, for instance, must now compete to attract jobs and capital (or to keep jobs and capital from fleeing to jurisdictions with better policy), and this scarcity is encouraging politicians to lower tax rates and reform tax systems.

This process, known as tax competition, has led to sweeping changes in tax policy. Personal income tax rates have dropped, corporate tax rates have plummeted, and more than 20 governments have adopted flat tax systems. With a few exceptions, these reforms were not implemented because politicians had read economists such as Milton Friedman and Friedrich Hayek. Instead, progrowth policies were adopted to attract the geese that lay the golden eggs (or to discourage them from escaping).

The economic analysis of this process is straightforward: Monopolies are bad, competition is good. This concept is well understood in the private sector. Consumers benefit when banks, grocery stores, or pet supply stores compete for their business. The notion of tax competition simply extends the analysis to political decision making when more than one government is involved. In the absence of any constraints, there is a tendency among politicians to raise tax rates because it is in their self-​interest to increase the size of government. The expansion of the public sector and the concomitant rising tax rates during most of the 20th century are certainly consistent with this public choice view of political behavior, which focuses on incentives to accumulate power and attract votes.

Globalization, however, has imposed constraints on politicians, and the process became especially important following the elections of Margaret Thatcher and Ronald Reagan. In 1979, when Margaret Thatcher became prime minister of the United Kingdom, the top personal income tax rate was 83%, and England was in terrible shape. During her tenure, she reduced the top tax rate to 40% and implemented other free-​market reforms. The economy of the United Kingdom, not surprisingly, recovered, and the nation prospered.

Similarly, in 1980, Ronald Reagan was elected president in the United States. The top tax rate was then 70% and America was suffering from stagflation—a debilitating combination of inflation, stagnation, and unemployment. To restore America’s economy, President Reagan slashed the top tax rate to 28%. Along with other reforms to reduce the burden of government, this tax reduction helped to restore America’s economy. However, what is really interesting about the Thatcher and Reagan tax cuts is that nations all over the world have been forced to play follow-​the-​leader. Average top tax rates in the developed world have since dropped from more than 65% to about 40%. This shift toward better tax policy is dramatic, and it explains, at least in part, why the global economy is much stronger today than it was in the 1970s.

It is crucial to realize that politicians in other nations almost invariably cut their tax rates because of competitive pressure, not because of a philosophical belief in smaller government or lower tax rates. This strong motivational effect is why tax competition is such an important force for good policy. Even statist policymakers are compelled to do the right thing when they fear that the neighboring nations will reap advantages at their expense.

Nor is it just the personal tax rate that is at issue. Corporate tax rates have dropped, on average, by more than 20 percentage points since Thatcher and Reagan took office. Indeed, Ireland deserves the lion’s share of the credit by slashing its corporate rate from 50% to 12.5%. Irish leaders turned their economy from the sick man of Europe into the Celtic Tiger. The global effect is even bigger. To compete, nations all over Europe and around the globe are racing to lower their corporate tax rates. Last, but not least, tax competition also is playing a role in the global flat tax revolution. Fifteen years ago, the only flat-​tax jurisdictions were the little British territories of Hong Kong, Jersey, and Guernsey. Today, there are nearly two dozen flat-​tax jurisdictions, including Russia, Slovakia, Iceland, and Estonia.

Not surprisingly, politicians from high-​tax nations do not like tax competition and resent being forced to lower tax rates. Much like the owner of a town’s only gas station, they want captive customers who have no choices. They prefer “tax harmonization,” policies aimed at preventing taxpayers from benefitting from better tax policy in other jurisdictions. There are two forms of tax harmonization.

Explicit tax harmonization occurs when nations agree to set minimum tax rates or decide to tax at the same rate. The European Union (EU), for instance, requires that member nations impose a value-​added tax (VAT) of at least 15%. The EU also has harmonized tax rates for fuel, alcohol, and tobacco, and there have been many proposals to harmonize the taxation of personal and corporate income. Under this direct form of tax harmonization, taxpayers are unable to benefit from better tax policy in other nations, and governments are insulated from market discipline.

Implicit tax harmonization occurs when governments tax the income their citizens earn in other jurisdictions. This policy of worldwide taxation requires governments to collect financial information on nonresident investors and to share that information with tax collectors from foreign governments. This information exchange system tends to be a one-​way street because jobs and capital generally flow from high-​tax to low-​tax nations. Under this indirect form of tax harmonization, just as under the direct form, taxpayers are unable to benefit from better tax policy in other nations, and governments are insulated from market discipline.

Working through the Organisation for Economic Cooperation and Development (OECD), an international bureaucracy based in Paris, politicians seek to hinder the flow of jobs and investment from high-​tax to low-​tax nations. Indeed, the OECD has a “harmful tax competition” project. It even put together a blacklist of low-​tax jurisdictions and threatened them with financial protectionism if they did not help high-​tax nations enforce their tax laws.

Although some divisions of the OECD are more market-​oriented, the bureaucrats in charge of the anti-​tax competition project have an openly statist orientation. In its 1998 report, it reported that “no or only nominal” taxes are the primary reason for being identified as tax havens. The OECD also complained in various reports that low-​tax policies “unfairly erode the tax bases of other countries”; tax competition is “re-​shaping the desired level and mix of taxes and public spending,” and tax competition hampers “the application of progressive tax rates and the achievement of redistributive goals.”

The OECD’s antitax competition project is bad policy, and it also is a threat to America’s economic interests. According to the OECD’s definition, the United States is a tax haven, and these favorable tax rules for foreign investors have helped attract more than $10 trillion of capital. But the antitax competition campaign also could have a direct impact on U.S. taxpayers because, for all intents and purposes, America would not be able to adopt a flat tax or a national sales tax if the OECD’s wish-​list policies became global tax rules.

Tax competition issues also have been addressed by academics. Charles Tiebout published a famous article in 1956 that introduced what became known as the Tiebout Hypothesis, which shows that tax competition is desirable because it allows people to choose jurisdictions that best match their preferences for spending and taxes. However, there also have been a number of academics who are hostile to tax competition. Advocates of this approach start with the theoretical assumption of a world with no taxes. They then hypothesize, quite plausibly, that people will allocate resources in that world in ways that maximize economic output.

They then introduce real-​world considerations to the theory, such as the existence of different jurisdictions with different tax rates. These different tax rates presumably lead some taxpayers to change the allocation of their resources. However, because those resources are being reallocated on the basis of tax considerations, rather than on the underlying economic merit of various options, critics of tax competition assert that people make less efficient choices in a world with multiple tax regimes when compared with a hypothetical world with no taxes. To maximize economic efficiency, proponents of what is called capital export neutrality believe taxpayers should face the same tax rates regardless of where they work, save, shop, or invest.

Critics respond, however, by explaining that capital export neutrality (CEN) is based on several highly implausible assumptions. The CEN model, for instance, assumes that taxes are exogenous—meaning that they are independently determined. Yet the real-​world experience of tax competition shows that tax rates are dependent on what is happening in other jurisdictions. Another glaring mistake in this analysis is the assumption that the global stock of capital is fixed—and, more specifically, the assumption that the capital stock is independent of the tax treatment of savings and investment. Needless to say, these are grossly unrealistic conditions.

In the real world, tax competition has played a critical role in promoting more efficient tax policy. Not only has it stimulated reductions in personal and corporate income tax rates, but it also has encouraged nations to reduce capital gains tax rates, death tax rates, wealth tax rates, and tax rates on capital income. These reforms have significantly improved incentives for productive behavior.

The existence of varying tax rates does not mean that competing tax systems automatically generate economically efficient choices. Indeed, there are even some forms of tax competition—such as special tax breaks for specific companies and specific behaviors—that almost certainly encourage suboptimal decisions. But tax competition generally encourages the right kind of tax reforms, which is an additional reason that multilateral bureaucracies, among them the OECD, the European Commission, and the United Nations, should not be permitted to hinder this liberalizing process.

The tax competition debate largely revolves around economics, but there are other important issues, particularly the role of financial privacy as a protector of human rights. Financial privacy laws are important in the tax-​haven fight because they make it difficult for governments to achieve the implicit forms of tax harmonization. If a Venezuelan puts money in a New York bank or a Swede puts money in a Swiss bank, for instance, they can choose whether to report any interest earnings to their home-​country tax collectors. This activity puts pressure on governments to lower tax rates. But the existence of financial privacy (thanks especially to nations with strict bank secrecy laws) means that people can shield their assets for nontax reasons as well.

Financial privacy laws have important implications because a majority of the world’s population still resides in nations with governments that oppress at least some segment of the citizenry. Financial privacy laws mean that real or potential victims of ethnic, religious, sexual, and/​or political persecution can shield at least some of their activities and assets from a hostile government. Likewise, there are governments that do not have the capacity to provide adequate protection against corruption, crime, and mismanagement. So-​called offshore banking and fund management is a way from people in these nations to protect their assets.

Politicians from high-​tax nations resent tax competition, but competition among governments has been good for taxpayers and the global economy. Tax rates have been reduced, tax reforms have been implemented, and global commerce has expanded. Along with indirect benefits, such as providing individual protection against venal or incompetent governments, low-​tax jurisdictions play a valuable and desirable role.

Further Readings

Bessard, Pierre. The European Tax Cartel and Switzerland’s Role. Lausanne, Switzerland: Institut Constant de Rebecque, 2007.

Edwards, Chris, and Veronique de Rugy. “International Tax Competition: A 21st-​Century Restraint on Government.” Policy Analysis No. 431. The Cato Institute, April 12, 2002.

McGinnis, John O. “The Political Economy of Global Multilateralism.” Chicago Journal of International Law 1 no. 2 (2000): 381.

Mitchell, Daniel J. “The Economics of Tax Competition: Harmonization vs. Liberalization.” 2004 Index of Economic Freedom. Marc A. Miles, Edwin J. Feulner, and Mary Anastasia O’Grady, eds. Washington, DC: The Heritage Foundation and Dow Jones & Company, 2004.

———. “The Moral Case for Tax Havens.” Occasional Paper No. 24, Friedrich Naumann Stiftung, December 3, 2005.

Mitchell, Daniel J., and Chris Edwards. Global Tax Revolution: The Rise of Tax Competition and the Battle to Defend It. Washington, DC: Cato Institute, 2008.

Rohac, Dalibor. “Evidence and Myths about Tax Competition.” New Perspectives on Political Economy 2 no. 2 (2006): 86–115.

Teather, Richard. The Benefits of Tax Competition. London: Institute for Economic Affairs, 2005.

Tiebout, Charles. “A Pure Theory of Local Expenditures.” The Journal of Political Economy 64 no. 5 (1956): 416–424.