Issues in International Taxation UAB 2011 Lecture 1 Gareth Myles University of Exeter and Institute for Fiscal Studies

Issues in International Taxation

UAB 2011 Lecture 1Gareth MylesUniversity of Exeter and Institute for Fiscal Studies

Introduction

• EU policy objectives• Single market with efficient trade• Free movement of capital and labour• Social support (“flexicurity”)

• Tensions• Subsidiarity• Competency

• Taxation • Provides revenue• Affects efficiency• Symbolizes sovereignty

Introduction

• These lectures will review economic analysis of these policy issues

• The topics to be covered are:• Tax competition

• International taxation

• Fiscal federalism

• This lecture begins with a review of recent developments in EU policy

Introduction

• The basis of indirect taxation in the EU is a VAT system

• The key features of VAT:• Producers can claim back VAT charged on inputs

• In principle only final consumption is taxed

• The theoretical justification for this is described in lecture 2

• This clarity is undermined by exemptions and the treatment of small business

Introduction

• In the 1980s the rate of VAT varied quite widely across EU member states

• Harmonization has been an EU policy objective since the Neumark Report of 1963

• A harmonization process began in 1992

• This was intended to encourage efficient operation of the single market

• It represented an enhancement of competence and a reduction in subsidiarity

Tax Harmonization

• Single market requires harmonization• Cross-border shopping• Protectionist use of taxes• Effect on mobile factors

• 1987 proposal• Two-rate VAT • A Standard rate (14-20%) and a Reduced rate (4-9%)

• In 1993 a minimum rate was introduced• Minimum of 15%, one or two rates of at least 5%• Zero-rating allowed to continue

• “Approximation” remains long-term goal

Tax Harmonization

1970-1974 1985-1990 2000

Standard(normal)

Reduced(essential)

Increased(luxury)

Standard(normal)

Reduced(essential)

Increased(luxury)

Standard(normal)

Reduced(essential)

Germany 11 5.5 - 14 7 - 16 7

France 23 7.5 33 18.6 2/7 23 20.6 2.1/5.5

Italy 12 6 18 19 4/9 38 20 10

UK 10 - - 15 0 - 17.5 5

Denmark 15 - - 22 - - 25 -

Source: Molle (2001)Table 1: VAT rates in Member

States

Harmonization

• Harmonization of excise duties also proposed• Rejected by Member States

• System of minimum rates introduced in 1993Cigarettes (per 100) Wine (per litre) Petrol (per litre)

Germany 7.67 0.00 0.58

France 8.64 0.03 0.63

Belgium 7.49 0.47 0.55

UK 18.40 2.30 0.81

Spain 4.84 0.00 0.40

Sweden 10.36 3.11 0.59

Source: Molle (2001)Table 2: Excise Taxes in Euros, 2000

Harmonization

European Commission, 2000 Member States have shown little enthusiasm for the proposals in Council meetings and […] have been reluctant to accept the greater harmonisation of VAT rates and tax structures.

2003 Draft Report of the Committee on Monetary and Economic Affairs

The European Parliament is strongly committed to the introduction of the definitive system of VAT, but given the lack of progress in that regard, there is no urgent need to harmonise rates.

Tax Principle

• Prior to 1993 the EU operated a destination tax system• Goods are taxed in country of consumption

• The destination system requires border tax adjustments

• The single market was completed in 1993• This removed borders between member states

• Conflicts with operation of destination system

• Tax differentials lead to cross-border shopping• This can enhance efficiency in an ideal economy• But is costly in practice:

• Direct waste of resources• Environmental costs• Distortion of regional trade patterns• Undermines freedom of governments

• Since January 1993 a transitional system in place

• Definitive system intended for 1997 but still not constructed

Tax Principle

• There are two alternative tax principles• Destination principle

• Tax in the country of final consumption (destination country)

• A tax on consumption

• Origin principle• Tax in the country of production (origin country)• A tax on production

• The EU has long favoured a move to a form of origin principle

Tax Principle

• The Tinbergen Report of 1953 analyzed the tax implications of the single market

• It concluded that an origin system be implemented

• The move to the origin principle has remained an EU goal ever since

The Community’s long term objective is moving to a definitive VAT system, based on the principle of taxation in the country of origin

(2003 Draft Report of the Committee on Monetary and Economic Affairs )

Tax Principle

Implementation of VAT

HMRC estimate of VAT tax was £15.2bn in 2008–09

Missing Trader Intra-Community (MTIC) fraud is a major explanation

Zero rating of goods at export implies large scale reclaims of VAT by exporting companies

If reclaim is accompanied by failure to pay VAT further down the chain the revenue service can pay more in refunds than is collected


European Commission in 2004 reported that losses from fraud were 10 per cent of net VAT receipts in some member states

A carousel fraud is operated as follows:Importers purchase products that are zero-ratedSell them on with VAT added to another traderThe purchasing trader reclaims the input VATThe seller does not pay the VAT due and

disappears


Figure 7.1: A simple illustration of carousel fraud


This is due to zero rating of exports Without this the importing company would

have been charged VAT by the original exporter

The final exporter would not be entitled to any refund of VAT

The opportunity for this type of fraud would not exist

• At the centre of EU single market policy is unhindered mobility of capital and labour

• Mobility between jurisdictions creates tensions with tax policy

• Subsidiarity is constrained• Tax differentials undermined by cross-border

shopping

• Adoption of additional EU competence is the natural solution• Resisted by some member states

Mobility

• Jurisdictions compete for mobile capital• Positive tax externalities imply equilibrium tax

rates too low• Revenues are reduced• Social policy is threatened• “Race-to-the-bottom”

• Mobile population can seek benefits• Recipients arrive• Contributors leave

• Undermines redistribution

Mobility

Corporate Taxation

• The rate of corporation tax has important effects:• Determines return on corporate assets• Internal accounting exploits differentials• Plant location is affected

• Statutory tax rates have fallen• This has been explained by tax competition• The EU has implemented policy to control tax

competition

1982 2001

Austria 61 34

Belgium 45 40

Finland 60 28

France 50 35

UK 53 30

Germany 62 38

Greece 42 38

Ireland 10 10

Italy 38 40

Netherlands 48 35

Portugal 55 36

Sweden 61 28

Source: Devereux et al. (2002)Table.3: Statutory Corporate Income Tax

Corporate Taxation

• Current EU policy is based on the Code of Conduct for Business Taxation • Refrain from introducing any new tax measures that may

be harmful • Amend any laws or practices that are harmful

• Harmful tax laws include:• A tax rate lower than the country’s general level• Tax benefits reserved for non-residents• Tax incentives for activities isolated from the domestic

economy

• Departure from international accounting rules

Corporate Taxation

Observations

• There are many issues in EU tax policy

• This is a reflection of the EU as an evolving entity

• And one which has a unique structure

• Some policy reforms have begun but have not been completed

• We remain far from having a finished fiscal structure

Tax Competition

• Competition ensures efficiency of economic activity

• Does the same argument extend to competition between governments?

• Mobility ensures good tax/benefit packages attract population

• Unattractive jurisdictions will lose population

• The nature of competition is key to the efficiency of equilibrium

Tax Competition

• Tax competition is the interaction among governments due to mobility of the tax base

• A tax on a mobile factor will cause relocation• Capital will locate where the net return is highest• Labor will seek employment where net wage is

highest

• Loss of tax base by one jurisdiction is a gain for another• Mobility causes a tax externality between

jurisdictions

Tax Competition

• Assume that jurisdictions tax capital

• Assume capital is perfectly mobile but residents are immobile

• With competitive behavior jurisdictions are “small” and take net return to capital as fixed

• With strategic behavior jurisdictions are “large” and take account of how tax policy affects the net return to capital

• In both cases inefficiency occurs in equilibrium

Competitive Behavior

• A small jurisdiction takes the net return to capital as fixed

• Let f’(ki) be the marginal product of capital in jurisdiction i where ki is the capital-labor ratio

• Let ti denote tax rate in i and the net return to capital outside the jurisdiction

• Costless mobility of capital equalizes the net return across jurisdictions so arbitrage implies

ii tkf '

Competitive Behavior

• Since f’’(ki) < 0 an increase in ti reduces ki

• The total income of labor in i is given by output less the reward to capital plus tax revenue

• Using the arbitrage condition

• Income is maximized when so ti = 0• No tax should be levied on capital

• The jurisdiction cannot capture any of the return to capital

ktkkfkfy iiiii '

iii kkfy ikf '

Strategic Behavior

• Now assume there are just two countries so each region is large

• There is a fixed stock of capital that allocates between the countries

• Costless mobility equates after-tax returns in the two countries

• This arbitrage condition determines an allocation of capital that depends on the tax rates

k

2211 '' tkftkf

Strategic Behavior

1' kf 2' kf

2010

1k 2k

21 tt

211 , ttk

Figure 18.1: Allocation of capital

• Fig. 18.1 represents the allocation of capital between countries

• Assume that country 1 sets a higher tax rate

• The tax differential is reflected in the difference in marginal products

• Country 1 has less capital in equilibrium

• An increase in tax rate causes capital to move to the other country

Strategic Behavior

• Each country maximizes the income of workers

• Since ki depends on t1 and t2 there is strategic fiscal interaction

• Each country chooses the tax rate to maximize income taking the tax rate of the other country as given

• The best-response functions of the two countries are and

iiiiii ktkkfkfy '

211 trt 122 trt

Strategic Behavior

• Fig. 18.2 displays the best-response functions

• The equilibrium occurs where

• The two countries are identical so the Nash equilibrium is symmetric

• The equilibrium values of the taxes are

• Each country has ½ of the capital stock

21 tt

12 tr

21 tr

1t

2t

Figure 18.2: Symmetric Nash equilibrium

1221 trtr

2/2/''*2

*1 kkftt

Strategic Behavior

• The taxes at the Nash equilibrium are inefficient• Capital is a fixed factor from the world perspective• If the two countries coordinated they could capture the entire

return to capital in taxation• The Nash equilibrium taxes do not achieve this

• The positive fiscal externality results in taxes which are inefficiently low

• The countries undercut each other to attract mobile capital – the “race to the bottom”

• Competition between large jurisdictions does not achieve efficiency

Strategic Behavior

• This argument applies to any tax base which is mobile

• It also applies to commodity taxation if there is cross-border shopping

• Cross-border shopping is possible the origin taxation (taxation in country of production)

• Destination taxation (taxation in country of consumption) prevents cross-border shopping but requires borders to be maintained

• Borders are inconsistent with a single-market in a federation

Size Matters

• Asymmetries in size or technology will lead countries to set different taxes

• This may benefit some countries at the expense of others

• If the asymmetry occurs in the number of residents then small countries gain

• The outflow of capital is less severe for the large country for any tax increase

• The large country sets a higher tax

Size Matters

• Fig 18.3 shows the advantage of smallness

• Country 1 has share s > ½ of total population

• Country 1 sets a higher tax t1 > t2

• R is the net return to capital

• Income per resident plus tax revenue satisfies c2 + g2 > c1 + g1

• Residents of the small country are better off

1' kf 2' kf

2010

1k 2k

R R

1g

1c

2c

2g

*2

*1 ,kk

1t

2t

Figure 18.3: Advantage of smallness

Public Good Provision

• Different conclusions can emerge if the use of tax revenue is considered

• Assume a public input is provided with production function

f(ki, gi)

• An increase in the tax rate now raises gi

• This can give an incentive to set taxes above the optimum level


• The standard model has a positive tax externality

• In the modified model

• The tax externality then becomes

01

222

1

222

t

ktkf

t

ykk

2122 , ttgg

1

22

1

222

1

222222 t

gkff

t

ktkf

t

ygkgkk


• Since

• A sufficiently strong complementarity can create a negative externality

• This occurs when

• In such a case the tax rates will be higher than the efficient level in the Nash equilibrium

01

22

1

2

t

kt

t

g

22

222

22

1

t

f

k

ff kkg

gk


• This condition has been tested by Bénassy-Quéré, Gobalraj, and Trannoy (2007)

• They express it as the requirement on an elasticity eK/t > 0

• The regression involves US FDI into Europe on taxes and public input provision

• It is concluded that the elasticity is negative

• So excessive tax rates (a “race-to-the-top”) are ruled out

Efficient Tax Competition

• There are circumstances in which tax competition can enhance efficiency

• It can limit wasteful subsidies designed to give home firms a competitive advantage

• Tax competition is a commitment device preventing reversion to high tax rates

• Non-benevolent governments are constrained by tax competition

Race to the Bottom

• Tax competition suggests mobility will drive down tax rates

• The reduction in tax rates reduces revenue and limits public expenditure

• The OECD and the EU have both shown concern about this race to the bottom• OECD 1998 report (20 recommendations)

• EU Code of Conduct on business taxation which identifies harmful tax competition

Race to the Bottom

• Tab. 18.1 shows the corporate tax rate for some EU and G7 countries

• All countries except Ireland and Italy have reduces rates

• Rate in Germany has fallen from 62 to 38 and in the UK from 53 to 30

• This seems to be evidence for the race to the bottom

4950USA

2861Sweden

3655Portugal

3548Netherlands

4152Japan

4038Italy

1010Ireland

3842Greece

3862Germany

3053UK

3550France

2860Finland

3545Canada

4045Belgium

3461Austria

20011982

4950USA

2861Sweden

3655Portugal

3548Netherlands

4152Japan

4038Italy

1010Ireland

3842Greece

3862Germany

3053UK

3550France

2860Finland

3545Canada

4045Belgium

3461Austria

20011982

Table 18.1: Statutory corporate income tax Source: Devereux et al. (2002)

Race to the Bottom

• There are many details of tax legislation that result in the statutory tax rate being different to the effective tax rate

• Tab. 18.2 shows the effective rate fell by less• This is evidence that the lower statutory rate has been

countered by a broadening of the tax base

82 84 86 88 90 92 94 96 98 01

Median statutory

50 48 46 43 39 38 37 36 37 35

Average effective

43 42 41 38 36 37 36 36 34 32

Table 18.2: Statutory and Effective Corporate Income Tax Rates Source: Devereux et al. (2002)

• Net effect of rate reduction and base broadening in Figure 1

• Revenue remained constant until the early 1990s

• Strong growth trend from 1990

• Increase in corporate profitability

• Revenues not adversely affected by tax competition

0

0.5

11.5

2

2.5

3

3.54

4.5

5

1965 1970 1975 1980 1985 1990 1995 2000

Year

Tax

Rev

enu

es (

% o

f G

DP

)

Source: Devereux et al. (2002) (using OECD data)(Weighted average for 14 EU countries plus

Canada, Japan and the US) Figure 1: Corporate Income Tax Revenue as a Percentage of GDP

Race to the Bottom

• Data for the UK in Fig. 2• Might expect UK to be

affected by proximity to Ireland

• There is no apparent effect in the data

• Revenues were rising from late 1990s

Race to the Bottom

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

1980 1985 1990 1995 2000

Year

Tax

Rev

enu

e (%

of

GD

P)

Source: Economic Trends

Figure 2: UK tax revenue from capital as a percentage of GDP

• Tax competition is harmful if it leads to equilibrium rates of tax below the efficient level

• The the fall in statutory corporate income tax rates is often given as evidence for tax competition within the EU

• The data shows that corporate tax revenues as a percentage of GDP have not fallen

• The EU has a voluntary Code of Conduct designed to lessen tax competition

Race to the Bottom

The Tiebout Hypothesis

• An alternative perspective on competition between regions

• We usually assume issues of preference revelation will prevent attainment of efficiency

• Individuals will have no incentive to truthfully reveal preferences or characteristics

• The provision of public goods is based on a variety of inefficient mechanisms

• And financed by distortionary taxation


• Does this change when the economy is separated into many jurisdictions?

• The Tiebout hypothesis argues that efficiency will then be achieved

• The argument of Tiebout observes• Inefficiency arises because of the externalities

between consumers• This causes free-riding

• The externality is a consequence of a small-numbers issue


• The argument is different if there are many potential communities

• Assume that different communities offer different packages of taxation and public goods

• The choice of community reveals preferences• There is no incentive to choose strategically

• Honest revelation takes place and efficiency is achieved


• Hence:• If there are enough communities with different

provision levels• And if there are enough consumers with each kind

of preference

• All consumers can then locate in an optimal community which is efficient in size

• This is the efficiency claim of the Tiebout hypothesis

• Unlike the Theorems of Welfare Economics there is no single way to formalize this result


• It does require that there are no frictions in housing markets

• It can apply if consumers’ incomes are from rent so unaffected by community choice

• If income is earned then employment opportunities must be replicated in all communities

• It can hold if the number of consumers and communities is infinite

• If both are finite problems of division arise

Documents

Issues in International Taxation UAB 2011 Lecture 1 Gareth Myles University of Exeter and Institute for Fiscal Studies