TAX COMPETITION: THEORY AND EMPIRICAL EVIDENCE

Michael P. Devereux

Centre for Business Taxation

University of Oxfordcopyright rests with the author

Plan

• A brief introduction to the theory– should we expect competition? – should we expect a “race to the bottom”?– can we distinguish “beneficial” and “harmful”

tax competition

• Evidence of tax competition– Trends in tax rates and revenues– Econometric evidence

• Conclusions

Basic tax competition theory

• Capital mobile across countries, but labour immobile

• Governments provide a public good paid for by a source-based tax on the return to capital

• They choose a tax rate to reflect (a) benefits of higher public good provision

(b) loss of capital abroad

• Tax rate lower than in a closed economy

Questionable assumptions

• Labour not mobile?

• No other taxes available to governments?• Labour income tax • VAT• Residence-based capital income tax

• No imperfect competition, economic rent, discrete choices

• No publicly-provided goods for production

Incidence & Some Implications

• Taxes on capital (in small open economy) cannot reduce the post-tax rate of return to owners

• So are effectively borne by domestic residents

• Better to tax them directly and avoid distortion to location of capital– ie. better NOT to tax capital income

Extensions to model (1)

Competition over discrete location choices, where firms earn economic profit

1. If firms want to locate near market, large countries attract investment, though they may have to pay a subsidy

2. If firms want to locate away from their competitors, governments can raise (some) tax without distorting investment

Extensions to model (2)

• 3 levels of decision:– Where to locate a new facility – depends on average

tax rate– How much to invest – depend son marginal tax rate– How much profit to shift to lower-taxed countries –

depends on statutory tax rate

• Governments could compete over any of these 3 tax rates– should depend on mobility of firms v capital v profit

Is competition harmful or beneficial? (1)

Compared to what ?– Closed economy ?– Partially co-ordinated group of countries ?

• eg. in capital taxes, but not labour taxes

– Fully co-ordinated group of countries ?– Countries globally co-ordinated ?

Is competition harmful or beneficial? (2)

• Competition may be generally good, but– taxes not like ordinary markets; and governments

provide goods that the private sector cannot– Is competition over environmental pollution

beneficial? – Competition over only some taxes distort choice of

instruments

• Is a distinction based on competition for firms & capital as opposed to competition for profit ?

Is competition harmful or beneficial? (3)

• All competition acts as a constraint in national policy setting

• If governments act in national interest then real harm is where other countries hurt, eg.– global pollution– preventing other countries raising taxes on capital ?

• But should we tax source-based profit anyway?– arguably not on efficiency grounds; and can use other

instruments for equity ?

Empirical Evidence

Do governments compete? Some possible sources of evidence:

1. Trends in tax rates, and tax reforms

2. Evidence of impact of taxes on business

3. Evidence of impact of foreign taxes on domestic taxes

Average OECD Statutory Corporation Tax Rates

20%

25%

30%

35%

40%

45%

50%

55%19

82

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

median unweighted mean

Statutory corporation tax rates: Old and new member states, 1995-2005

20.0

22.0

24.0

26.0

28.0

30.0

32.0

34.0

36.0

38.0

40.0

1995 1997 1999 2001 2003 2005

15 old member states 10 new member states

Corporation Tax Rate Reductions in EU, 2003-5Reduction (%) Year of reform

Austria 34 to 25 2005

Belgium 39 to 33 2003

Cyprus 25 to 15 2003

Czech Republic 31 to 28 to 26 2004, 05

Estonia 26 to 24 2005

France 35.4 to 33.8 2005

Greece 35 to 32 2005

Hungary 18 to 16 2004

Italy 36 to 34 to 33 2003, 04

Latvia 22 to 19 to 15 2003, 04

Netherlands 34.5 to 31.5 2005

Poland 28 to 27 to 19 2003, 04

Portugal 30 to 25 2004

Slovakia 25 to 19 2004

EU Statutory corporation tax rates, 2005

0

5

10

15

20

25

30

35

40

45

But do trends tell us anything ?

• An implicit hypothesis that (a) globalisation and hence (b) competition have been increasing, but– also requires evidence of pattern of increased

mobility– theory says little about competition with

imperfect mobility– tax rates may have moved for other reasons– tax revenues tell a different story

Outward FDI: US and UK

0

50

100

150

200

250

1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003

Year

2000

$bn

UK US

But do trends tell us anything ?

• An implicit hypothesis that (a) globalisation and hence (b) competition have been increasing, but– also requires evidence of pattern of increased

mobility– theory says little about competition with

imperfect mobility– tax rates may have moved for other reasons– tax revenues tell a different story

OECD Corporation Tax Revenues as % of GDP 1965-2004

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%19

6519

6619

6719

6819

6919

7019

7119

7219

7319

7419

7519

7619

7719

7819

7919

8019

8119

8219

8319

8419

8519

8619

8719

8819

8919

9019

9119

9219

9319

9419

9519

9619

9719

9819

9920

0020

0120

0220

0320

04

GDP weighted average unweighted average

Implicit Tax Rates in Capital: Old and New Member States 1995 - 2003

10

15

20

25

30

35

1995 1996 1997 1998 1999 2000 2001 2002 2003

%

15 old member states 10 new member states

2. Evidence of impact of taxes on business behaviour (1)

• Plenty of empirical evidence of effect of taxes, affecting – location of firms– direct flows of capital

• Studies use a variety of measures of both capital and tax rates – and hence estimates of elasticities vary widely

2. Evidence of impact of taxes on business behaviour (2)

• Also evidence of effects of tax on the location of profit, eg:– Repatriation of dividends to parent companies– Use of debt in high-tax subsidiaries– Transfer prices– Comparison of profit across countries

Corporate Taxable Income as % GDP, relative to Statutory Tax Rates, 2004

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

40.0

10 15 20 25 30 35 40

Statutory Tax Rate

Cor

pora

te T

axab

le In

com

e as

% o

f GD

P

But evidence of tax competition ?

One more stage required before governments should respond to concerns of effects of tax:

• What are the welfare consequences of the induced behaviour of firms? eg:

– Is the aggregate capital stock lower? – Are productivity and wages lower?

• Relatively little research on these issues

3. Evidence of impact of foreign taxes on domestic taxes

Direct examination of relationship between tax rates

• very little research

• difficulty in identifying appropriate tax rates– eg. implicit rates (or revenue/GDP) may show

common movements due to correlation in economic cycle across countries

One study

Devereux, Lockwood & Redoano (2005)• examine effective marginal tax rate and statutory

tax rate in OECD countries• find a significant effect on the statutory rate of

statutory rate in other countries– Consistent with competition for firms (via the effective

average tax rate)– Consistent with competition for profit

• Overall, results suggest significant competition, which more than explains reforms up to 2000

Conclusions (1)

Governments do compete in statutory corporation tax rates

• EU statutory rates of corporation tax have fallen steadily, and go on falling– new member states increasing competition

• But revenues have remained buoyant; can this continue?

Conclusions (2)

Does it matter?

• Depends on what is the “optimal” rate of source-based corporation tax– arguably it is zero anyway– harmonisation of CT may lead to competition in

public services used in production– if harmonisation were possible, why not

consider residence-based tax within the EU?

Or are political considerations paramount?

Conclusions (3)

• Longer term issues arise with increasing labour mobility– less easy to rely on taxes on residents if they

are more mobile– may eventually imply need to restrict labour

mobility, or agreement on income tax rates