Tax Evasion, Tax Competition

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    TheEconomicJournal, 109 [Januaiy), 93-101. Royal Economic Society 1999. Pubiished hy BlackwellPublishers, 108 Cowley Road, Oxford OX4 IJF, UK and 350 Main Street, Maiden .MA 02148.USA.

    TA X EVASION, TAX COMPETITION AND THE GAINSFROM NONDISCRIMINATION: THE CASE OF

    INTEREST TAXATION IN EUROPE

    Eckhard Janeba and WolfgangPeters*

    This paper uses a game-tlieoredc approach to analyse the taxadon of interest income inEurope in the presence of tax evasion. The model allows tis to assess the success of variousreform proposals. We argue tbat the tax treatment of nonresidents' interest income plays acrucial role. When decisions on discrimination and on withholding tax rates are made non-cooperadvely, the outcome is similar to a prisoners' dilemma. All countries discriminate, but inequilihrium internationally mobile portfolio capital evades taxation successfully. In contrast, ifall governm ents d id not d iscriminate, tax competition leads to less tax evasion.

    The integration of capital markets in Europe has hrought various benefits. Atthe same time, however, governments struggle to contain tax evasion. Interna-tional capital flight as an attempt to evade taxes is particularly relevant in thearea of taxation of interest income. Banking secrecy laws in some EU countriesand low tax rates in small countries like Luxembourg, which hoost its role asfinancial centre, have led to the effective elimination ofthe taxation of interestincome for some investors.The Economist speaks, not surprisingly, about 'The

    Disappearing Taxpayer' (May31, 1997).Several proposals have been made in order to overcome this situation.' The

    European Commission supports the introduction of a minimum tax rate and/or the status of a community resident. Under the concept of a communityresident a country's tax on interest income is independent of the residence ofthe investor (practically realising the source p rinc iple ). By con trast, a proposa lof the OECD (1977) argues in favour of a maximum withholding tax rate oninterest income. None of these proposals has been unanimously acceptedsince gains and losses from non-coordinated policies differ greatly across

    member states. The main beneficiary of the present situation is Luxembourgwhich attracts large amounts of foreign capital, in particular from Germany.The United Kingdom opposes any coordination for political reasons andbecause tax coordination may also threaten London's role as the leadingfinancial centre in Europe. In contrast, Germany sticks to its traditional banksecrecy law which en ables resid ent investors to evade Germ an taxation byinvesting abroad.

    * We aie grateful to Tim Besley, Karljosef Koch, Gunther Schulze and an anonymous referee forhelpful suggestions. All errors are our own responsibility. Einancial support by Deutsche Forschungsge-meinschaft, Sonderforschungsbereich 303 at the University of Bonn, is gratefully acknowledged. Theresearch was undertaken as part of the European network on the 'Eiscal Implicadons of EuropeanI t i ti ' hi b i f d d d th EC H C it l d M bilit P

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    94 \ : THE ECON OM IC JOURN AL [JANUAR

    The purpose of this paper is to model the situation of non-coordinated policies in the presence of tax evasion in order to assess the success of various reform proposals. For this purpose, we allow governments to chowhether they discriminate against nonresidents or not. Discrimination tathe form of differential tax rates on residents and nonresidents. We therecontribute to the li terature on tax competition by endogenising the set of rates from which each govemment chooses. At first glance, it seems advangeous to have a larger set of tax instruments. We will show, however, that incentive to discriminate is common to all governments, and, in equilibrileads to no taxation of internationally mobile portfolio capital. This outcois similar to a prisoners' dilemma and reflects the current situation in the EThe introduction ofthe status of a community resident, which in our modeequivalent to no discrimination by all governm ents, would make governm e

    weakly bette r off in terms of revenu es. In fact, we show that u nd er non discrinatory taxation governments are quite successful in combating tax evasirelative to the set of tax instalments.

    The tax treatment of nonresidents ' interest income plays also a role in analysis of Razin and Sadka (1991). They assume that countries are small acannot influence the net return on investment. In that case policy coordition can not improve upon the nonco operative status qu o. In contrast to Raand Sadka we believe that countries like Luxembourg, though small in terof popu lation or size, exert inark et power with respect to internation ally h igmobile portfolio capital.^

    The setup of our tax competition model is motivated by experiences wwithholding taxes in the United States (Goulder, 1990), and in particular differential tax treatment of residents and nonresidents in Germany's unieral attempts to tax interest income in 1989 and 1993 (see, for exampNohrbass and Raab, 1990; Schlesinger, 1990; Deutsche Bundesbank, 1994)both cases huge capital amounts fled Germany and were invested in Luxbourg where foreigners' interest income is tax free. Interestingly, the 19legislation was a failure because the attempt of taxing nonresidents hurt othe German government via higher interest rates on debt. Since 1993 nresidents have been exem pted from the withho lding tax.

    1. The Model

    The economy consists of two countries, labelledA and B. Both countries arinhabited by a large number of investors. Some investors evade personal taon interest income. The government of each country tries to combat evasion, but is restricted to use withholding taxes on interest income. Tgovemment objective is to minimise tax evasion which is equivalent to m

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    1999] TAX EVASION, TAX CO M PET ITIO N AND GAINS 95

    mising tax revenues.^ For simplicity, we do not explicitly model the decisionproblem of tax evaders. Th eir beh aviour is indirectly repre sente d in the govern-ment revenue function. We distinguish, however, between two types of taxevaders and therefore two types of tax bases. First, there are some evaders who

    never invest abroad. These individuals might either face too high transactioncosts, or are too risk averse regarding exchange rate fluctuations, or are simplyincompletely informed about foreign investment opportunides. This impliesthat each government can extract revenues from a domestic non-mobile taxbase. The second type of tax evader is one who always shops for the lowest taxrate. Th us there is an interna tionally m obile tax base which always locates in th elow-tax country. Both tax bases respond elastically to (the minimum) tax ratebecause with hig her tax rates evaders make portfolio adjustments.^

    Tax bases and therefore revenue functions are represented in a reduced

    form. Denote by Rj(tj), j = a, b, the revenue functions of country A's andcou ntry B's dom estic tax base as functions o ft h e tax rates ^ j , //,. Let /?,(/,),/, min{^am, tbm]y be the revenue function ofthe mobile tax base as functionof the smaller of the two tax rates. We impose the following mild assumptionson all revenue funcdons ij = a, h, m)\ RjiO)O and Rjitj) ^ 0, eachrevenue function Rj{tj) is cond nuo usly diCferendable if/^^(^y) > 0 , and eachrevenue funcd on is single-peaked and has a un iqu e max imum att" =3Lrgm3iXi_(L[o^\]Rj{tj).Our assumptions are compadble with a revenue functionwhich looks either like a bell-shaped curve (e.g. the standard Laffer curve), or

    an increasing funcdo n (e.g, a completely inelasdc tax base ).We now wish to analyse the following two-stage game. In the first stage,

    governments decide whether to discriminate against the mobile tax base.Disc riminadon is possible by imp osing differendal tax rates on the two taxbases, i.e., ti ^ / j ^ . i a, h. We abbreviate discrim inadon and no n discrimina-don by D and N. In the second stage governments simultaneously choose taxrates. Governments are forward looking and therefore we solve for the sub-game-perfect equilibrium.

    1,1, Nondiscriminatory Taxation

    We f i rs t analyse the case in which bo th governments do no t d iscr iminate(JV, A ^ ^ ) .T h e u n i fo rm tax ra t e o f g o v ern men ti is d e n o ted t,. Since the mobi letax base always locates in the low -ta x co un try, we can de fine t hr ee differentreg ion s. Le t ^ be the set of tax rates{{ta, th) [0 , 1] X [0 , !]! /< / / ,} such

    ^ This is not the same as assuming that the govemment is of Leviathan type (see Edwards and Keen,1996, for a discussion of the Le\iat]ian hypothesis). Ourmode! is hased on the fact thai in EU countriesinterest income is taxable. Tbis is also the motivation behind Germatiy's second attempt to tax interestincome. The German Supreme Court ruled that income must he taxed comprehensively for horizontalequity reasons.

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    that country A attractsthe mobile tax base. D efine in the same way the set JBand also set: ? which is the set of equal tax rates. Assuming w.l.o.g. thatthemobile tax base is split evenly when ta = tb, we can write government A'revenue funcdon (and similarlyfor govemment B)

    + ififif

    tf,)

    tf,) G

    We wish to characterise the Nash tax rates ((*, t*) of the (TV, N) subgameFor this purpose it is helpful to consider Fig. 1 which shows a typical payofuncdon for govemment A if it always attracted the mobile tax base {t/, = 1)The left peak is the sum of the revenues from tlie domesdcand the mobile taxbase. The right peak shows the revenues from the domesdc tax base. The tax

    rates corresponding to the two peaks are denoted by f^ and t^. If (j 0 , a discondnuity arisesat ta = tb where both countries sharethe taxreven ue from the mo bile tax base.

    In Fig. 1 we illustrate also that each governmentcan guarantee itselfcertain level of tax revenues. Each government exploitsits own domestic taxbase opdmally through fj. No govemment will ever accept revenues less thRjitp, j = a, b. This is called the ' inside opdon' . The figure shows a limit taxrate, t^, which is the smallest tax rate such that the revenues from both taxbases, the domesdc and the mobile, are at least as high as from the ' insid

    op tion '. M ore fonnally, the limit tax rate is defined ast"; = argmm[i: s.t. R,{t,) -F R^itj) ^ Rjit'j)].

    The limit tax rate is a threshold up to which govemment A is willing toundercut its o p p o n en t and it determines a government 's potendal to attracthe mobile tax base. Clearly, the winner of the mobile tax base must choosetax rate which doesnot exceed the limit tax rate of its opp one nt . The countr

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    with the lower limit tax rate is the only candidate for attracdng the mobile taxbase. To avoid a clumsy notadon, and without loss of generality, we assumet^ ^ tj;. A Nash equilibrium in pure strategies under (A^, A^) must then sadsfy:

    ( 0 C C ^ {a)

    (ii) t* = tl = argmzxRh{t(,) (1)

    {iii) tl = t+^ tl

    When * < ^J, the mobile tax base locates inA and condidons ii) and {ii)have obvious meaning. However, the first two condidons do not rule outB'sincentive to undercut. For existence of a Nash equilibrium we impose theaddidona l condit ion {iii).^

    We are now in a posidon to analyse how successful govemments are incombadng tax evasion under nondiscriminadon. We cal l govemmentsweaklysuccessful in combating tax evasion if there exists a tax rate tuple{ta, h) such thatthere exist no other tax rate combinadon that makes at least one govemmentstrictly better off v^ithout making the other worse off. We can strengthen thenodon of success as follows. Governments are said to bestrongly successful incombating tax evasion if there exists a tax rate tuple(ta, //>) such that there existsno oth er tax rate tup le that increases the sum of revenues. We then have

    P R O P O S I T I O N 1: Suppose that both governments do not discriminate ag ainst non-residents and t^ '^ t^ "^ tl. (a) In equilibrium govemTnents are weakly successfulin combating tax evasion. M oreover, if( b ) ( ^ < m i n { ( ' ^ , / ^ } , or if (b ') (^ < tf,then govemments are strongly.successful.

    Proof: (a) Consider an equilibrium with unequal tax rates, e.g.t* ='t.

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    {t'a, t'b) should be an elem ent of .;^. H enc e, the jo in t maxim um can not b.j&. (b') The arguments in case oft^ < tl' are similar, A tax tuple (t'a, t'b) whileads to a jo in t revenue exceeding that of the Nash equilibrium must beelement of .^ and therefore t'a= ( > 4 = 'A- This, however, contra dict:

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    1999] TAX EVASION, TAX COMPETITION AND GAINS 99

    \

    D

    N

    D

    n

    N

    K

    Fig. 2: Payoff matrix for (non-) discrimination

    govemment A and the lower left entry to govemmentB. The payoff tableshows that if one government playsN the payoff for D is at least as high aswhen playing N. Both govemments therefore have a weak preference forplayin g Z).' Th is gives

    PRO PO SI T I O N 2: Suppose /", < m i n ( ( J - , ( f ) and C ^ ft '^^^ subgame-perfect equilibrium in pure strategies exists. In the first stage each gffvemmen t w eaklyprefers to discriminate ag ainst nonresidents. How ever, any situation in which atleast one country do es not discriminate is weakly preferred by one and not rejected bythe other govemment.

    When govemments compete in tax principles, l ikeD and N, and then in taxrates, the outcome of tlie overall game is similar to that of the prisoners'dilemma. Both govemments end up in the worst possible case because they failto exploit the mobile tax ba.se,*'

    The main result of this paper can be generalised to situadons with morethan two countries, as would be relevant for the EU. Consider, for instance, athree-country model. The above model can be easily adapted by assuming thatdie mobile tax base of the twcxountry model represents in fact the intema-donal mobile capital of those investors who live in the third country, saycoun try C. Co untries A and B co m pe te for this tax base, as we described above.Of course, the tax compeddon argument applies to the mobile tax base of any

    ^ Note that under (D. N) govemment A is better off than under (N, N) since in the former case ithas more instnmients. Tlierefore its total reventie tmder (D,N) is at least as high asunder{N, N).

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    100 THE ECONOM IC JOURNAL [JANUAR

    country because there are alwa)^ two govemments who compete for this base. It is straightforward to show then that in a three-country model with same structure as above, the following strategies are part of a subgame-perfequilibrium: AJI three g overnmen ts choose to discm ninate and eac h countinternationally mobile capital is untaxed.

    2. ConclusionsIn this paper we try to capture the main features of the current tax treatmof interest income in the European Union. Internationally mobile capescapes taxation by moving to tax havens like Luxembourg. By contrinternationally immobile capital is taxed at least through nationai withhing taxes. In our model this situation is explained as the outcome of a

    competition game between member states of the EU which discriminagainst nonresidents. We have abstracted from the fact that the EU capmarket is not closed and capital often flees to tax havens outside of the This, of course, aggravates the tax evasion problem/-* Our analysis suggthat even when capital flight to non-EU countries is not a major problcoo rdinatio n within the Eu rope an Un ion is difficult, in particula r if bsecrecy laws and the unanimity decision rule for EU decision making maintained.

    The European Commission's proposal of introducing the community rdent is interesting because it aims al solving the prisoners' dilemma. Tproposal corresponds to the (A^, A^) case in our theoretical model and wo(weakly) improve governments' success in combating tax evasion compared(D, /) ). ' It is uo t clear, however, w he the r this prop osal would find sufficsupport in the EU. Agreeing upon {N, N) means that the country with thlowest 'inside option' is the best candidate for attracting the mobile portfcapital. Thus, big countries Uke France or Germany would continue to ptheir inside option and do not benefit from the proposal. Luxembourg, l ikely winner, is no t expected to compe nsate the o the r m em ber states for t

    agreeing.^' Alternatively, governments may consider introducing a minimtax rate in order to avoid a beggar-thy-neighbour policy. '^ A minimvmi rate on the mobile tax base in the (D, D) regime might be even mo

    '* For a recent analysis of capital flight to EU and non-EU coun tries see Htuzinga and Nielsen Their paper does not consider investors in EU tax havens and the issue oftax discrimination.

    '" From a theoretical perspective il is not entirely clear why countries are ahle to write contractprinciples, but not on tax rates. A possible explanation is that tax bases and therefore optimal tax are uncertain at the time when governments choose whether to discriminate or not. It is then very cor even impossible to write a contract with state-dependent tax rates. By contrast, it is conceivablecountries agree on nondiscrimination before the shock is realised. We are grateful to Tim Besley brought the issue of contractihility to our attention.

    '' A referee pointed out that larger countries may benefit indirectly from introducing the conce

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    attractive. Both govemments gain and the mobile tax base is taxed at amaximum when /, t" . Whether this option is feasible depends also on theextent capital is mobile to non-EU tax havens.

    Indiana University, Bloomington,USAEuropean University Viadrina, Frankfurt (Oder), Germany.

    Date of receipt of first subm ission:September 1996Date of receipt of final typescript: June 1998

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    Kanbur, R. and Keen. M.(1993). Jeux sans frontieres:tax competition and tax coordination whencoun tries differ in size',.\mmcan Economic Review, vol. 83. pp. 877-92 .

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