Tax Wars: International Tax Co-operation and Competition
The perils of Tax Competition
(see updates, below). Tax competition is the process by which jurisdictions use fiscal incentives (such as tax breaks and subsidies) to attract investment. It can involve whole countries “competing” against each other, but it can also happen between states in a federation, such as inside the United States or Switzerland, or even between cities.
Tax competition is always harmful, for several reasons. It short-circuits democratic (or other) domestic or local processes by which governments set their tax policies. It results in the tax burden within countries being shifted away from corporate taxation in particular and towards other forms of tax whose burden falls disproportionately on the poor and the middle classes. Weaker states such as in Africa are far less able to cope with the external pressures of tax competition, resulting in a lower revenue base, greater inequality, greater dependence on foreign aid, and weaker accountability of government as a result of the shifting tax burden (see here for more details.)
Tax competition is an area where orthodox economics collides head-on with democratic ideals. This kind of “competition” between countries creates external pressures that undermine the right of electorates to decide whether or not they want to live in a high-tax or a low-tax economy, or how to organise the relative weights of different forms of taxation within the economy. However, it is also important to realise that there are two perspectives from which this issue can be viewed: first, from the point of view of individual countries, and second, from a global systemic perspective. Tax competition is generally harmful in both respects.
To understand why tax competition is harmful, it is first necessary to expose some common fallacies.
One fallacy, widely used by the proponents of tax competition, is that market competition is good, so all forms of competition, including tax competition, must be good. This fallacy stems from confusion between two forms of competition: the healthy kind, and the unhealthy kind. Competition between companies in well-run markets is an example of the healthy kind: it helps stimulate innovation, improve productivity and efficiency, and lowers prices (and prevent companies from colluding to fix prices). The unhealthy kind of competition is perhaps best illustrated with examples, such as competition between companies to supply the biggest bribe to win a contract, or competition on environmental standards in a race to the bottom. Jurisdictions can also compete in other unhealthy ways (often related to tax competition) by, for example, offering laxer regulation or stronger secrecy, thus providing better shelter for tax evaders and other criminals.
Frequently, both the healthy kind and the and unhealthy kind of competition operate simultaneously. When countries compete with each other, healthy competition for foreign investment involves competing to have better institutions, rule of law, good infrastructure, technology, education, efficient markets, etc. But tax competition between countries is of the unhealthy kind: for this kind of competition involves countries engaging in beggar-thy-neighbour games to suck financial capital and investment out of each other by offering lower taxes (or more secrecy or laxer regulation) which do nothing to improve efficiency or enhance competition -- indeed, like any other form of subsidy, these incentives are likely to promote inefficiency. The advantage gained by one country from lowering its taxes is often short term because it is quickly offset by similar moves in neighbouring countries (see an example from Ireland here.) This leads to long term revenue losses in all the countries involved. Not only this, but tax competition often involves special schemes and narrow incentives which are often discretionary and selective, resulting in distorted markets and greater corruption.
Another fallacy rests on the idea that competition between companies is like competition between countries. As the influential Financial Times commentator Martin Wolf put it: “the notion of the competitiveness of countries, on the model of the competitiveness of companies, is nonsense.” Think about it this way: when a company cannot compete, it goes bankrupt and another (hopefully better) one, takes its place. For all the pain involved when firms go bust, this process does weed out bad firms and keeps others on their toes - and is a source of capitalism’s dynamism. However, if a country cannot “compete” – this is a route to becoming a failed state, an altogether less wholesome proposition. Poor countries are particularly vulnerable.
It is also worth noting how tax competition distorts markets. Tax competition has “macro” effects (i.e. competition between countries to attract / retain investment) and “micro” effects, with companies using aggressive avoidance techniques to achieve unfair advantages over competitors. The latter is yet another “blind spot” in the field of economics. It is typically assumed that all companies compete on a level playing field as far as exogenous factors are concerned. In reality, however, this is clearly not so. Some companies take an ethical position and choose to be good citizens. Other do not. The outcome is an economic distortion which undermines fair competition. Directors who want to act in an ethical or responsible fashion place their companies at an unfair disadvantage vis à vis the extreme practititioners at the other end of the spectrum. (Other distortions are discussed below.)
Are corporation taxes falling, or rising as a result of tax competition?
Orthodox economic analysts try to counter all this by saying that while tax rates (particularly corporation taxes) have indeed been falling over the long term under tax competition (the average corporate tax rate for OECD members has declined from 37.6 per cent in 1996 to 28.3 per cent in 2006, according to KPMG), they argue that taxes (and particularly corporation taxes) as a share of GDP have been rising, at least in OECD countries, so the fears of tax competition are overblown.
Let us dissect this. First, the orthodox models always use an unweighted average of countries. In more detail, however, some of the bigger countries such as the US, Japan and Germany have seen corporation tax as a share of GDP fall since 1965. As a result, the weighted average of countries – which is the more appropriate measure – shows exactly the opposite trend: corporation tax as a share of GDP has been falling. Tax competition is real, and it is biting.
But this is by no means all. For one thing, corporate profits as a share of GDP have been rising far more quickly than the rise even in this unweighted average mentioned above – meaning that corporate taxes as a share of corporate profits have in fact fallen sharply. Not only that, but it seems that there has been an expansion of the types of activities that are covered by corporate taxation -- such as a trend for individuals to incorporate themselves as companies for tax purposes -- which has boosted the headline figures for corporate taxation, while disguising the underlying dynamics.
And there is more: the poorer countries find it far more difficult than rich countries do to counter the effects of tax competition: so pressures from tax competition in the developing world is yet more intense. Take Zambia as an example. Between 1992 and 2004, the copper industry's total contribution to the Zambian treasury fell from over $200 million to just $8 million - even though copper prices had climbed by more than 25% and copper production remained relatively stable. This is an extreme example, but the pressures are indeed intense. A July 2007 story in the New York Times, illustrating how multinational drugs companies have slashed jobs in the U.S. while benefiting from large tax holidays, provides a good case study from the rich world. These external pressures to lower tax rates are typically unhealthy, as evidenced by a quote from a recent McKinsey report: “Popular incentives, tax holidays, subsidised financing or free land, serve only to detract value from those investments that would likely be made in any case.” In a recent TJN newsletter , (page 6) Alex Cobham examines new research which shows that richer countries are better able to resist the pressures of tax competition, and discusses some of the policy and research implications.
And there is still more, which is perhaps even more alarming, for the pressures of tax competition are evolving, and they risk posing additional dangers in future. IMF deputy managing director Murilo Portugal highlighted these concerns in a speech in July 2007.
There is no doubt that public finances in the advanced economies will face an exceptional confluence of challenges during the upcoming years. Expenditure pressures on various fronts are likely to coincide with adverse dynamics in revenues as the ability to tax mobile factors of production weakens, while economic growth is likely to slow as labor forces decline in size and productivity growth may level off. This provides a radically different environment for fiscal policy than in past decades that were characterized by benign demographics, rapid productivity growth, relatively low commodity prices, and the uninhibited exploitation of natural resources more generally.
Evidence of the impact of heightened tax competition for capital has been mounting. In the OECD countries, and the EU specifically, statutory corporate tax rates have declined sharply over the past decade. But so far there has not been a pronounced fall in government revenues in many countries, despite the reduction in tax rates. We are not quite sure why this is so: It could reflect in part the fact that the tax base has increased, due to the beneficial effects of globalization on productivity and growth. It could also reflect an expansion in the types of activities covered by taxes, and efforts to broaden the tax base by removing exemptions could have also been bearing fruit. In addition, the cyclical surge in corporate tax revenues has played a role. However, it is far from clear to us and to many others that there would not be more marked adverse effects on revenues in the future. Were that to happen, the implications for sustainability given the other challenges I have noted will become even more serious.
(It is well worth reading Portugal’s speech in more detail.)
Some proponents of tax competition would argue that corporation taxes are not a problem in terms of social inequality, because companies simply shift the burden of these taxes onto other stakeholders such as workers and shareholders. This, too, is deeply mistaken. To see why this is so, take the example of a multinational company with an African subsidiary employing much capital but few workers. Pressure to lower corporation taxes (and replace them with other forms of taxes) will mean that wealth is shifted away from Africans towards western countries. This is not just a cross-border problem; more generally, corporation taxes are widely recognised to reduce inequality. By contrast, other forms of taxation such as Value-Added Tax (VAT) or sales taxes do not generally get forced lower by tax competition, and countries -- particularly poor ones -- increasingly have to rely on these kinds of indirect tax. These kinds of taxes are regressive: they ultimately increase disparities in income and wealth.
Are low taxes good?
Others try to counter these arguments by saying that tax is a cost, low taxes are generally desirable, and so tax competition, by pressuring countries to cut taxes, is therefore a good thing. The Economist magazine went so far as to argue that tax competition is “the only agent of productivity for governments.” (The magazine fail to cite a single economist to back up this assertion.) These arguments are, quite simply, nonsense, for several reasons.
First, it should be noted that TJN does not take a position on whether taxes should be high or low. As we have already argued, tax policies should be decided by domestic electorates, not by foreign bankers or other interest groups, and external pressure from tax competition short-circuits healthy democratic processes.
The ultimate external pressure comes from tax havens – which are (as discussed elsewhere on this site) incitements to cross-border crime and corruption and market distortions. Tax havens also negate David Ricardo’s theory of comparative advantage, which says that production should gravitate towards geographically relevant areas – cheap manufactures from China, or fine wines from France or Chile, for example. Tax competition and tax havens, by contrast, turn this on its head: instead thousands of companies relocate to the Cayman Islands, for example, without any obvious economic reason why they should be there. They promote corrupt capitalism, as in the celebrated case of the energy trader Enron, which had 692 subsidiaries in the Cayman Islands alone.
Here it is also worth noting, as an aside, that prosperity in these countries has grown dramatically in line with rising tax takes, which makes the facile argument that lower taxes are generally the route to greater prosperity look faintly ridiculous. Taxes do not just go up in smoke: if they are well spent, on good roads or education, for example, they can enhance a country’s ability to “compete” in global markets. Three of the world’s five most “competitive” countries described in the World Economic Forum’s 2006 Global Competitiveness Report are Finland, Sweden and Denmark, which are among the highest-tax countries in the world. It is also important to consider, particularly from the point of view of developing countries, the role that taxation, and particularly direct taxation, plays in the development of accountably and responsive governments. (See TJN’s section on accountability and a newsletter for more details.) A recent Canadian study comparing taxes across countries concluded that “high-tax countries have been more successful in achieving their social objectives than low-tax countries. Interestingly, they have done so with no economic penalty.”
Second, while company managers often see taxes as costs, they are not costs in any sense of inhibiting the efficiency of markets. Instead, they are distributions to society. Tax incentives are subsidies, which provide companies with advantages over their competitors that have nothing at all to do with the quality or price of the goods or services that they are selling. In accountancy terms, competition happens above the line, not below it. These incentives articicially favour multinational companies over smaller firms, and this distortion does nothing to promote efficient markets. To say that tax competition is “the only agent of productivity for governments” is patently ridiculous. There are several perfectly good mechanisms that keep governments on their toes and prevent them raising tax rates too high. One is democracy: voters are keenly aware of tax levels. Another is interest rates and international bond markets, which are a potent disciplining force. Corporate lobbyists and other special interest groups are another major source of pressure on governments to lower tax rates. The list could go on.
The tax burden has shifted
Overall, central government spending in OECD countries has risen sharply over the past few decades, and since this has not been accompanied by ballooning government deficits, it follows that governments’ overall tax take, as a share of GDP, has grown. Again, one might ask, does that not prove that the worries about tax competition are overblown? It does not.
The key point here is that the tax burden has shifted under the pressures of tax competition, powerfully worsening inequality within countries. The tax situation of the world’s wealthy elites is improving as a result of tax competition. This problem has been particularly acute in poor countries (see Cobham, 2007), whose governments are far less able to adjust to the pressures of tax competition. The relative tax burden on corporations has fallen, while the tax burden on labour and spending has had to rise, which has demonstrably increased inequality. Concerns about inequality are evident across the political spectrum from left to right, as evidenced by the example of the IMF deputy managing director’s speech, described above, or an article in the prestigious American journal Foreign Affairs co-authored by Matthew Slaughter, a former economic advisor to President George W. Bush.
Over the last several years, a striking new feature of the U.S. economy has emerged: real income growth has been extremely skewed, with relatively few high earners doing well while incomes for most workers have stagnated or, in many cases, fallen. . . . There is reason to worry even if one does not care about social equity. . . U.S. policy is becoming more protectionist because the American public is becoming more protectionist, and this shift in attitudes is a result of stagnant or falling incomes. Public support for engagement with the world economy is strongly linked to labor-market performance, and for most workers labor-market performance has been poor. . . . . The best way to avert the rise in protectionism is by instituting a New Deal for globalization -- one that links engagement with the world economy to a substantial redistribution of income. In the United States, that would mean adopting a fundamentally more progressive federal tax system.
What can be done about it?
Ultimately, the answer to the problem of tax competition is to set up a framework of rules to protect national tax bases, giving electorates more freedom to be able to achieve the tax systems they feel are right for their countries. This has to happen on a truly global level. The fundamental components of this would be international co-operation and transparency.
One ultimate goal to aim for would be the automatic exchange of tax information between jurisdictions, preventing national élites from escaping their responsibilities and leaving poorer sections of society to shoulder the burden of taxation. This would almost certainly require some form of global institution to protect the integrity of the system.
The Financial Times, in an editorial on June 25, 2007, outlined the general strategy that is now required.
Regulation must be global. Moreover, such regulation must include taxation. As finance goes global, so must the depth of co-operation among fiscal authorities. A world in which a global plutocratic class pays little or no tax, while benefiting from the stability generated by taxes imposed on the "little people", will prove unsustainable.
It is important to remember that claims are often made that co-operating or co-ordinating tax policies between states involves "surrendering national sovereignty." This claim, too, is fallacious - for while countries trying to adapt to tax competition individually do indeed have the exclusive legal competence over tax policy, in practice this autonomy is a mirage, because unfettered tax competition removes states' actual capacity to design their tax systems according to national political preferences. Co-operation on taxation allows states to achieve negotiated solutions through democratic channels, rather than simply being forced to do what electorates do not necessarily want. It is also important to note that co-operation on taxation does not necessarily mean harmonisation, as some advocates of tax competition claim.
Some regional and even global efforts have already been set up to counter the harmful effects of tax competition, though they are all weak or deeply flawed. A good example is the European Union, where efforts are underway – only weakly, so far – to co-ordinate tax policies. (This short 2007 report on tax competition in Europe from the pressure group Compass explains more.) The OECD countries implicitly recognise the harm that tax competition can inflict on countries, with its initiative on harmful tax competition. “Some tax practices are anti-competitive and undermine fair competition and public confidence in tax systems,” it says. However, this initiative is flawed, partly because it tends to reflect only the interests of rich OECD countries, and it fails to recognise the role that some of the world’s biggest financial centres – notably the City of London and New York – are tax havens.
A number of other initiatives would help complement efforts to counter the pernicious effects of tax competition. This is too complex an area to deal with in depth here, but at this stage we offer just a few examples. One would be to set up county-by-country reporting requirements in international financial reporting standards for companies (see more in Richard Murphy's article on page 6 of this newsletter.) Another approach would be to tax international business on a unitary or consolidated basis, so that national tax authorities treat related entities (such as subsidiaries of transnational corporations) as a single unit, with consolidated accounts, combining all the activities of the firm and eliminating internal transactions between its various parts. (In September 2007 TJN submitted this proposal to the UK government on tax competition and on unitary taxation.) The resulting unitary tax base would then be apportioned between states on a formula based on the proportion of real business done in that state. Each state could still apply its own rate of tax (although it might be desirable to limit the differences.) This would stop companies from manipulating transfer pricing or conducting fictitious activities through shell companies in tax havens (and many other tax dodging techniques) that prevent developed and developing countries from taxing international businesses effectively. (Read more about this idea of "formulary apportionment" in this report by the Brookings Institution and in this briefing paper on tax competition.) Efforts to curb bank secrecy more generally will also help mitigate the anti-democratic effects of tax competition.
Many of the other issues TJN is involved with, such as capital flight, financial secrecy, and the like, overlap strongly with this one. This is just a short analysis of some of the possible solutions: this section remains a work in progress which will be updated over time. Comments are welcome - please send them to email@example.com.
Updates and further reading
Aug 20, 2012 - Vietnam and how tax incentives undermine policy processes
March 30, 2012 - Corporate Taxation - The Next Race to the Bottom
Jan 10, 2012 - Tax Competition and Inequality:The Case for Global Tax Governance, new paper by Thomas Rixen. Original here.
Aug 5, 2011 - US study: tax flight is a myth
Jan 2011 - On the Dole, corporate style. David Cay Johnston on new research about the proliferation of tax incentives, and wasteful competition between jurisdictions to supply them.
Dec 2010 - Is tax competition harming developing countries more than developed? A seminal paper by Mick Keen and Alejandro Simone. Original here. Reprinted with permission of Tax Analysts. Copyright 2004.
Oct 2010: UK VAT abuse and the music industry: how tax havens undermine markets.
Sept 2010: Africa Tax Spotlight: the tax competition edition.
Tax wars: new terminology for tax competition.
Dr Thomas Rixen, In Need Of A Fix: Double tax avoidance rules as the institutional foundation of tax competition in Tax Justice Focus, July 2008 >
New paper in European Tax Policy journal: Deadlocked European Tax Policy - Which Way Out of the Competition for the Lowest Taxes? By Christian Kellermann and Andreas Kammer, Feb 2009 >
Extra insights, March 2009 in this blog by Richard Murphy from the G20 meet: how tax havens undermine democracy. >
Slide show of presentation by Richard Murphy in the City of London: how tax competition affects developing countries. November 2008. >
A paper by Bruno Gurtner and John Christensen on tax competition, presented in Mexico, October 2008. >
Richard Murphy writes on the merits of tax co-operation, August 2008 >
Edmund Valpy Fitzgerald of Queen Elizabeth House at Oxford University outlined some principles and challenges associated with tax competition in this 2002 paper
Oct 2006 - Tax Research on the UK's stable corporate tax take, amid falling tax rates
2005 - Joel Slemrod, University of Michigan, Tax Competition with Parasitic Havens