Revisiting the debate on tax competition vs. tax coordination

1. Revisiting the debate on tax competition vs. tax coordination Assaf Razin and EfraimSadka September 2011

2. Classical Tax Competition Ideas • Referring to tax competition among localities in the presence of capital mobility, Oates (1972, p.143) argues that competition may lead to inefficiently low tax rates (and benefits): • "The result of tax competition may well be a tendency toward less than efficient levels of output of local services. In an attempt to keep taxes low to attract business investment, local officials may hold spending below those levels for which marginal benefits equal marginal costs, particularly for those programmes that do not offer direct benefits to local business."

3. Residence vs. Source Principles • In Razin and Sadka (1991) we presented a theoretical framework to demonstrate that, under certain assumptions, e.g. the “residence principle” of international taxation is optimally enforced by member states, there are no gains from tax coordination over the tax competition regime. But the residence principle is not easily enforced and countries instead resort to source-based taxation of income from capital.

4. Arbitrage Relationship = Tax rate levied on residents on domestic-source income = Effective tax rate levied on residents on foreign-source income = Tax rate levied on non- residents on income originating in the host country Residence principle Source principle

5. Efficiency • Residence principle achieves efficiency in the allocation of world aggregate investment; i.e., production efficiency: mpk= mpk* • Source principle achieves efficiency in the allocation of world aggregate savings; i.e., mrs=mrs* • Recall the the Diamond-Mirrlees production efficiency theorem.

6. But the residence principle is not easily enforced and countries instead resort to source-based taxation of income from capital • In this situation, tax competition among countries, may lead to inefficiently low tax rates and welfare-state benefits because of three mutually reinforcing factors. • First, in order to attract mobile factors or prevent their flight, tax rates on them are reduced. • Second, the flight of mobile factors from relatively high tax to relatively low tax countries shrinks the tax base in the relatively high tax country. • Third, the flight of the mobile factors from relatively high tax to relatively low tax is presumed to reduce the remuneration of the immobile factors, and, consequently, their contribution to the tax revenue.

7. The Model • Continuum of host countries • Two labor skill types • Free migration • Perfect capital mobility • Upward supply schedules of migrants of the two skill types from the rest of the world as a source • Majority voting on a pay-as-you-go fiscal system consisting of capital and labor income taxesand uniform per capita benefits

8. Equilibrium

9. Fiscal Coordination In the coordinated –policy equilibrium the cutoff utilities are controlled by the grand policy maker, who set the common tax rates on capital and labor, and the level of benefits:

10. Competition vs. coordination: The race is not to the bottom • We compare the tax policies that exist under competition and under coordination. Specifically, we ask whether competition can lead to "a race to the bottom" in the sense that it yields lower tax rates and welfare-state benefits, relative to the coordination regime. We carry this comparison via numerical simulations. • Figure 1(a) depicts the tax rates under competition and under coordination (for various levels of the productivity parameter. We can clearly see that competition yields higher, not lower, tax rates than coordination, contrary to the race-to-the-bottom hypothesis. Figure 1(b) shows that benefits in the coordination regime are lower that under the competition regime. Figure 1(c) shows that the number of skilled migrants is higher under coordination than under competition.

11. Comparing coordinated and uncoordinated regimes:Skilled majority

12. Taxes: Comparing skilled and unskilled majority

13. Taxes

14. Migration Volumes

15. Excluding Capital Mobility

16. Number of skilled migrants is higher under coordination than under competition

17. Gains and Losses associated with the volume of migration • Gains from migration to the host country: the infra-marginal gains due to diminishing marginal productivity of labor. • Losses from migration to the host country: the native-born population share with migrants the tax collected from capital income (or fixed factors) financing the uniform benefit per capita to which the migrants are entitled.

18. Fiscal Externality • The native-born decision maker ignores the fact that a tax-migration policy which admits an extra migrant raises the well-being (a cost to the native born) that must be accorded to migrants by other host countries, in order to elicit the migrant to come in. • Consequently, the policy offer too high level of benefit, levies too high taxes, and admits too many migrants.

19. Conclusion • The literature on tax competition with free capital mobility cites several reasons for a race to the bottom. • In contrast, with fixed population that can move from one jurisdiction to another, the Tiebout paradigm suggests the tax competition yields efficient outcome. • We identify a fiscal externality associated with migration which raises the tax rates on labor and capital, and the volume of migration, for all skill types to be too high , compared to a coordination regime.