TAX COMPETITION IN THE EU LOUVAIN, 30 March 2007

1. TAX COMPETITION IN THE EULOUVAIN, 30 March 2007 Carola Maggiulli DG TAXUD European Commission Presentation Louvain

2. Origins: Oates (1972): «The result of tax competition may well be a tendency toward less than efficient level 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 programs that do not offer direct benefit to local business. » Formalisations: Zodrow – Mieszkowski (1986): Pigou, Tiebout, Property Taxation, and the Underprovision of Public Goods 5J. Of Urban Economics) Wilson (1986): A Theory of Interregional Tax competition (J. of Urban Economics) Other sources: Wilson (1999): Theories of Tax Competition (National Tax Journal) Zodrow (2003): Tax Competition and Tax Coordination in the European Union (International Tax and Public finance) Krogstrup (2004): A Synthesis of Recent Developments in the Theory of Tax Competition (EPRU Working Paper 2004-02) Basic model of tax competition Presentation Louvain

3. Basic model of tax competition: assumptions - large number of identical jurisdictions - fixed population and land, identical tastes and income • a single good is produced by capital and fixed factor (land/labour) • capital stock is fixed in the system but perfectly mobile between jurisdictions • perfectly competitive markets • government produces public services (modeled as publicly provided private goods) • two tax instruments: source-based tax on capital and tax on the fixed factor (a head tax) • governments maximize the welfare of residents (benevolent governments) Presentation Louvain

4. Basic tax competition model: equations Production function with standard properties (constant returns to scale): f(K), fK (K) > 0, fKK (K) < 0 where K = amount of capital per head invested in production Government budget constraint: P = tK + h where P = public good, h = head tax, t = tax on capital Utility function of the representative citizen: U (P, C) where C= private consumption good The budget constraint of the representative citizen: consumption is equal to wage income plus savings minus taxes paid Presentation Louvain

5. Basic tax competition model: first-order conditions obtained by maximizing the welfare function w.r.t. budget constraints 1. case: no constraints on head tax finance (ZM) / zero capital mobility (Krogstrup) (1) • states that the tax rate is increased to the point where the marginal utility of public spending is equal to the marginal utility of private spending • (1) is equivalent to the Samuelson condition for the efficient provision of public goods, which requires that the sum of marginal rates of substitution (between public and private goods) is equal to the marginal rate of transformation • the ratio (1) is also called the marginal cost of public funds; MCPF = 1 represents the first-best optimum in the absence of distortionary taxes Presentation Louvain

6. Basic tax competition model: first-order conditions 2. case: perfect capital mobility/ constraints in the head tax finance (proper tax competition case) -financial market equilibrium condition (2) - after-tax rate of return r is given to the individual jurisdiction (small country assumption) - If the tax rate t is increased, gross rate of return must also increase so that the capital owner still earns r in the world market • therefore the increase of t lead to capital outflow until (2) holds • the change of capital stock is obtained by totally differentiating (2) with respect to t (3) Presentation Louvain

7. Basic tax competition model: first-order conditions - the government’s problem is again to max. the citizen’s utility function subject to the two budget constraints, the financial market eq. condition (2) as an additional constraint, which gives the following f.o.c. (4) where εK is the elasticity of capital to the tax rate defined as (5) Presentation Louvain

8. Basic tax competition model: underprovision of public goods • (4) states that now MCPF >1; the marginal utility of public spending is larger than the marginal utility of private spending in equilibrium (since it is now more costly to finance public spending through taxes than in the 1. case) » • this is an inefficiency outcome, i.e. underprovision of public goods • in the conditions of perfect capital mobility source tax on capital becomes distorting, it entails an efficiency cost • MCPF >1 implies also that capital tax rates are at the sub-optimal level; coordinated tax increases would be Pareto-improving, as resources would be moved form private to public spending • The results MCPF ≠ 1 holds generally in the second-best world, when lump sum taxes are not available and public spending is financed through distortionary taxes (for ex. in the area of environmental taxation; as long as MCPF >1, optimal tax on emissions < Pigouvian tax) Presentation Louvain

9. Basic tax competition model: race to the bottom • The governments act uncooperatively; they set the tax rates to max. the welfare of their own citizens and always take the world after-tax r.r. and the tax rates of other jurisdiction as given • this leads to capital flows between countries changing the first-order conditions (i.e. the countries which reduce their tax rates gain at the expense of others in the form of higher return on the fixed factor and larger tax base) • this triggers new changes in tax rates until the new equilibrium (bottom) is reached • In the simplified conditions of ZM-model (large number of small jurisdictions etc) the bottom is zero; it is optimal to eliminate capital tax and finance public spending only through tax on the fixed factor • more generally, however, the bottom is not necessarily zero, it is the equilibrium condition in which the cost of decreasing the tax = the benefit of capital inflow Presentation Louvain

10. Basic tax competition model: main conclusions - Even if the bottom were not zero, it still holds, as long as the governments don’t coordinate, that compared with zero capital mobility (or head tax financing of public spending) • tax rates on capital are at the below optimal level 2) public services are underprovided, i.e. MCPF > 1 The main policy implication of BMTC: Tax coordination always improves welfare efficiency as it would help to increase public spending towards the first-best optimum Presentation Louvain

11. Extensions of the basic model • Relaxation of the simplifying assumptions does not change the main conclusions of BTCM, with a few important exceptions • Large countries (Wildasin (1988)) -assume a finite number of countries each big enough to influence the after tax return to capital with its tax policy - the elasticity of capital supply w.r.t. domestic tax rate (εK above) is now smaller in absolute terms, as capital outflows from the countries increasing their tax rates are smaller - this implies that MCPF is smaller (see (4) above) and, thus the extent of underprovision of public funds is smaller and the capital tax rate that fulfils (4) is higher than in the small country case - but it still holds that MCPF > 1, capital tax rates are below the optimal level and public goods are underprovided Presentation Louvain

12. Extensions of the basic model 2 • Assymmetric countries Wildasin (1999), Bucovetsky (1999) • As indicated above, larger countries face lower elasticity of capital (are less concerned about capital outflows), and hence lower MCPF, and tend to choose higher tax rates on capital than smaller countries • The resulting tax differentials lead to the inefficient reallocation of capital from large to small countries • Small countries are better-off in the equilibrium (benefit from tax competition more than large countries) • Policy conclusion: because of inefficient reallocation the case for tax coordination is stronger, but on the other hand, it may be more difficult to reach an agreement on tax coordination, for ex. between the EU Member States Presentation Louvain

13. Extension of the basic model 3 3)More than one tax instrument • In ZM-model a non-distortionary tax instrument is available, and the model says that it is always optimal to finance public spending through that instrument • What about other distortionary taxes? If labour supply is variable (unlike ZM-model), also labour taxes are distortionary, as they affect labour-leisure decisions and thus labour supply • Bucovetsy – Wislon (1991): • If countries are small, it is still optimal to tax only labour, as labour-leisure substitution possibilities are limited, but capital supply is unlimited • If countries are large, it is optimal to use also capital taxes but public goods are still undeprovided • Policy implication: higher capital mobility (more intense tax competition) will always lead to a shift of tax burden from capital to labour Presentation Louvain

14. Extensions of the basic model 4 4) Labour mobility Brueckner (2000) • Individuals have different preferences for public goods, which affects their choice of location • the outcome is differential tax rates across jurisdictions, which represents a form of allocative inefficiency, but does not change the basic result of the underprovision of public goods 5) Income uncertainty Sinn (1994, 1996, 1997) • In BTMC public goods enter the welfare function in the same ways as private goods; they are « publicly provided private goods » • Public spending is, however, also about redistribution • Redistribution essentially provides protection against the risk of income uncertainty, as private insurance markets fail to do this • Tax competition limits redistributive activities of the governments and entails an important social cost • In Sinn’s model tax competition for mobile factors (skilled labour and capital) implies that no redistribution takes place and capital taxes only have a nature of benefit taxes (payment for the use of infrastructure) Presentation Louvain

15. 6) Leviathan governments - BMTC assumes thatgovernments are benevolent, i.e. their sole purpose is to maximize the welfare of citizens - public choice literature rejects this assumption; gov. officials are assumes to be interested in their own welfare as much as that of their citizens, hence the objective is to max. tax revenues instead of social welfare • Under such conditions tax competition may turn out to be beneficial as it restrict the wasteful use of tax revenues Edwards – Keen (1996) • combines the Leviathan and benevolent tendencies in the same model: the objective function is the weighted average of the two • Tax coordination in this context always benefits gov. officials as it facilitates the expansion of the public sector • The effect on the welfare of citizens is ambiguous; it depends on the extent to which higher tax revenues are used to wasteful consumption or to increase social welfare through public spending • The final outcome thus depends on the parameters of the government’s objective function; how much weight is given to Leviathan and benevolent elements respectively Presentation Louvain

16. 7) Tax exporting Huizinga – Nielsen (1997) - If part of the capital stock is owned by foreigners and assuming the markets are imperfectly competitive, the governments may be able to export part of the tax burden on capital to foreigners (governments assumed to be benevolent) • Hence increasing taxes is less costly than in the absence of foreign ownership • Tax exporting effect may more than offset the efficiency cost of tax competition and lead to overprovision of public goods Krogstrup (2004) • In the presence of foreign ownership the eequilibrium condition can be written as • (6) • Where µ = share of foreign ownership. (6) shows that • MCPF >1, if µ < εK and vice versa • hence whether tax exporting leads to under- or overprovision of public goods depends on the relative sizes of the elasticity of capital to tax rate and the share of foreign ownership • Sörensen (2001) argues that the share of foreign ownership would have to be implausibly large to completely outweigh the downward pressure on pubic services from tax competition • however, MXPF is lower and hence the eq. level of capital taxes is higher than in the absence of foreign ownership • Huizinga-Nicodème (2003) show statistically significant positive correlation between country-level foreign ownership shares and CIT rates ―> does not yet prove that tax exporting effect eliminates tax competition Presentation Louvain

17. Agglomeration economies Baldwin –Krugman (2002) & al. • new economic geography models differ from BTCM in several respects • firms, capital and goods are mobile internationally, labour is immobile • two sectors: agriculture (perfect competition, constant returns to scale), manufacturing imperfect competition, increasing returns to scale) • the location of manufacturing firms depends on th trade costs and the strength of scale economies • Because of trade costs and scale economies manufacturing firms locate in one country form which they export • this creates location-specific external economies of scale effects which further benefit the firms located in the country (agglomeration in manufacturing)) • the country hosting agglomeration (core country) can afford to impose higher taxes on mobile capital as long as taxes don’t exceed agglomeration rents • bell-shaped relationship between trade costs and tax differentials; tax differentials between core and periphery countries first increase and then decrease with trade openness (economic integration) Implications: • Tax differentials may persist even in the conditions of full capital mobility • Tax rates may differ between the countries of the same size (no small country benefit) • Tax coordination is not necessarily beneficial as long as the countries are at the different levels of development • Minimum rates set at sufficiently low levels would benefit high-tax countries without harming others Presentation Louvain

18. Political economy considerations • Globalisation and financial integration increases tax competition but they also have another effect, called compensation hypothesis: with more openness and higher economic fluctuations public demand for higher protection increases the financing of which requires higher taxes Persson-Tabellini (1992) • democratically elected policy-maker plays the Nash game and takes the tax rates of other countries as given • -median voter takes, however, the resulting eq. tax rates as given as associated them with the policy-makers preferences • median voter elects the policy makers which will max. his/her utility • the higher the capital mobility, the more median voter prefers the policy maker with preference for higher taxes • -this « move to the left » mitigates the downward pressure of tax competition on tax rates, but does not reverse it Presentation Louvain

19. Positive and normative implications • Positive implications: how does economic integration (higher capital mobility) affect the economies? Nearly all the models considered above predict that capital mobility decreases the source-based tax on the mobile factor (capital) and shifts the tax burden towards immobile factors (labour). Capital mobility also decreases tax revenues and the provision of public goods. There are, however, counteracting or mitigating factors, including size of the country, agglomeration benefits, foreign ownership, political pressure. The strength of each of these factors is largely an empirical issue. 2) Normative implications: how beneficial is tax coordination/ harmonisation when capital is internationally mobile? • The answer to this question depends on the assumptions of the model, as indicated above. The main dividing line is between public choice approaches (Leviathan models) and public finance approaches (benevolent governments). This is to a large extent an issue of belief. • The benefits of tax coordination have turned out to be, however, relatively small, albeit positive, in model simulations even in the context of standard model (no Leviathan etc.). • This is shown, for instance, in Sörensen (2001), Parry (2003) and Bettendorf & al. (2006). Presentation Louvain

20. Evolution of average statutory corporate tax rates inthe EU-25, EU-15, NMS-10 and non-EU OECD-6 (1995-2006) Presentation Louvain

21. Evolution of average statutory corporate tax rates in the EU-13 (exluding Lux. and Denm.) and Non-EU OECD-6 (1979-2005) Presentation Louvain

22. Present discounted value of depreciation allowances in the EU-13 and non-EU OECD-6 (1995-2005) Presentation Louvain

23. Present discounted value of depreciation allowances in the EU-13 and Non-EU OECD-6 (1979-2005) Presentation Louvain

24. Evolution of the effective average (EATR) and marginal (EMTR) corporate tax rates in the EU-13 and non-EU OECD-6 Presentation Louvain

25. Evolution of the effective average (EATR) and marginal (EMTR) corporate tax rates in the EU-13 and Non-EU OECD-6 (1979-2005) Presentation Louvain

26. Evolution of the dispersion (standard deviation-SD) of the EATR and EMTR in the EU-13 and non-EU OECD-6 Presentation Louvain

27. Evolution of the corporate income tax revenues as % of GDP in the EU-15 and the NMS-10 (unweighted averages) Presentation Louvain

28. Evolution of implicit tax rates (ITR) on labour, capital and consumption in the EU-25 Presentation Louvain