Shared Fiscal Policy Challenges and Globalization:
The Role of Cooperation
Dennis Botman and Teresa Ter-Minassian1
May 2008
Abstract
Spillover effects of macroeconomic policies become more pronounced as globalization
proceeds. Externalities, and measures to address them, are particularly pronounced in the
fiscal area, raising the question to what extent policy cooperation is desirable. We discuss
three areas of increased fiscal interdependence: global aging, global warming, and tax
competition. The world faces unprecedented demographic change over the next decades,
which, if left unaddressed, leads to unsustainable debt trajectories. The fact that this is a
global, rather than an individual country, challenge implies rapidly rising real interest rates.
We show that an early, cooperated, fiscal response through a package of measures will
minimize output and consumption losses, while complementary structural reforms are best
handled at the individual country level. Similarly, climate change is a global externality
requiring an early cooperative fiscal response, particularly regarding mitigation measures,
while adaptation measures are best left to the private sector, possibly with support from
individual governments. Globalization also puts pressure on the taxation of mobile factors of
production. This can be observed in declining statutory corporate income tax rates in OECD
economies, emerging markets, and developing countries. Some degree of tax competition
may be beneficial and cooperation should not aim for harmonization of tax rates, but instead
try to avoid harmful tax practices. These three challenges, and the measures to address them,
pose important questions for social policy and coherence, within countries, between
generations, and across nations.
JEL Classification Numbers: E62, F41, F42, H30, H55, H62
Keywords: Global aging, global warming, tax competition, international fiscal policy
cooperation.
Author’s E-Mail Address: dbotman@imf.org and tterminassian@imf.org
1
Paper prepared for the conference on Social Policy: Vision and Reality, Jerusalem, May 2008. The authors
would like to thank Steve Symansky, Michael Keen, and Sanjeev Gupta for many helpful comments and
suggestions. The views expressed in this paper are those of the authors and should not be attributed to the IMF,
its Executive Board, or its management.
533571056 February 17, 2016 (4:13 PM)
2
I. INTRODUCTION
This paper discusses recent work at the International Monetary Fund (IMF) in three areas of
increased fiscal interdependence—global aging, global warming, and tax competition—and
the potential role for international cooperation. The interactions between globalization and
fiscal policy can be subtle and complex. With globalization, demographic change in one
country has macroeconomic implications for its trading partners because of interactions
through trade and financial market channels. International trade itself has been spurred by
declining transportation costs, which in turn partly reflects that negative environmental
externalities have not been priced properly into private sector decision-making. Finally, the
process of globalization also directly affects the effectiveness and design of fiscal policy, as
evidenced, for example, in tax competition and declining import tariff revenue following
trade liberalization.
That increased integration of goods and financial markets affects the effectiveness of fiscal
policy is well understood. For example, in the classical Mundell-Fleming model, financial
integration makes fiscal expansion more effective, as crowding out through higher domestic
interest rates is reduced. Apart from a domestic risk premium, the interest rate in each
country is highly correlated with the world real interest rate on which policies in an
individual economy have little effect. In contrast, trade integration reduces the effectiveness
of fiscal policy as part of the fiscal expansion falls on imported goods. Therefore, whether
fiscal externalities are positive or negative depends critically on whether the financial or
trade interaction dominates.
In the first part of this paper, we discuss these interactions in the context of population aging
using the IMF’s Global Fiscal Model (GFM). The GFM is largely a modified version of the
Mundell-Fleming model in the new-open-economy-macroeconomics tradition. Often, the
implications of demographic change are studied for individual countries, which tend to result
in modest effects on real interest rates and debt service costs. However, taking into account
that population aging will put pressure on public finances in all OECD economies—albeit
not to the same extent and at the same moment—as well as emerging markets and developing
countries, yields considerably larger effects on debt service costs. Indeed, as the world is a
closed economy, one would expect that “global aging” would lead to considerable crowding
out through higher interest rates, with little offset from increased international trade in goods
and services. As such, the fiscal costs from aging give rise to negative international
externalities, and measures to contain these costs are an international public good. In this
context, we will analyze the effects of alternative fiscal measures, as well as supportive nonfiscal reforms that maintain public debt sustainability and the potential role for international
cooperation.
In addition to global aging pressures, global warming also has potentially significant
macroeconomic effects. Emission of greenhouse gases poses a clear-cut negative externality,
while measures to respond to it suffer from a classic “free-rider” problem. Dealing with
3
climate change is made difficult by its slow-moving, stock nature, by considerable
uncertainty, coupled with the real possibility of catastrophe, by interactions with other market
failures, and by the exhaustibility of fossil fuels.
Nevertheless, it is widely recognized that an early, cooperative, policy response is required,
with fiscal measures playing a key role. Indeed, the fiscal implications of climate change
could be among its most powerful and immediate, affecting—in differing ways—all
countries. This relates to the direct impact of global warming on tax bases and spending
programs, but even more so to using fiscal instruments to mitigate the extent of climate
change, and to adapt so as to limit the damage that remains. In this context, the paper
discusses the role of alternative fiscal measures, the nature of international cooperation, and
the potential macroeconomic effects of mitigating climate change.
Globalization also directly affects the conduct of fiscal policy. For example, financial
globalization can increase revenue volatility and give rise to contingent liabilities.
Globalization could also have an impact on the expenditure side of budgets. There could be
increased demand for public spending, in particular social protection to prevent rising income
inequality, as well as further investment in human and physical capital to improve
competitiveness. Some of these issues, however, do not require international cooperation.
In this paper, we focus on the effects of globalization on the ability to tax mobile factors of
production. There is evidence that tax competition has reduced statutory tax rates in OECD
economies, emerging markets, and developing countries. At the same time, revenue from
corporate income taxation in these countries has held up well, possibly pointing to base
broadening, or to cyclical factors related to asset price developments. Tax competition is
evidenced not only in reductions in statutory rates, but also in the proliferation of selective
tax incentives, for example through tax holidays. The paper discusses these issues and the
role for international cooperation to prevent harmful tax practices.
The rest of the paper is organized as follows. Section II reviews the demographic trends in
selected economies and their impact on debt sustainability; the pros and cons of alternative
strategies to create fiscal space to accommodate aging-related spending pressures; and the
spillover effects of global aging and fiscal consolidation. It also discusses the merits of
international cooperation to put public finances on a sustainable footing, and the role and
spillover effects of complementary structural reforms. Section III deals with possible fiscal
measures for mitigating and adapting to climate change, their potential macroeconomic
effects, and the role for policy cooperation. Section IV presents recent evidence on the extent
and types of tax competition and the role for international policy cooperation. Section V
concludes.
4
II. GLOBAL AGING2
A. The Analytical Framework
To analyze the macroeconomic and spillover effects of demographic change, Botman and
Kumar (2007) use the IMF’s Global Fiscal Model (GFM). GFM allows a quantification of
the effects of population aging on interest rates, consumption, growth, and the spillover
effects through trade and financial market channels. Specifically, GFM extends the newopen-economy-macroeconomics framework to incorporate sufficient non-Ricardian
characteristics to allow for an analysis of the effects of fiscal policy and interdependence.
GFM is described in more detail in Botman, Laxton, Muir, and Romanov (2006).
There are three key reasons why full Ricardian equivalence does not hold in GFM. First, the
model features overlapping generations in the spirit of Blanchard-Weil. The use of
overlapping generations allows the assumption of Ricardian equivalence to be relaxed,
implying that government debt is perceived as net wealth. Essentially, consumers have a
short, and more realistic, planning horizon, which implies that even temporary changes in
fiscal policy affect their incentives to consume and work as they discount any future fiscal
policy reaction. Second, GFM incorporates the assumption that some consumers do not have
sufficient access to financial markets to smooth their consumption over time. This is
consistent with evidence that even in the advanced economies up to a third of the consumers
are liquidity constrained. Liquidity-constrained agents consume their entire disposable
income every period and therefore any change in fiscal policy that affects this disposable
income will have real effects. Third, GFM allows labor supply and capital accumulation to be
endogenous and respond to changes in incentives related to the after-tax real wage or the
after-tax rate of return of capital. This in turn allows the model to incorporate distortionary
taxes and analyze the consequences of changes in their rates.
It should also be noted that capital mobility in GFM is perfect, implying that interest rates are
set in world markets. As a result, especially for small open economies, the crowding-out
effects of government debt via higher interest rates will tend to be smaller than with
imperfect capital mobility. These features provide a useful benchmark for the analysis,
especially regarding the medium- and long-term effects of fiscal policy. GFM also has a
stylized financial sector block, with two types of assets, namely government debt (which can
be traded internationally) and equity (which is assumed to be held domestically). Changes in
the outstanding stock of debt have direct implications for long-term interest rates, which as a
result of the perfect capital mobility assumption are transmitted internationally.
2
Most of the material in this section is drawn from Botman and Kumar (2007).
5
B. Global Demographic Pressures
The budgetary challenges facing the EU countries from demographic trends have been
analyzed extensively by the European Commission, country authorities, as well as a wide
range of observers (see e.g., European Commission, 2006a and 2006b; Hauner, Leigh, and
Skaarup, 2007). The assessment of the budgetary challenges is based on the projections by
Eurostat that indicate on average a doubling of the old-age dependency ratio, defined as the
ratio of population older than 65 relative to the working-age population, from 2005 to 2050
in the EU25 countries. Over this period, the modal age-cohorts move from mid-30s to late
50s. These changes are projected to exert significant upward pressure on age-related public
expenditures, primarily for pensions and health care. For the EU25 as a whole, the average
increase (weighted) in age related expenditures is projected at almost 3½ percent of GDP; for
the EU15, it is 3¾ percent of GDP and for the new EU member states (EU10) it is ¼ percent
of GDP. However, amongst the EU10, Poland has implemented a major pension reform that
implies a marked decline in its pension expenditures—amounting to almost six percent of
GDP. Excluding Poland, the average age related expenditures for EU10 are likely to increase
by 4½ percent of GDP.
If one considers separately the age related expenditures emanating from pensions and from
health and long-term care, the following picture emerges. Pension expenditures are projected
to increase by 2.3 percent of GDP on average in EU15 and by 0.3 percent of GDP in EU10
(excluding Poland the increase amounts to 4¾ percent of GDP). Health and long-term care
spending is envisaged to increase by 2¼ percent of GDP in EU15 and by 1½ percent of GDP
in EU10. The baseline scenario assumes that the increase in life expectancy will lead to some
postponement of the need for additional care. The health care projection assumes an elasticity
of demand higher than unity in the short-term, but this is expected to gradually decline to
unity over the projection period.
The projected increases in age-related spending and the sustainability gaps in other major
countries and regions are also striking. In the case of the United States, in particular, the
increase in age-related spending over 2005–50 is projected at about six percent of GDP,
mostly on account of higher health care spending. Given the structural primary deficit of
around 1¾ percent (2005), the U.S. faces a sustainability gap of around 7 percent of GDP
(OECD, 2001; and Hauner, Leigh, and Skaarup, 2007).3 There are marked aging-related
budgetary pressures also in Japan, where the initial conditions, both in terms of the large
primary deficit and high debt levels, warrant substantial adjustment (Hauner, Leigh, and
Skaarup, 2007, and Botman, Edison, and N’Diaye, 2007). Under announced policies, and
taking into account current debt levels and structural fiscal positions, public debt dynamics
appear unsustainable for all G-7 economies (Figure 1).
3
The estimated adjustment need is very sensitive to assumptions regarding the interest rate-growth differential.
6
Figure 1. G-7—Projected Cumulative Growth in Old-Age Population (dashed line, right-hand-side
axis, in percent) and Increase in Age-Related Spending Relative to 2005 (in percentage points of GDP)
140
120
100
80
60
40
20
Source: Hauner, D., D. Leigh, and M. Skaarup, 2007.
2050
2045
2040
2035
2030
2025
2020
2015
2010
2005
0
2050
2045
2040
2035
2030
2025
2020
2015
2050
2045
2040
2035
2030
20
10
9
8
7
6
5
4
3
2
1
0
2050
2050
2045
2040
2030
2035
160
United States
40
0
160
G7 average
140
120
100
80
60
40
20
0
2050
10
9
8
7
6
5
4
3
2
1
0
2025
2020
2015
2010
2005
0
60
2045
20
80
2045
40
100
2040
60
120
2040
80
140
2035
100
0
160
United Kingdom
2035
120
10
9
8
7
6
5
4
3
2
1
0
-1
20
2030
140
40
2030
160
60
2025
0
80
2025
2050
2045
2040
2035
2030
2025
2020
2015
2010
20
100
2025
40
120
2020
60
140
2020
80
160
Italy
2020
100
10
9
8
7
6
5
4
3
2
1
0
-1
2015
120
Japan
0
2005
140
10
9
8
7
6
5
4
3
2
1
0
20
2005
160
Germany
40
2005
2050
2045
2040
2035
2030
2025
2020
2015
2010
2005
0
60
2015
20
80
2015
40
100
2010
60
140
120
2010
80
160
France
2010
100
10
9
8
7
6
5
4
3
2
1
0
2010
140
120
2005
10
9
8
7
6
5
4
3
2
1
0
-1
160
Canada
2005
10
9
8
7
6
5
4
3
2
1
0
7
Figure 2. Effects of Alternative Aging Cost Projections on Debt Dynamics in Germany 1/
(in percent of GDP)
350
Baseline: 4 percent of GDP aging costs by 2050
Maastricht debt limit
300
High aging costs (7.75 percent of GDP by 2050)
Low aging costs (2.75 percent by 2050)
250
200
150
100
50
0
2007
2018
2029
2040
Source: Botman, D. and S. Danninger, 2007.
1/ Includes the estimated revenue from higher VAT rates in 2007 and revenue loss from
lower social security contributions by workers and employers in 2007 and lower corporate
income taxation in 2008.
Aging is not limited to industrial countries: there are marked pressures in many major
emerging markets also. Among the largest nine emerging markets,4 while the population in
some is projected to grow substantially over the next four to five decades, the 65+ part of the
populations is projected to increase significantly in all countries (between 150 and 400
percent), and the old-age dependency ratio is expected to, on average, triple by 2050. Korea
faces the steepest increase, almost a five-fold increase, albeit from a favorable starting
position with a sizable structural surplus (see Feyzioğlu, Skaarup, and Syed, 2007). There are
also significant pressures in China and Russia, and the projected increase of the old-age
dependency ratio in these countries is markedly higher than in the G7 countries, as are the
projected age-related expenditures.
4
These include Argentina, Brazil, China, India, Indonesia, Korea, Mexico, Russia, and Turkey.
8
There is considerable uncertainty surrounding these projections, not least arising from the
impact of technology and the evolution of health care costs. In the case of Germany,
according to EU estimates, the projected increase in age-related spending is somewhat below
the EU average, rising by about 2¾ percent of GDP between 2004 and 2050. This is due to
an increase in pension expenditures of around 1½ percent of GDP, which reflects the farreaching reforms that have been enacted (including the Agenda 2010 and Hartz reforms). The
increase in health-care expenditure is projected to be 1¼ percent of GDP, lower than the EU
average (see European Commission 2006b). In contrast, a more pessimistic view is expressed
by the IFO Institute, with aging costs estimated at 7¾ percent (see Werding and Kaltschütz,
2005). Braumann and others (2006) employ a fiscal-aging cost profile in between these two
scenarios. Figure 2 illustrates the sensitivity of the debt profile to these alternative aging
costs assumptions. Despite this sensitivity, debt dynamics are unsustainable under current
policies—even if we ignore the effect of population aging in other countries and the resulting
pressure on real interest rates in Germany.
C. Alternative Measures to Create Fiscal Space
As debt seems unsustainable under current policies in a large number of countries, fiscal
space needs to be created to address aging costs. Botman and Kumar (2007) discuss the
macroeconomic effects of alternative fiscal measures to create this space, and the pros and
cons of early versus delayed adjustment. Specifically, they find that revenue and expenditure
measures have differing impacts on output and consumption. On the revenue side, Botman
and Kumar (2007) quantify the required fiscal space to maintain debt below the Maastricht
limit and the resulting output effects of these measures, using the GFM. The negative GDP
growth impact of the different tax measures ranges from 0 to ¼ percent, with measures from
most to least distortionary ranked as follows5:

Raising corporate income taxation reduces incentives to save and invest, and is found
to be the most distortionary form of taxation. Furthermore, it runs counter to recent
trends to reduce taxation of capital and dividend (more on this in Section IV).

Raising personal income taxation, possibly through base broadening, partly reduces
incentives to save and invest and partly reduces labor supply.

Raising payroll taxes on workers or employers negatively affects labor supply or
demand, which runs counter to efforts to increase labor participation in many
countries.
5
This ranking of revenue measures is consistent with Baylor (2005) and Bayoumi and Botman (2005).
9

Raising indirect taxes, for example the VAT, entails the smallest efficiency loss, and
also protects the tax base in an aging society, but may be regressive compared to the
other revenue measures (at least in the short term).
Regarding measures on the expenditure side, entitlement reform (for example, raising the
retirement age) have the smallest impact on growth. Reducing current government
expenditure has the advantage of crowding-in private consumption, but nevertheless leads to
a reduction in output, due to “home-bias” in government spending. Recent analysis has
shown that the resulting welfare effects depend critically on the degree of substitutability
between private and public consumption (Kumhof, Laxton, and Leigh, 2008). Reducing
public investment entails the largest losses, given the relatively high social rate of return of
public investment in most countries that face aging pressures.
For Germany, achieving the required two percent of GDP adjustment during 2008–11 by
relying exclusively on just one of the adjustment measures appears difficult, and the
government likely will need to choose a combination of measures. For instance, reducing
government spending—whether on goods and services or social security transfers—by
2 percentage points of GDP by 2011 implies unrealistically large cuts in discretionary
spending. Similarly, further increases in the VAT rate are also limited (including as a result
of EU regulations), although further base broadening would be possible by reducing the
number of items under the lower (7 percent) VAT rate. Raising direct taxation is
distortionary and runs counter to the government’s intentions to increase incentives for labor
participation and investment. Therefore, these results suggest that in general, fiscal space
should be created through a combination of measures (“package”), which should be
gradually phased-in. Such a package should include raising indirect taxation combined with
base broadening measures, entitlement reform (raising the retirement age, preventive care),
and targeted expenditure cuts in social security transfers, and discretionary current
government spending.
Adjustment packages of this kind can maintain debt sustainability, while minimizing
economic distortions. However, the details of the package will necessarily have to be country
specific, depending on the size of tax distortions, the efficiency-equity trade-off, and political
economy considerations.
Prefunding future aging costs results in a reduction in real interest rates, by about 40 basis
point in the medium term when government debt reaches a trough—the magnitude of this
effect depends critically on how non-Ricardian consumers are. Although, given the size of
the German economy, this effect is larger than would be observed in other euro area
countries, it is relatively modest as Germany’s national savings rate still has only a limited
effect on the global savings and investment balance. A higher VAT, and base broadening of
income taxation imply reduced incentives for labor participation, and result in a decline in
hours worked and an increase in the real wage. Investment responds positively through
10
“crowding-in” after debt starts to decline. Output gradually increases as a result, although it
takes a long time before GDP returns to the level observed before the fiscal adjustment was
initiated. As consumption declines, the real exchange rate depreciates, and the trade balance
records stronger surpluses. Higher national saving results in increasing claims on the rest of
the world through accumulation of net foreign assets. Higher interest earnings from the net
foreign asset position imply that the current account remains above the initial steady-state
level for a considerably longer period than consumption and the trade balance.
D. Spillover Effects and the Role of International Cooperation
In addition to analyzing debt dynamics under population aging in Germany in isolation,
Botman and Kumar (2007) analyze simultaneous aging in Germany, the rest of the euro area,
the U.S., and the rest of the world. For this purpose they calibrate GFM to these
countries/blocks assuming aging costs by 2050 in Germany equal to four percent of GDP, in
the rest of the euro area 4½ percent of GDP, and in the U.S. six percent of GDP, while
assuming that the rest of the world faces no demographic change. This provides a lower
bound estimate of the effect on real interest rates because, as discussed above, various other,
large open economies will face aging pressures as well. The analysis assumes that each
country implements a country-specific adjustment package to maintain debt below the
Maastricht limit (euro area countries) or broadly at the current level (U.S.).
The model is parameterized to reflect key macroeconomic features of Germany, as well as
the rest of the euro area, the United States, and the rest of the world. In particular, the ratios
of consumption, investment, wage income, and income from capital relative to GDP are set
to their values in 2006. Similarly, key fiscal variables—revenue-to-GDP ratios from taxation
of corporate and personal income, from VAT, and from social security contributions by
workers and employers, as well as current government spending—have been calibrated to the
fiscal structure of Germany, and that of the other regions. The macroeconomic effects of the
simulations are presented relative to the baseline, which is the initial calibrated steady state.
The key behavioral parameters are based on microeconomic evidence. These include
parameters characterizing real rigidities in investment, markups for firms and workers, the
elasticity of labor supply to after-tax wages, the elasticity of substitution between labor and
capital, the elasticity of intertemporal substitution, and the rate of time preference.
Taking into account aging pressures in the rest of the euro area and the United States adds a
dramatic dimension to the debt dynamics due to Germany’s own aging profile (Figure 3). As
the euro area and the U.S. face significant spending pressures from aging and, given weak
starting fiscal positions, fiscal deficits increase, current account deficits emerge or increase,
leading to higher real interest rates. Germany is an open economy implying that these higher
rates will increase borrowing costs for the government on newly issued debt. This link
between countries through international financial markets is the key spillover effect of global
aging, and ignoring the interdependencies between countries will lead to a misleading
11
judgment about the macroeconomic outlook of a country, and the efficacy of a policy
response.
This pressure on global interest rates may be mitigated to some extent if entitlement reform
occurs or is expected. In that case, optimizing, forward-looking, consumers—depending on
the length of their planning horizons and on the expected magnitude of the reform—will save
more today in anticipation of lower public pension benefits in the future. Also, in an aging
society, the capital-labor ratio will likely increase, causing downward pressure on real
interest rates. On the other hand, however, the debt trajectory in Figure 3 does not assume a
positive risk premium—for example as a function of the level of government debt, or of net
capital inflows—understating the likely effects of aging on real interest rates.
Figure 3: Effects on German Debt Dynamics of Global Population Aging 1/
(in percent of GDP)
400
Aging in Germany alone
Maastricht debt limit
350
Aging in Germany, euro area, and U.S.
300
250
200
150
100
50
0
2007
2018
2029
2040
Source: Botman and Kumar, 2007.
1/ Includes the estimated revenue from higher VAT rates in 2007 and revenue loss from
lower social security contributions by workers and employers in 2007 and lower corporate
income taxation in 2008; aging-related expenditure costs are 4 percent of GDP by 2050.
Increase in real interest rates consistent with evidence in Ford and Laxton (1999) who find
that a 12.5 percent increase in debt in the OECD increased real interest rates by 100 basis
points (on new debt) during the 1980s. Assumes aging costs of 4.5 percent of GDP by 2050
in the euro area and 6.0 percent in the U.S., with debt increasing by 17.5 percent by 2022.
12
Next, Botman and Kumar (2007) quantify whether the spillovers through financial market
channels dominate those through trade channels and thus whether global aging gives rise to
negative or positive international externalities. Specifically, they analyze a number of
scenarios of early versus delayed creation of fiscal space.
Figure 4. Effects on Real GDP in Germany of Fiscal Cooperation 1/
(Deviation from initial steady state in percentage points)
Early cooperated adjustment
10
Germany delays
Euro area delays
US delays
6
2
-2
2007
2017
2027
2037
2047
Source: Botman and Kumar, 2007.
First they consider all three countries/regions undertaking early joint action, and then each
one delaying by 10 years, while the other two implement early adjustment. They also explore
pair-wise delays (e.g., U.S. and rest of euro area delay by 10 years, while Germany continues
with adjustment), and then all three delaying. A key result is that Germany benefits
substantially from early fiscal adjustment in the rest of the euro area, and in the U.S.
(Figure 4). Although exports decline relative to the initial steady state level following lower
consumption in the two regions and therefore lower demand for imports from Germany, this
is more than offset by the decline in real interest rates through financial linkages between
13
Germany and the euro area and the U.S. The result is an investment rebound and higher
domestic demand in Germany.6
Delaying adjustment in Germany has short-term benefits, but substantial medium-term costs
in terms of foregone output, as the adjustment will need to be more sizeable and interest rates
increase during the intervening period. Similarly, while the euro area and the U.S. benefit,
like Germany, in the short-run from delaying their respective adjustments and free riding on
consolidation elsewhere, if all countries opt to postpone addressing this issue, each one loses.
Under the early, cooperative, response, investment is significantly higher (through the
interest rate channel), which initially also crowds in higher labor effort; consumption is also
higher, and although there is now a weaker external balance, and correspondingly lesser
accumulation of net foreign assets, there is a substantial benefit in terms of higher real
output. Thus, the current account of each country improves less under the cooperative
response than when an adjustment is initiated in isolation; the mirror image to these
movements in the current account of reforming countries is a decline in the external balance
of the rest of the world.
However, there is a potential prisoner's dilemma: delaying adjustment avoids short-term
output losses, while one benefits from others’ adjustment through lower interest rates (which
more than offsets lower exports). Interestingly, political economy considerations can play an
important role in determining whether a prisoner’s dilemma situation will emerge. If
policymakers have a high discount rate, the non-cooperative solution in which all
countries/regions delay adjustment could materialize, as this appears most attractive in the
short term. The cooperative solution can be obtained as a decentralized equilibrium if
policymakers aim to maximize the net present value of output and do not have a high
discount rate. In this case, countries will optimally, individually, decide to prefund future
aging costs.
The adverse effects on Germany, the euro area and the U.S. of cooperative adjustment are not
too pronounced—they are substantially less than a ¼ percentage point lower growth over the
next decade, relative to all delaying.7 Although not negligible, the relatively small effects on
6
The differential effects on real interest rates between large and small economies implies an interesting
hypothesis: large economies should have a greater incentive for prudent fiscal polices than small economies .
Small economies with integrated capital markets have a smaller incentive to implement a fiscal contraction as
the real interest rate will not decline much relative to larger open economies, or small closed or financially less
integrated economies. On the other hand, and abstracting from the role of monetary policy, large open or
relatively closed economies have a smaller incentive to use fiscal policy as a demand stabilizing instrument
because of the stronger crowding out effects and smaller multipliers.
7
The short-term negative effects on growth of joint action could be larger if wages and prices are sticky,
although for the U.S. and the euro area as a whole, monetary easing could mitigate output losses in that case.
14
global growth of early joint action also reflect the fact that the implementation of the package
is assumed to be done in a gradual manner—about ½ percent a year, during six (Germany
and the euro area) to ten years (for the U.S., which faces higher aging costs). The short-run
negative effects of cooperative action would be much larger if all three implemented a
significant adjustment over a very short period of time—although the benefits in terms of
higher growth would then come sooner as well. Also, the adjustment does not occur in the
whole world—the “rest of the world” (including Japan, China, India and other emerging
markets accounting for over 40 percent of world GDP) is assumed not to undertake
adjustment. Of course, if there were to be a slowdown in global growth because of other
reasons, undertaking fiscal adjustment, even if gradual, would be procyclical. It should also
be noted that the analysis in Botman and Kumar (2007) does not take into account the
potential role of migration in maintaining debt sustainability.
E. Complementary Structural Reforms
Even under a cooperative, early, fiscal response, there will be short-term output and
consumption losses. Botman and Kumar (2007) find that these losses can be mitigated, or
even reversed, for the euro area countries if creating fiscal space is combined with
expeditious implementation of the Lisbon Strategy. The Lisbon strategy adopted in 2000,
entailed a wide-ranging program of economic, social and environmental reforms, designed to
enhance growth and employment in the EU and allow it to compete more effectively in the
global economy. The backdrop of the strategy was the exposure of EU countries to growing
international competition, the needs of the knowledge-based economy, and demographic
challenges. The strategy was reinforced in 2005 with a sharper focus on structural reforms to
improve competitiveness, dynamism, and employment.
Botman and Kumar (2007) analyze the macroeconomic effects of three key aspects of the
Lisbon Agenda: increasing labor participation; higher R&D spending to help increase
productivity; and greater product market competition to spur efficiency and higher growth:

Increasing labor participation. In the simulations, stronger incentives for labor
demand and especially labor supply together imply an increase in labor participation
in Germany equal to 5 percent of the labor force over the five-year period. The
participation rate for the euro area, excluding Germany, is around 62½ percent (see
Central Planning Bureau, 2006). As a result, relatively more reform on both the
demand and supply side will be needed to meet the target of a 70 percent participation
rate for the euro area (compared to Germany where the starting position was 65
percent). Increasing labor participation by this amount has large positive effects on
consumption and real GDP, offsetting most of the short-term costs from prefunding
aging costs. However, because of the reduction in the real wage, overall consumption
increases by less than output.
15

Higher R&D spending. In the simulations, Germany’s R&D intensity—defined as
the share of R&D spending in GDP equal to 2½ percent in 2004—is assumed to
increase to 3 percent by 2010. For the euro area, excluding Germany, R&D spending
is about 2.1 percent of GDP and, to reach the goal of 3 percent of GDP spending by
2010, the required increase in R&D spending is 40 percent. The increase in
productivity leads to lower consumer, producer, and export prices, causing a negative
terms of trade effect. Consumption will therefore increase by less than the increase in
GDP.

Increasing product market competition. In the simulations, higher product market
competition is formalized through a reduction in firms’ markups. Increasing
competition across firms reduces the price markup as these firms increase output,
since the demand curves they face have become more elastic. Product market reform
has a significantly positive effect on output in the medium and long run. There is a
marked increase in the capital stock, reflecting the reduced incentives to limit
investment and labor demand to maintain monopolistic rents. The reform has large
positive effects on the real wage. However, in the long run, the increase in output
benefits capital more than labor effort (or hours worked) since labor is the less elastic
resource (see also Bayoumi, Laxton and Pesenti, 2004).
It is notable that output expands considerably if Germany implements the full Lisbon strategy
and meets all its objectives (Figure 5). In addition, consumption, for both the “wealthy,
optimizing” consumers and the “low-income, rule-of-thumb” consumers increases, more than
compensating for any losses from the fiscal adjustment. As such, prefunding aging costs
through fiscal cooperation and structural reform are complementary, as the near-term
contractionary effects of adjustment are ameliorated by the reforms, which yield substantial
benefits in their own right.
Interestingly, most of the gains from structural reforms accrue to the reforming country (lefthand panel in Figure 5). Thus, spillover effects of such reforms appear to be modest and there
will be less need for international cooperation in this area. Figure 5 (second panel) also
shows an alternative scenario of partial and delayed achievement of the Lisbon objectives,
which has the implication that the short-term output and consumption losses from prefunding
of future aging costs cannot be reversed. Since the initial adverse effects of fiscal adjustment
are not offset by reforms, policymakers may be inclined to postpone, or implement more
gradual, fiscal adjustment, both in Germany and the rest of the euro area. This in turn
reinforces the finding that, to avoid large negative consequences for output, and to maintain
intra— and intergenerational equity, early cooperative fiscal adjustment and full
implementation of country-specific structural reforms are essential.
16
Figure 5: Fiscal Cooperation and the Lisbon Agenda: Effects on real GDP in Germany
(Deviation from initial steady state in percentage points unless otherwise noted)
Achievement of Lisbon Strategy
Delayed and Partial Achievement of Lisbon Strategy
35.0
Germany implements full Lisbon Agenda
Cooperation only
Euro area implements full Lisbon Agenda
30.0
34.0
Full implementation
30.0
Partial and delayed implementation
26.0
25.0
22.0
20.0
18.0
15.0
14.0
10.0
10.0
5.0
6.0
0.0
2.0
-2.0
-5.0
2007
2017
2027
2037
2047
2007
2017
2027
2037
2047
Source: Botman and Kumar, 2007.
III. FISCAL IMPLICATIONS OF CLIMATE CHANGE8
A. Introduction
Climate change (CC) is a global externality, and a uniquely complex one:

Costs of mitigation come long before benefits (hence the discount rate is critical).
Global temperature depends not on the current flow of emissions but on the
cumulative stock, with emissions taking decades to have their full effect and decay.
Thus, there is a strong intertemporal mismatch between the (early) costs and (late)
benefits of reducing emissions. This raises issues of inter-generational distribution,
with views on the appropriate discount rate, largely reflecting differing ethical
judgments, becoming critical in assessing alternative policy responses (see for
instance Stern and others (2007) and the collection of papers in the recent Journal of
Economic Literature (Vol. 45, number 3)).

Considerable uncertainty and risk of catastrophe, and irreversibilities. The
relationships between emissions, policy interventions, market responses, and
economic damage remain very uncertain.

Interaction with other market failures, such as R&D, and the pre-existing tax
system. Innovation in mitigation and adaptation, for example, may convey spillover
benefits that the innovators cannot fully capture, which raises questions of policy
8
Most of the material in this section is drawn from International Monetary Fund (2008a and 2008b).
17
support. The design of mitigation instruments may be affected by their impact on
government revenue and the wider tax system.

Free-rider problem, requiring international cooperation. Countering global
warming requires slowing and then (starting in 2020–40) cutting global greenhouse
gas (GHG) emissions (by 60–80 percent). But each country would prefer others to
shoulder the costs of doing so—a classic “free-rider” problem. The coordination
challenge this poses is amplified by asymmetries in the physical impact of climate
change and past emissions. Emissions have the same effects wherever they arise, but
those effects differ greatly across countries (being most adverse in lower-income
countries). So does responsibility for current concentration levels: high-income
economies generated about 80 percent of past fossil fuel-based emissions, and hence
account for much of the prospective damage. But, limiting that damage requires that
others also cut emissions because, within a decade, most emissions will come from
outside the OECD. Asymmetric interests and views on historical responsibility
further complicate identifying generally acceptable policy responses.
Climate change, and measures to respond to it, have potentially significant macroeconomic
effects. The potential economic consequences include productivity changes in agriculture and
other climate-sensitive sectors, damage to coastal areas, stresses on health and water systems,
changes in trading patterns and international investment flows, financial market disruption
(and innovation), increased vulnerability to sudden adverse shocks, and altered migration
patterns—all with potential implications for external stability (International Monetary Fund,
2008a, p. 5).
The fiscal implications of CC could be quite large, will affect all countries, but in
different ways. Climate developments will directly affect fiscal positions, through their
impact on tax bases and spending programs. But, potentially even more important, and
urgent, is the case for purposive use of fiscal instruments in mitigating the extent of CC and
adapting to it, so as to limit the damage that remains. Adaptation, for the most part, is a
matter for local, national and regional responses – in strengthening sea defenses, for example,
or improving management of water systems. While financing these expenditures raises
important issues of burden sharing, the direct international spillovers thus appear to be
limited. As a result, the discussion here focuses on the mitigation side.
B. Fiscal Aspects of Mitigation and the Role for Cooperation
Fiscal measures can play a key role in mitigating the extent of climate change and adapting
to limit the damage that remains. Of course, fiscal instruments are not the only way to reduce
GHG emissions, but can be particularly well targeted. Performance standards for cars, for
example, limit fuel used per mile traveled but do not charge drivers for the emissions from
the marginal mile traveled. Preferences and traditions in the relative use of regulatory and
18
fiscal instruments vary, but the best-targeted policy is to charge an appropriate price for GHG
emissions.
The classic prescription to deal with the externality at the heart of CC is to impose a ‘carbon
price,’ equal to the marginal social damage from emissions. This ensures that emitters’
decisions reflect the full social consequences and, not least, serves as an efficient anchor for
innovative activity. And what matters, as argued in International Monetary Fund (2008a, p.9)
is not simply, or even mainly, the initial level of such a price, but the confident expectation of
a modest but sustained increase over time. The future path of the carbon price, and its
credibility, are critical, for several reasons. In particular, since energy investments are
commonly made for the long term—possibly decades—and with substantial sunk costs,
efficient decision-making requires confidence on the future course of carbon prices. So too
do incentives to innovate. And current emissions are the counterpart of current extraction
decisions by owners of fossil fuels, which depend on future as well as current prices.
Pigovian policy requires a steady increase in the real carbon price.
Efficiency requires—absent other market failures—that this carbon price be the
same for all emissions, however and wherever they arise. The social damage from CO2
emissions being the same wherever in the world they arise, efficiency requires that marginal
abatement costs also be the same. This requires identical carbon prices: otherwise the same
emissions reduction could be achieved more cheaply by raising the carbon price on fuels, or
in regions, where it is low, and decreasing it where it is high. As such, the fully cooperative
approach involves a uniform carbon price in all countries, with cross-country transfers
addressing equity concerns. Country-specific transfers may also be required within countries
to address equity concerns as, in both developed and developing countries, increased fossil
fuel prices are likely to have a regressive impact. It should be noted, however, that
earmarking revenue from carbon pricing is generally undesirable—except that it may help
overcome political resistance.
A carbon price can be implemented in a number of ways: including through a carbon tax, by
cap-and-trade—allocate a fixed total of rights to emit, but allow them to be bought and
sold—or by hybrids combining features of each. There is a large literature on this instrument
choice problem, reviewed in IMF (2008a). The choice has implications, not least, for
international macroeconomic performance and adjustment. Under a global cap-and–trade
scheme, for instance, faster growth in one country will tend to drive up the permit price and
so have an adverse impact on other countries that tends to offset the traditional expansionary
effect through the trade route; under a common tax scheme, there may be a similar effect
through an increase in the price of the underlying resource, but the adverse spillover is likely
to be much less (McKibbin and Wilcoxen, 2004). Depending on how rights are initially
allocated across countries, moreover, cap-and-trade schemes can lead to significant
international flows, or even to Dutch disease problems for large sellers of permits.
19
One important aspect of mitigation—especially given the fiscal challenges discussed
elsewhere in this paper—is its potential as a source of government revenue. Receipts from
carbon pricing—whether as tax revenue or from auctioning emission rights—can ease
pressures on public finances, which could be used to support climate related R&D, prefund
future aging costs, or as discussed in Section IV, offset pressure on tax revenue as a direct
result from increased international competition. Revenue from carbon pricing may, for
instance, assist governments to cope with revenue pressures from international tax
competition or trade reform. How large this revenue might be remains uncertain. Estimates in
IMF (2008a) suggest that it might in some regions amount to 1-2 percent of GDP: sizable,
though by no means transforming the fiscal outlook.
It might be tempting to suppose that carbon pricing can thus yield a “double dividend” in the
sense of not only mitigating CC but also improving the overall efficiency of the tax system—
in which case it would be optimal to set the carbon price above the Pigovian level. But this is
much less clear-cut. For, in addition to the beneficial “revenue recycling” effect just
described, there is a “tax interaction” effect: carbon pricing will affect the distortions caused
by the pre-existing tax system. By raising the consumer price of energy-intensive goods, for
instance, it would have effects similar to a reduction in the after-tax wage, and thus reinforce
the distortionary impact of labor taxes—implying an optimal carbon price below the Pigovian
level. In any event, the best use of additional revenue from carbon pricing, including to offset
any adverse equity impact (discussed below) will vary with countries’ circumstances.
While the case for some degree of cooperation in dealing with CC is clear, many obstacles to
this remain (International Monetary Fund, 2008a):

Competitiveness and leakage —at the heart of the free-rider problem is each
country’s fear that unilateral action would disadvantage producers of energy-intensive
products (such as aluminum, paper, steel, and international transport) in world
markets. Furthermore, 25 countries cause about 80 percent of emissions, but wider
agreement is likely to be needed for efficient and effective mitigation. “Leakage”
(shifting of emissions to nonparticipants) is also a concern.

Implementation—how to assure each participant that others are meeting their
commitments? Furthermore, what account should be given to pre-existing taxes and
other measures?
There are a number of options to encourage cooperation in taking mitigation measures.
Rather than adopting a uniform carbon price, countries could adopt minimum carbon tax
rates. There has also been much discussion of border tax adjustments (BTA)— imposing a
carbon charge on imports from countries not levying one, and perhaps remitting the carbon
tax for exports. This has the merit of preserving mitigation in respect of domestic
consumption without impacting international competitiveness. Moreover, it is one of the few
credible devices by which countries implementing carbon pricing can encourage participation
20
by others: participants gain, presumably, from the BTA; and nonparticipants would then
benefit by imposing a carbon price themselves, since by doing so they would capture revenue
otherwise accruing to others. Against this, however, BTA risks hiding tariffs or export
subsidies, and may be WTO-inconsistent. It also raises many practical issues, including the
need to assess carbon prices implicit in taxes paid abroad (perhaps in a chain of production
activities across several countries). Overarching the issue is a need for greater coherence in
national energy tax policies. The diversity of fiscal and other instruments of energy policy
complicates cross-country comparisons, impeding effective coordination. There is scope in
many countries for taking inventory of significant measures in place, so as to assess their
coherence, transparency, and effectiveness.
C. Macroeconomic Effects of Mitigating Measures
What would mitigation measures of the kind above mean for macroeconomic performance?
The recent World Economic Outlook investigates this, using the 2007 version of the G-cubed
model (see International Monetary Fund, 2008b). G-cubed is a dynamic intertemporal global
general equilibrium model developed by McKibbin and Wilcoxen (1998) and is well suited
for evaluating the short-, medium-, and long-term effects of mitigation policies across
countries. Detailed modeling of regions helps account for differences in countries’ initial
income levels and potential growth rates. Disaggregated production structures summarize the
input-output relationships and sectoral cost structures. Forward-looking expectations
underscore the importance of policy credibility for inducing changes in behavior
(International Monetary Fund, 2008b, p.31).
The simulations assume that the goal of policymakers is to keep global emissions 96 percent
below the baseline of no-policy change, or achieve a 60 percent reduction from the 2002
level, in 2100. International Monetary Fund (2008b) compares the macroeconomic effects
under either a uniform carbon tax, under a cap-and-trade policy, or under a hybrid policy. In
addition to these main policy experiments, the model is used to explore implications of
policy coordination, country participation, technological improvements, and the robustness of
mitigation policies to macroeconomic shocks.
The focus is on the costs rather than the potential benefits of mitigation policies during the
three decades following their introduction. Simulation results in G-Cubed are largely
driven by assumptions about countries’ technologies, particularly their ability to substitute
away from emission-intensive inputs. Country-specific results in G-Cubed depend to a large
extent on assumptions about elasticities of substitution in production, consumption, and
trade, which jointly determine the incremental costs at which individual economies can
reduce their emissions.
In the policy experiment, all economies introduce a common carbon price in 2013 and
credibly commit to keeping it in place over the long run, adjusting the rate as necessary to
21
achieve the profile of global emissions at the levels mentioned above. The results for the
effects of a uniform carbon tax on real GDP are illustrated in Figure 6. There is considerable
cross-region variation, with the output loss being modest in most regions, but sizable in
China and the OPEC countries. After the imposition of the carbon tax, firms change their
technology, substituting away from carbon-intensive inputs and into capital (including noncarbon alternative technologies), materials, and labor. Households alter their consumption
patterns, also substituting away from carbon-intensive goods. With higher carbon prices
raising costs for firms, productivity and output decline. Aggregate investment falls because
the average marginal product of capital is lower in each region, while consumption declines,
following real incomes. The levels of real activity fall permanently relative to the baseline.
As discussed in more detail in International Monetary Fund (2008b), changes in national
levels of GNP and consumption reflect countries’ costs of reducing emissions. Each
economy’s marginal abatement costs (MACs) in G-Cubed depend on how intensely it uses
carbon-based energy to produce goods for domestic consumption and for export, which in
turn are driven by such factors as energy efficiency, factor endowments, and the production
and export structure.
The relatively high level of carbon intensity of the Chinese economy will be reduced as firms
and households use energy more efficiently. The same is true for OPEC members and the
United States, albeit to a lesser extent. Given a uniform carbon price, economies reduce
emissions up to the point at which they have the same MACs. Economies with lower MACs
undertake more emission reductions. China, in particular, reduces emissions by the most,
followed by the United States and OPEC members.
The macroeconomic effects of introducing a global cap-and-trade system—fixing a global
emissions level corresponding to the same reductions as above—are similar, the main
difference being in the international flows that arise as a consequence of international trade in
permits. For most economies, these transfers are small, and hence the macroeconomic effects
are similar to a uniform carbon tax; for China (a recipient), other emerging and developing
economies (payers), and OPEC members (recipients), transfers reach about 10 percent, –
2 percent, and 1 percent of GDP, respectively, by 2040. China receives the largest transfers
because it is comparatively inefficient in the use of energy and can reduce emissions at much
lower costs than other economies. Advanced economies, as well as other emerging and
developing economies, buy emission rights from China because emission reductions are very
costly for these countries.
22
Figure 6. Effects on Real GDP of a Uniform Carbon Tax
(Deviation from the baseline in percent)
United States
Japan
Eastern Europe and
Russia
Western
Europe
OPEC
China
Other developing and emerging
economies
0
-5
-10
-15
-20
-25
2013
20
30
40
Source: IMF, 2008b.
IV. CORPORATE INCOME TAX COMPETITION
A. Trends in Corporate Tax Rates and Revenue
Globalization reduces the ability to tax mobile factors of production, creating incentives for
tax competition (see International Monetary Fund, 2007). Specifically, as globalization
proceeds, countries are pressured to reduce corporate income tax (CIT) rates, to
attract/protect real investment and moderate incentives for tax avoidance (e.g., through
transfer pricing). Although the debate on tax competition usually focuses on corporate
income taxation, increased international mobility of labor (migration) could also lead over
time to erosion of the tax base for social security contributions and other taxes levied on
labor. Insofar as high-skilled labor is more mobile than low-skilled labor this would also
reduce the ability to use payroll taxation for redistribution purposes.
Indeed, there has been a marked decline in statutory corporate income tax rates in industrial
countries (Figure 7), emerging markets in Asia, Latin America, and Europe (Figure 8), and in
new EU member states (Figure 9). Nevertheless, corporate income tax revenue has held up
well, which could reflect a number of reasons:

Base broadening—indeed effective tax rates have declined less than statutory rates.
This could reflect in particular a trend to reduce, or in some cases eliminate, a
preferential tax treatment of debt financing.
23

The role of asset prices—asset prices can have a significant effect on revenue
buoyancy, which is not fully reflected in the calculation of cyclically-adjusted
balances.

A higher share of profits in the economy, increased volatility of profits (which can
affect favorably tax collection in the event of imperfect loss offset), and stronger
incentives for firms to incorporate.
Figure 7. Tax Competition in Industrial Countries
Average Corporate Income Tax Rates and Revenue in Industrial Countries
(Average across countries)
(In percent)
5
50
12
Statutory Tax Rate
In percent of total tax revenue
(right scale)
45
4
10
40
35
8
Effective Average Tax Rate
3
6
30
2
In percent of GDP
(left scale)
25
4
1
20
2
Effective Marginal Tax Rate
15
1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004
0
1980
Sources: Institute for Fiscal Studies and Fund staff calculations.
1985
1990
1995
2000
0
2005
Source: OECD Revenue Statistics 2006.
Figure 8. Tax Competition in Emerging Markets
Statutory Corporate Income Tax Rates and Revenue in Emerging Market Countries
(Average across countries)
(Averages across groups of countries, in percent)
10
35
In percent of total government revenue
(right scale)
8
Latin America and Asia
30
20
15
6
Overall
25
10
Europe
4
20
15
1995
1997
1999
2001
2003
2005
Sources: KPMG 's Corporate and Indirect Tax Rate Survey 2007 and University of Michigan.
2007
5
In percent of GDP
(left scale)
2
0
1990
0
1992
1994
Source: FAD database.
1996
1998
2000
2002
2004
2006
24
Debrun (2008) evaluates the potential links between asset prices and corporate income
revenue in G7 economies. The analysis is based on various econometric estimates of the
short-term elasticity of revenues to house and stock price cycles (over and above the effect
that the latter have on the business cycle). In general, the revenue effect is found to be
quantitatively important, which could explain why corporate tax revenue has held up well
despite lower statutory tax rates.
In many regions, corporate income tax competition does not take the form of lowering
statutory rates, but instead leads to the proliferation of special economic incentives, in
particular tax holidays. Despite the lack of conclusive evidence on their effectiveness in
attracting and sustaining investments (including FDIs), and despite their often significant cost
in terms of foregone revenues, tax incentives and tax holidays continue to proliferate
especially in developing countries.9
Figure 9. Tax Competition in Old and New EU Member States
(In percent)
Statutory Corporate Income Tax Rates in Old and
New EU Member States, 1995-2006
40.0
35.0
30.0
25.0
20.0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
15 old member states
10 new member states
Source: Keen, 2008.
Botman, Klemm, and Baqir (2008) compare the general tax provisions and investment
incentives in seven east-Asian economies—the Philippines, Malaysia, Indonesia, Lao,
9
Although there is considerable evidence that differences in international taxation affect the volume, location,
and character of FDI in developed economies—see Gordon and Hines (2002)—the evidence on tax holidays in
emerging markets is more negative, as detailed in Guin-Siu (2004).
25
Vietnam, Cambodia, and Thailand. To facilitate these comparisons, they calculate effective
tax rates, which consider the overall structure of taxation including the manner in which a
project is financed (debt versus equity), the length of tax holidays, the depreciation methods
and allowances, interest-deductibility rules, the general corporate income tax rate, and the
after tax profitability of an investment project in the different countries. The latter is assumed
to equal zero percent (giving the effective marginal tax rate), twenty, respectively fifty
percent. They find that investment incentives are broadly comparable in these countries and
reduce effective tax rates considerably (Figure 10).
In Sub-Saharan African countries too, corporate income tax rates have declined (although
they remain high by international comparisons), while revenue has remained stable
(Figure 11). The stability of revenue occurred despite a proliferation of incentives. In 1980,
3% of these countries had free zones with tax benefits, while in 2005, 45% did. During the
same period, the proportion of countries offering tax holidays rose from 45% to 71%.
Figure 10. Reduction in Effective Tax Rates From Receiving the Maximum Tax Holiday 1/
(In percentage points)
Figure 10b. Debt financed; plant and machinery;
Figure 10a. Equity financed; plant and machinery;
80
0
EMTR
EATR p = .20
EATR p = .50
60
-5
40
-10
20
-15
EMTR
EATR p = .20
EATR p = .50
-20
0
-20
Figure 10c. Equity financed; buildings;
Vietnam
Lao P.D.R.
Indonesia
Vietnam
Lao P.D.R.
Indonesia
Vietnam
Lao P.D.R.
Indonesia
Malaysia
Thailand
Cambodia
Philippines
Malaysia
EATR p = .50
-35
Thailand
-20
Cambodia
-15
EATR p = .50
Philippines
-5
-30
EMTR
EATR p = .20
40
30
20
10
0
-10
-20
-30
-40
-50
-10
EMTR
EATR p = .20
Malaysia
Figure 10d. Debt financed; buildings;
0
-25
Thailand
Cambodia
Philippines
Vietnam
Lao P.D.R.
Indonesia
Malaysia
Thailand
Cambodia
-40
Philippines
-25
Source: Botman, Klemm, and Baqir, 2008.
1/ EMTR refers to the effective marginal tax rate, which is calculated for an investment project that breaks even and which measures the size of the investment
conditional on its location. EATR refers to the effective average tax rate, which determines the location of investment. As depreciation methods and rates vary
between investments in plant and machinery respectively investment in buildings, these effective tax rates are calculated seperately.
26
Tax holidays are generally not well targeted, and are therefore regarded as the most
damaging form of tax incentives, posing significant dangers to the wider tax system. One
advantage of tax holidays—as opposed to other forms of tax subsidies—is that they provide
benefits up front. Indeed, Doyle and van Wijnbergen (1984) show that an initial period of tax
concessions followed by a gradually rising tax rate can be the outcome of a sequential
bargaining process between firms that incur fixed costs of investment and the government.
Nevertheless, although all forms of tax incentives carry some disadvantages, tax holidays in
particular are generally not recommended for the following reasons. First, tax holidays are
not cost effective because profits are exempted regardless of their amount. The most
profitable investments, which would have taken place in any event, benefit most, as shown in
Botman, Klemm, and Baqir (2008). Second, the same authors show that tax holidays are
most attractive for footloose industries that tend to exit the country at the end of the holiday
period. These industries are likely to bring the smallest benefit to the overall economy.
Instead, firms investing in long-lived assets, whose revenues may not fully recover costs
during the period of the holiday, benefit least from tax holidays. Third, tax holidays are open
to abuse and provide many opportunities for tax avoidance (for instance by using transfer
pricing or other devices to shift earnings into holiday companies). This is especially true for
countries with weak revenue administrations and insofar as leakage occurs from special
economic zones. Finally, if the home country of the foreign investor operates a worldwide
system of taxation, without tax sparing, then the impact of the holiday may be diluted once
profits are repatriated.
Figure 11. Tax Competition in Sub-Saharan Africa
(In percent)
20.0
3.0
15.0
2.0
10.0
1.0
5.0
0.0
0.0
CIT Revenue / GDP
Source: Keen, 2008.
Average CIT rate (right axis)
2004
4.0
2002
25.0
2000
5.0
1998
30.0
1996
6.0
1994
35.0
1992
7.0
1990
40.0
1988
8.0
1986
45.0
1984
9.0
1982
50.0
1980
10.0
27
Because of these reasons, it is frequently argued that it is more efficient to have a low
uniform corporate income tax rate than selective incentives for companies through holidays.
In case there is a need for further investment incentives, these are best targeted if directly
conditioned on the investment activity, for example, by offering accelerated depreciation.
However, as argued in Botman, Klemm, and Baqir (2008), without regional cooperation to
move in this direction, it will be difficult to achieve unilateral reform, as replacing holidays
with a general reduction in the CIT rate and offering accelerated depreciation will either not
provide the same incentives for localization of new investment, or be very costly.
B. Globalization, Tax Rates, and International Cooperation
Are these trends of lower statutory corporate rates and the proliferation of special incentives
likely to continue? Is there a race to the bottom, and is this good? In general, a certain degree
of tax competition can be welfare-enhancing, but corporate revenue is still an important
source of revenue for many countries, there are equity concerns, and there is a clear risk of
beggar-thy-neighbor policies.
Policy coordination has proven to be difficult not least because it is unclear what form it
should take. Indeed, harmonization of tax rates may be unnecessary, while in principle a
minimum rate could benefit all countries. However, acting on rates alone is not enough as the
tax bases and/or procedures matter as well. Furthermore, some countries gain from tax
competition, while others lose, and compensating international transfers may be hard to
arrange.
Rather than trying to achieve an international uniform corporate income tax rate, cooperation
should aim to avoid harmful tax practices. In this regard, the main initiative is the OECD
harmful tax practice project, which has come to focus on information sharing. In addition,
codes of conduct, or treaties, proscribing certain practices have recently been adopted (or are
under discussion) in the EU, Central America-Panama-DR, and other regions (see Keen,
2008).
Globalization has not only been associated with a reduction in corporate income tax rates.
Trade liberalization has also resulted in pressure on tariff revenue, which is still an important
source of revenue in many developing and emerging market economies—about one-quarter
of tax revenue in Sub-Saharan Africa, for example (Figure 12). In the early stages, trade
liberalization may actually increase revenue from trade taxes as a result of tariffication,
removal of exemptions, and cutting prohibitive tariffs. However, at some point further
liberalization will reduce trade tax revenue.
Trade liberalization may thus be blocked, or become less beneficial, unless revenue can be
recovered from domestic sources. The conventional view has been that revenue recovery
should occur by matching tariff cuts with increases in indirect taxes, so that consumer prices
28
are unchanged, production efficiency improves, and revenue increases. However, there are a
number of qualifications to this argument, including the treatment of imported intermediates
and recent suggestions that tariffs may be preferable to VAT in that they reach the informal
sector, although it should be noted that VAT is also imposed at the border and is equivalent
to an import tariff if the VAT is not credited (see Keen, 2008).
Have countries in practice managed (or chosen) to recover lost trade tax revenues by
increasing domestic taxes? Baunsgaard and Keen (2006) find for a large panel of low and
middle-income countries during 1980-2000, that for middle-income countries, recovery from
reductions in trade tax revenue is about one-for-one, but recovery is low—about 30 percent,
at best—for low-income countries. Furthermore, there appears to be no systematic tendency
for the presence of a VAT, by itself, to improve recovery. The choice of revenue recovery
measures following trade liberalization does not require international cooperation, but instead
is best left to the country implementing the reform.
Figure 12. Trade Liberalization and Tax Revenue in Low and Middle-Income Countries
(In percent)
Low-income countries
Middle-income countries
25
25
Total tax revenue
Total tax revenue
Trade revenue
20
20
15
15
10
10
5
5
Trade revenue
0
0
1975-79
1980-84
1985-89
1990-94
1995-2000
1975-79
1980-84
1985-89
1990-94
1995-2000
Source: Keen, 2008.
V. CONCLUSIONS
Spillover effects of macroeconomic policies become more pronounced as globalization
proceeds. Externalities, and measures to address them, are particularly pronounced in the
fiscal area, raising the question to what extent policy cooperation is desirable. This paper has
discussed three areas of increased fiscal interdependence: global aging, global warming, and
tax competition.
29
The world faces unprecedented demographic change over the next decades, which, if left
unaddressed, will lead to unsustainable debt trajectories in advanced, emerging, and
developed economies. The fact that this is a global, rather than an individual country,
challenge implies rapidly rising real interest rates and therefore debt-service costs. Analyses
using the IMF’s Global Fiscal Model suggest that spillover effects through financial market
channels dominate those through trade channels, giving rise to negative externalities from
population aging. Maintaining sustainable public finances requires creating fiscal space for
age-related spending which should be gradual and broad based, relying on revenue (base
broadening, indirect taxes) and expenditure measures (entitlement reform, rationalization of
current government spending), while avoiding higher direct taxation. The composition of the
package is best left to the country implementing the reform. However, international
cooperation on the timing of implementing such a country-specific package would yield
substantial benefits. We argued that an early, cooperative response through a package of
fiscal measures will minimize output and consumption losses, while complementary
structural reforms are best handled at the individual country level.
Similarly, climate change is a global externality requiring an early cooperative fiscal
response, particularly regarding mitigation measures, while adaptation measures are best left
to the private sector, possibly with support from individual governments. The cooperative
response should feature a uniform carbon price, increasing over time. Such a response would
have significant and permanent macroeconomic implications, especially for countries with
low marginal abatement costs. To encourage cooperation, rather than adopting a uniform
carbon price, countries could adopt a minimum carbon tax rate, possibly in combination with
selective border tax adjustments— imposing the tax on imports, and, perhaps, remitting the
carbon tax for exports.
Globalization also puts pressure on the taxation of mobile factors of production and on
revenue from import tariffs. This can be observed in declining statutory corporate income tax
rates or the proliferation of special incentives in OECD economies, emerging markets, and
developing countries. Trade liberalization has also led to a decline in tariff revenue for lowand middle-income countries. Some degree of tax competition may be beneficial and
realistically cooperation should not aim at harmonization of tax rates, bases, or procedures,
but instead focus on the prevention of harmful tax practices. In addition, the implementation
of revenue recovery measures following trade liberalization is best left to individual
countries.
These three challenges, and the measures to address them, pose important questions for
social policy and coherence, within countries, between generations, and across nations.
30
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