European Commission
Taxation and Customs Union
TAX COMPETITION IN THE EU
LOUVAIN, 30 March 2007
Carola Maggiulli
DG TAXUD
European Commission
Presentation Louvain
European Commission /
Taxation and Customs Union
Basic model of tax competition
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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)
Presentation Louvain
European Commission /
Taxation and Customs Union
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
European Commission /
Taxation and Customs Union
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:
C  f ( K )  (r  t ) K  r K  h
consumption is equal to wage income plus savings minus taxes paid
Presentation Louvain
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Taxation and Customs Union
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)
-
U P ( P, C )
1
U C ( P, C )
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
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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)
fK  t  r
- 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)
f
1

t
f KK
Presentation Louvain
European Commission /
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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)
UP
1

UC 1  K
where εK is the elasticity of capital to the tax rate defined as
(5)
K  
k t
t
 
 0, sin ce
t k
k  f KK
Presentation Louvain
f KK  0
European Commission /
Taxation and Customs Union
Basic tax competition model: underprovision of
public goods
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-
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(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
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Taxation and Customs Union
Basic tax competition model: race to the bottom
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-
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
European Commission /
Taxation and Customs Union
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)
1) 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
European Commission /
Taxation and Customs Union
Extensions of the basic model
•
Relaxation of the simplifying assumptions does not change the main
conclusions of BTCM, with a few important exceptions
1) 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
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Taxation and Customs Union
Extensions of the basic model 2
2) Assymmetric countries
Wildasin (1999), Bucovetsky (1999)
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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
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Taxation and Customs Union
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 labourleisure 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
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Taxation and Customs Union
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
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Taxation and Customs Union
6) Leviathan governments
- BMTC assumes that governments 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
European Commission /
Taxation and Customs Union
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)
UP
1 

UC
1  K
-
-
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 countrylevel foreign ownership shares and CIT rates ―> does not yet prove that tax exporting effect
eliminates tax competition
Presentation Louvain
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Taxation and Customs Union
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
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Taxation and Customs Union
Political economy considerations
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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
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Taxation and Customs Union
Positive and normative implications
1)
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
European Commission /
Taxation and Customs Union
Evolution of average statutory corporate tax rates in
the EU-25, EU-15, NMS-10 and non-EU OECD-6 (1995-2006)
40
38,0
38,1
37,2
37,2
37,8
37,2
36,7
36,5
35
35,0
35,9
35,3
35,0
35,6
34,7
34,6
35,2
33,9
34,6
34,6
34,4
34,4
34,4
33,8
33,3
32,6
32,1
31,9
31,4
31,1
30,6
30,4
30
30,0
30,2
29,6
29,7
29,4
29,5
28,7
27,4
27,4
27,1
26,2
25,5
25,9
25
23,8
21,5
20,6
20,4
20
1995
1996
1997
1998
1999
EU-25
2000
EU-15
2001
2002
NMS-10
Presentation Louvain
2003
Non-EU OECD-6
2004
2005
2006
European Commission /
Taxation and Customs Union
Evolution of average statutory corporate tax rates in the EU-13
(exluding Lux. and Denm.) and Non-EU OECD-6 (1979-2005)
55%
50%
45%
40%
35%
30%
25%
20%
15%
AVERAGE EU-13
AVERAGE Non-EU OECD-6
Presentation Louvain
20
05
20
03
20
01
19
99
19
97
19
95
19
93
19
91
19
89
19
87
19
85
19
83
19
81
19
79
10%
European Commission /
Taxation and Customs Union
Present discounted value of depreciation allowances in the EU-13
and non-EU OECD-6 (1995-2005)
79%
78%
77%
76%
75%
74%
73%
72%
71%
70%
1995
1996
1997
1998
1999
AVERAGE EU-13
2000
2001
2002
2003
AVERAGE NonEU-OECD6
Presentation Louvain
2004
2005
European Commission /
Taxation and Customs Union
Present discounted value of depreciation allowances in the EU-13 and
Non-EU OECD-6 (1979-2005)
84%
82%
80%
78%
76%
74%
72%
70%
AVERAGE EU-13
AVERAGE NonEU-OECD6
Presentation Louvain
20
05
20
03
20
01
19
99
19
97
19
95
19
93
19
91
19
89
19
87
19
85
19
83
19
81
19
79
68%
European Commission /
Taxation and Customs Union
Evolution of the effective average (EATR) and marginal (EMTR)
corporate tax rates in the EU-13 and non-EU OECD-6
35%
30%
25%
20%
15%
10%
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
EATR AVERAGE EU-13
EATR AVERAGE NonEU-OECD6
EMTR AVERAGE EU-13
EMTR AVERAGE NonEU-OECD6
Presentation Louvain
2005
European Commission /
Taxation and Customs Union
Evolution of the effective average (EATR) and marginal (EMTR)
corporate tax rates in the EU-13 and Non-EU OECD-6 (1979-2005)
40%
35%
30%
25%
20%
15%
20
05
20
03
20
01
19
99
19
97
19
95
19
93
19
91
19
89
19
87
19
85
19
83
19
81
19
79
10%
EATR AVERAGE EU-13
EATR AVERAGE NonEU-OECD6
EMTR AVERAGE EU-13
EMTR AVERAGE NonEU-OECD6
Presentation Louvain
European Commission /
Taxation and Customs Union
Evolution of the dispersion (standard deviation-SD) of the EATR
and EMTR in the EU-13 and non-EU OECD-6
0,09
0,08
0,07
0,06
0,05
0,04
0,03
0,02
0,01
1995
1996
1997
1998
1999
2000
2001
2002
2003
EATR SD EU-13
EATR SD NonEU-OECD6
EMTR SD EU-13
EMTR SD NonEU-OECD6
Presentation Louvain
2004
2005
European Commission /
Taxation and Customs Union
Evolution of the corporate income tax revenues as % of GDP in
the EU-15 and the NMS-10 (unweighted averages)
Corporate income tax, % of GDP
4
3,7
3,5
3,3
3,3
3,4
3,4
3,3
3,1
3,0
3,0
3
2,9
2,7
2,6
2,6
2,6
2,5
2,5
2,4
2,5
2000
2001
2,6
2,7
2,7
2002
2003
2004
2
1995
1996
1997
1998
1999
EU-15
NMS-10
Presentation Louvain
European Commission /
Taxation and Customs Union
Evolution of implicit tax rates (ITR) on labour,
capital and consumption in the EU-25
45
40
35
30
25
20
15
1995
1996
1997
1998
ITR Capital
1999
ITR Labour
2000
ITR Consumption
Presentation Louvain
2001
Tax-to-GDP
2002
2003