Tuesday, July 17, 2007

The perils of tax competition

Healthy market competition allows consumers to choose between suppliers of goods and services. This keeps companies on their toes, it keeps prices down, keeps quality high, and stimulates innovation. Most people would say it is a good thing.

But there is another kind of competition, an altogether different proposition. It is tax competition: the process by which countries (or states in a federation) vie with each other to attract mobile capital by dangling tax breaks, subsidies, and other forms of special incentive. Here, the healthy processes involved in normal market competition simply don’t apply. Citizens (except for a very wealthy globe-trotting tiny minority) cannot shop around between states to choose which one will provide them with the best public services. The incentives that result from tax competition do not enhance market efficiency, but instead they undermine it. For one thing, they completely distort Ricardo’s theory of comparative advantage, whereby investment flows to where it is most productive. Special, sectional exemptions fostered by tax competition are particularly pernicious and distortionary. As Greg Leroy said in a recent TJN newsletter (vol. 2 No. 4) describing an “economic war” that between U.S. states:

The bottom of the iceberg – in every sense of the word – is tax breaks. Those granted by states – income, sales and excise – are the least visible, least accountable, and most corrosive ways states fund economic development.

Ah, but the supporters of tax competition will argue, but governments need discipline, and external pressure to lower tax rates is a good way of doing this. Well, TJN does not have a position on whether any given country should have lower or higher tax rates: it is not for us, or any other interest group, to dictate how countries should conduct their domestic tax policies. But TJN does have a position on tax competition: we oppose it. The idea that external downwards pressure on taxation from tax competition is needed to “correct” the results of choices made by domestic electorates reveals a deep contempt for the very idea of democracy.

Tax competition is biting, and the threats to governments -- particularly the poorest ones that are least well equipped to deal with the pressures – appears to be growing. In a speech in July, deputy IMF managing director Murilo Portugal highlighted some of these challenges, and outlined some of the necessary steps forward, including the need for a global response:

Evidence of the impact of heightened tax competition for capital has been mounting. In the OECD countries, and the EU specifically, statutory corporate tax rates have declined sharply over the past decade. . . a shared feature of all four key challenges to fiscal sustainability—aging, climate change, globalization, and fiscal risks—is that they transcend the boundaries of national policymaking. The fact that large parts of the world economy will face the economic and fiscal consequences at the same time implies the danger of beggar-thy-neighbor policies, or, alternatively, scope for gains from cooperation, as we will discuss in more detail later. Similarly, many of the largest fiscal risks many countries face today are of a transnational nature, particularly those stemming from the financial markets.

A special section on tax competition is now up on our website. It exposes some of the fallacies that lie behind the arguments of those who advocate tax competition and who downplay its significance. It provides some pointers as to what the next steps need to be.

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