Why is There No Race to the Bottom in Capital Taxation?

Abstract

This article explains the absence of a race to the bottom in capital taxation by analyzing fiscal competition under budget rigidities and tax equity constraints (fairness norms). We outline a political economic model of tax competition that treats the outcome of tax competition as one argument in the governments utility function, the others being public expenditure and tax equity. In accordance with previous theoretical research, tax competition tends to cause a reduction in taxes on mobile capital and an increase in the tax rates on relatively immobile labor in our model. Yet, our model predicts that governments do not fully abolish taxes on mobile capital. Instead, the government being least restricted by budget constraints and equity norms cuts tax rates to levels slightly below the lowest tax rates of those countries, in which governments are more constrained, where effective constraints are country size, budget rigidities and fairness norms. Analyzing data from 23 Organization for Economic Co-operation and Development countries between 1975 and 2004 we find empirical support for the hypotheses derived from our theoretical model.A striking feature of international tax competition is the fact that independent jurisdictions share a mobile tax base. As a consequence, a country lowering its capital tax rate attracts an immediate inflow of capital, thereby reducing the tax base of other countries. These respond to the shrinking tax base and to declining tax revenues by lowering their capital tax rate to competitive levels. In equilibrium, tax rates on mobile capital approach zero in all countries. This result has become popular under the ''race to the bottom'' hypothesis. 1 Yet, tax revenues are for governments what buoyancy is for swimmers: vital. As a consequence, the early models of tax competition-models predicting capital tax rates converging to zero-sent alarming shock waves to politicians. These dire expectations were fueled by political scientists who predicted that governments will find it Authors' note: For helpful comments we thank Rob Franzese, Steffen Ganghof, Mark Hallerberg, and Jude Hays. Replication data and Stata do-file can be downloaded from: http://www.polsci.org/pluemper/replication.html.1 See Wildasin (1989); Wilson (1986); and Zodrow and Mieszkowski (1986). Wilson (1999) and Wilson and Wildasin (2004) provided for comprehensive surveys on subsequent research. The zero capital tax equilibrium was most prominently described by Frey

How Socialization Attenuates Tax Competition

“…20 Tax competition is widely believed to occur in Switzerland, and anecdotal examples abound. For instance, in 2011 the cantonal government of Zurich proposed a tax reduction for people 11 Hays 2003;Basinger and Hallerberg 2004;Plümper, Troeger, andWinner 2009. 12 Brueckner 2003;Franzese and Hays 2007a.…”

“…26 A general problem in this debate is that a high share of wealthy people can be both a cause and a consequence of tax reforms, especially in Switzerland, where voters can influence tax decisions with direct democratic rights. See Schmidheiny 2005. 27 Hallerberg and Basinger 1998;Swank and Steinmo 2002;Hays 2003;Basinger and Hallerberg 2004;Swank 2006;Plümper, Troeger, and Winner 2009;Cao 2010. 28 Radaelli and Kraemer 2008;Genschel, Kemmerling, and Seils 2011;Genschel and Schwarz 2011. 29 Braun and Gilardi 2006;Simmons, Dobbin, and Garrett 2006;Dobbin, Simmons, and Garrett 2007;Gilardi 2012.…”

Tax Reforms in Latin America in an Era of Democracy

“…This feature will allow us and other researchers to examine the effect of the reforms that have taken place on the neutrality and efficiency of the system and to gauge the effort of each country in enhancing those characteristics in their respective tax systems. 7 An abbreviated list from only the past decade includes Steinmo and Swank (2002), Basinger and Hallerberg (2004), Ganghof (2006), Hays (2009), Plümper, Tröger and Winner (2009), and Genschel and Jachtenfuchs (2011. 8 For this reason, it would be inconvenient to add up both datasets to perform an econometric analysis.…”

Theories of Policy Change and Variation Reconsidered: A Prospectus for the Political Economy of Public Policy

“…One claim is that countries will not be able to tax mobile capital because it can jump ship, but a line of work in comparative political economy finds that this does not happen: countries carry on taxing (see review and test in Plümper et al 2008). What constrains policy makers is a set of national factors, such as the size of the country, norms about fairness and budget constraints.…”