Fiscal autonomy and tax competition
4. STATE INCENTIVES UNDER TA X COMPETITION
Important insights into the potential solutions to the problem of tax competition can be gleaned from a closer look at the strate-gic landscape that states face under conditions of tax competition.
This analysis reveals that while tax competition represents a more complex problem than frequently assumed, it is not intractable.
Economists and political scientists have used game theoretic tools to analyse the incentive structures of states under tax compe-tition.53 While it abstracts away some relevant complexities of tax competition—for instance, by treating states as unitary actors—
game theory can serve as a useful heuristic to better understand the dynamics of international fiscal policy.54 In this section, I will present and comment on some of its central findings with respect to tax competition. In doing so, we can look at tax competition generally without distinguishing between the three forms of tax competition introduced in section 2.
My description of the phenomenon of tax competition thus far might suggest that state attempts to attract capital from abroad are
53. I thank an anonymous referee for pushing me to say more on this point.
54. Cf. Rixen, The Political Economy of International Tax Governance, 14.
individually rational but collectively suboptimal. And indeed, sev-eral if not most game-theoretic analyses have presented tax com-petition as a game of prisoner’s dilemma.
In a symmetric case as depicted in table 1.1, this analysis is con-vincing. Independently of the other country’s fiscal policy, each country has an incentive to defect—that is, to lower its tax rates in order to poach or lure tax base from its neighbour. Despite the fact that the Pareto-optimal outcome is the cooperative one, where the two countries do not compete on taxes, the suboptimal Nash equi-librium where they will end up is that of tax competition.55
However, the symmetric case does not adequately repre-sent what is going on in the real world. More realistically, when one allows for countries of different sizes, the situation and the conclusions of the model change significantly. As Bucovetsky first pointed out, under tax competition, small countries have an
Table 1.1 payoffs under symmetric tax competition
Country B Country A
Tax Under-tax
Tax 0; 0 –10; 5
Under-tax 5; –10 –4; –4 (Nash eq.)
55. Analyses that see tax competition as a problem of this sort include Eckhard Janeba and Wolfgang Peters, ‘Tax Evasion, Tax Competition and Gains from Nondiscrimina-tion: The Case of Interest Taxation in Europe’, Economic Journal 109, no. 452 (1999):
93–101; Mark Hallerberg and Scott Basinger, ‘Internationalization and Changes in Tax Policy in OECD Countries. The Importance of Domestic Veto Players’, Comparative Political Studies 31, no. 3 (1998): 321–52. The model that has become the baseline model of tax competition in the economics literature, while not using the language of the pris-oner’s dilemma, comes to the same conclusion. See Zodrow and Mieszkowski, ‘Pigou, Tiebout, Property Taxation’. We shall look at this model in more detail in chapter 3.
advantage over large ones.56 In this case, the payoff structure of the two countries looks as shown in table 1.2.
While it is true that the Nash equilibrium is still the collec-tively suboptimal scenario of tax competition, it is no longer true that both countries prefer the cooperative outcome to the Nash equilibrium of tax competition. Why is this so? What explains the bias that size introduces into the payoffs from tax competition?
The answer to this question lies in the interaction of two differ-ent effects.57 First, the tax rate effect: when a country lowers one of its tax rates, it will collect less revenue ceteris paribus, in this case given the same tax base. Second, the tax base effect: when a country lowers its tax rate, the resulting capital inflows will add to its tax base and thus its revenue. Which of the two effects outweighs the other depends to a large extent on the size of the country. For large countries, the tax rate effect dominates, since they lose substantial domestic revenues while attracting relatively small capital inflows.
For small countries, however, the tax base effect dominates—their gains from capital inflows tend to more than compensate for the
56. See Bucovetsky, ‘Asymmetric Tax Competition’.
57. For the treatment of these effects, see also Vivek H. Dehejia and Philipp Genschel, ‘Tax Competition in the European Union’, Politics & Society 27 (1999): 408; as well as Rixen, The Political Economy of International Tax Governance, 43.
Table 1.2 payoffs under asymmetric tax competition
Small country Big country
Tax Under-tax
Tax 0; 0 –10; 5
Under-tax 3; –8 –5; 3 (Nash eq.)
lost revenue. This explains why small countries benefit from tax competition and have no interest in shifting to a world of tax coop-eration represented by the top-left of table 1.2. By definition, then, this game is no longer a prisoner’s dilemma.58
As argued convincingly by Dehejia and Genschel,59 it is this second game rather than the prisoner’s dilemma that we should use as a heuristic to think about state incentives under tax com-petition. It is no coincidence that most tax havens today are small countries. And it is not surprising, either, that it is countries such as Switzerland, Luxembourg, and Singapore that are consistently blocking reforms towards more tax cooperation. While tax com-petition is collectively detrimental, it is beneficial for them. Dehe-jia and Genschel take the analysis one step further by asking why large countries do not use their geopolitical weight to bring tax havens into line.60 The answer, they suggest, has two components.
First, merely increasing the number of cooperators is not enough.
As long as there is even one tax haven left, there will be massive capital outflows from the cooperating countries. This is what the authors call the ‘outside world constraint.’ Second, changing the payoffs of each tax haven is costly. The more of these transfer pay-ments one makes to strengthen the coalition, the smaller the gains are to the large countries as the initiators of tax cooperation. In other words, Dehejia and Genschel conclude, tax competition poses a dilemma: ‘either actors reduce intracoalition conflict by selectively excluding potential claimants on side payments, but then the outside world constraint becomes more stringent, or they
58. Rixen refers to this second game as an ‘asymmetric prisoner’s dilemma’. Yet, since he recognizes the change in incentives, the difference between his analysis and mine is merely terminological. Rixen, The Political Economy of International Tax Governance, 45.
59. See Dehejia and Genschel, ‘Tax Competition in the European Union’.
60. Dehejia and Genschel, ‘Tax Competition in the European Union’, sec. 4.
mitigate this constraint by extending the coalition to outsiders, but then any potential gains are eroded by intracoalition transac-tions costs needed to ensure these gains.’61
This model allows us to refine our understanding of tax com-petition. In particular, the insights it offers into the incentives of various types of countries will be useful to assess the feasibility of various reform proposals. Let us look at some of the conclusions we should draw from this analysis.
First, it is useful to highlight that the distinction with respect to the different incentive structures of small versus large countries cuts across the distinction between the effects that tax competition has on developed versus developing countries. This leaves us with a ty-pology of four different categories of countries, shown in table 1.3.
61. Dehejia and Genschel, ‘Tax Competition in the European Union’, 426.
Table 1.3 the effect of tax competition on different types of countries
Country size (population) Level of
development
Large Small
High-income France,
Germany, Japan, United States, etc.
Ireland, Luxembourg, Singapore, Switzerland, etc.
Low-income Argentina,
Brazil, India, Mexico, etc.
Cambodia, Haiti, Namibia, Panama, etc.
Note first what table 1.3 does not tell us. It does not allow us to say that tax havens only occur in a particular subset of the four different categories. While small countries have the structural advantage described above, large countries are doing everything they can to level the playing field in the game of tax competition.
The United States, Germany, or Japan are perhaps not the first countries that come to mind when one thinks about tax havens, but they have managed to create niche loopholes to stem the tide of capital outflows to smaller countries. All of the three countries just mentioned rank in the top ten of the ‘Financial Secrecy Index’
constructed by the NGO Tax Justice Network, which has been de-veloped as a ‘tool for understanding global financial secrecy, tax havens or secrecy jurisdictions, and illicit financial flows.’62
What table 1.3 does allow us to do is to refine our understanding of the winners and losers from tax competition in a way that mat-ters for the regulatory response. Large low-income countries lose out under tax competition; as the last section showed, both aspects of their autonomy prerogative—size of the public budget relative to GDP and level of redistribution—are violated. Large high-income countries are often able to protect the level of their revenues. They still tend to lose out under tax competition by paying the price of higher inequality. What is more, table 1.3 allows a more nuanced perspec-tive on small countries. On the one hand, small high-income countries are clear winners from tax competition, and condemning their role in the international fiscal system appears to be the most straightfor-ward case, ethically speaking. The case of small low-income countries, on the other hand, is more complex. There are some small low-income countries—from the ones named in table 1.3, Panama is
62. See Tax Justice Network, ‘Financial Secrecy Index’, accessed 17 February 2014,
<http://www.financialsecrecyindex.com/>.
an example—that actively use their size advantage to compete for foreign tax base. Both for them and for larger low-income countries that attempt to do the same—albeit less successfully due to their size—a tricky question arises: Should one tolerate their tax competi-tion practices as a way for them to pull themselves out of poverty?
In other words, from a collective viewpoint, is the case for shutting down a tax haven less robust when that tax haven is a low-income country? These are questions that the regulatory response to be defended in subsequent chapters of this book will have to take into account.
Second, the game-theoretic analysis presented in this section provides an explanation for why the prediction of a race to the bottom formulated by economic theory does not hold in practice.
As Dehejia and Genschel point out,63 even for small countries, there will be a point where lowering the tax rate further will no longer be advantageous. Why? Because the lower the tax rate, the lower the positive tax base effect for small countries; at some point, it will no longer suffice to compensate the tax rate effect. ‘The com-petition for foreign tax base is subject to diminishing returns and therefore is self-limiting.’64
Third, the asymmetry in incentives to compete for taxes be-tween small and large states shows that, politically, the solution will have to come from larger states. Small states, even though they will of course pay lip service to ideas of tax justice, do not have an interest in creating a framework of tax cooperation. The impor-tance of this point can hardly be overstated.
Fourth, and finally, the dilemma of tax cooperation formulated by Dehejia and Genschel offers a clue as to what large countries must
63. See Dehejia and Genschel, ‘Tax Competition in the European Union’, 409.
64. See Dehejia and Genschel, ‘Tax Competition in the European Union’, 409.
and can do to change the payoff structure of small countries and get them on board for reform. They argue, you recall, that tax coopera-tion is likely to be ineffective or at least too costly, due to the outside world constraint. As long as there is at least one destination for capital to flee to, any multilateral cooperation to raise tax rates will be futile.
However, and I take it this weakens the dilemma posed by Dehejia and Genschel somewhat, rates are only one of the fiscal parameters that tax cooperation can operate on. Indeed, given that this book is based on the idea of fiscal autonomy of states, co-operation on rates and certainly outright rate harmonization are not attractive options precisely because they would violate this autonomy. The other parameter that large states pursuing tax co-operation can work on is the tax base. Here, they have more room for manoeuvre. For instance, an important step towards changing the payoff structure of tax havens would be to stop pushing them into competing for mobile tax base, as capital exporters are doing today by setting the floor of tax rates on worldwide income at zero.
At present, to return to an earlier example, institutional arrange-ments such as the deferral on foreign income of U.S. multination-als not only encourage other countries to compete for the tax base in question but also the United States de facto forfeits its residual right to tax that base if the tax haven chooses not to tax it. In other words, the United States in effect voluntarily limits the reach of its corporate tax base to its own territory—note that this does not apply to its personal income tax, whose base is worldwide income.
More generally, abolishing deferral and exemption arrangements reduces the pull of tax havens because the outflowing capital would not actually escape the fiscal net. The outside world constraint is considerably weaker if the tax base is worldwide income.65
65. To avoid double taxation, a credit system could be put in place. See Rixen, The Political Economy of International Tax Governance, 32–43.
This last point will be particularly relevant to my later discus-sion of the feasibility of different reform proposals. But before asking the question of what is feasible, the next chapter will turn to the issue of what is ethically desirable. Once we know what an ethically acceptable framework for international taxation would be, we will then be in a position to analyse the feasibility of various strategies to get there.
5. CONCLUSION
This opening chapter has put in place the normative and empiri-cal premises for regulating tax competition. Taking as a given that states are political units with a considerable amount of autonomy, I have spelt out this autonomy in the fiscal realm as a prerogative to set the size of the public budget relative to GDP, as well as to determine the level of redistribution. For now, I have assumed that the autonomy prerogative rests on democratic foundations, with governments making choices that reflect the preferences of their citizens. This assumption will be relaxed in chapter 4.
Second, the chapter has given an overview of the various types of tax competition and how they work. A distinction has been drawn between the poaching of foreign tax base, on the one hand, where the tax base moves from one country to another while the owner of the capital in question stays put—as in the cases of in-dividual tax evasion, as well as profit shifting of MNEs—and the luring of foreign tax base, on the other hand, where owner and cap-ital move together, as in the case of FDI.
Third, I have outlined the ways in which tax competition is problematic from an ethical perspective. Most importantly given the normative premises of this book, tax competition undermines
the fiscal autonomy of states. While high-income countries suffer mostly in terms of a more regressive tax structure, low-income countries also lose out on government revenues. In addition, this asymmetry means that tax competition tends to exacerbate income differentials between rich and poor countries.
Finally, I have relied on game theory to sharpen our under-standing of the incentives of states to engage in tax competition.
It turns out that small countries have a structural advantage under tax competition that will make them reluctant to enter into tax cooperation. Keeping this insight in mind will be key to devel-oping a regulatory framework for tax competition in subsequent chapters that is not only ethically sound but also feasible.
Chapter 2