Globalization and tax competition

1. Globalization and tax competition Alexander W. Cappelen Econ 4620

2. Plan • What is globalization? • How does globalization affect pre-tax income inequality? • How does globalization affect redistributive policy? • Possible solutions.

3. Globalization • What is globalization? • Economic integration • Increased international mobility of capital, commodities/services and people. • But globalization also has other, social and cultural dimensions. • Two types of causes • Technological and social changes • Reduced costs of transportation and communication • Lower social barriers and increased language skills. • Political reforms • Reduction in import tariffs and other barriers to trade. • Increased number of market economies.

4. What is new about the current globalization process? • Globalization is not new phenomenon. • According to some measures the world was equally integrated before the first world war. • The process of globalization is different today. • It is primarily capital, not labour that has experienced increased international mobility. • The composition of trade has changed • Intraindustri trade • The size to the welfare state and the average tax levels have increased.

5. Globalization and development • Globalization creates a potential for growth and development. • Increased trade and international investments give new countries access to • New technology • New products • New markets • New information

6. What are the consequences of globalization? • As a result of economic integration the world has • Experienced a unique growth in international trade • Increased economic growth • Reduced national autonomy • The growth has not been equally distributed • Increased inequality? • Nationally? • Internationally?

7. Increased pre-tax inequality • There is considerable evidence that income inequality has increased in the developed countries • Globalization can create increased pre-tax inequality in at least three ways: • Equalization of international factor prices. • The way level of unskilled workers might fall while the wage level of the high skilled might increase as a result of trade with less developed countries. • However, the major part of international trade takes place between rich industrialized countries.

8. Cont. • Reduced power for the labor unions. • Firms can move their production to other countries and this increases their bargaining power with respect to the labor unions. • The winner takes all society • In some markets we have ”winner”. When markets are integrated several national winners are replaced by one international winner.

9. Globalization and redistribution • Globalization will also reduce the governments ability finance welfare services and redistribute income. • Economic integration and increased mobility makes it easier for mobile tax bases to move to another country. • This gives rise to so-called tax competition between countries. • A ”race to the bottom” • Cross-border shopping and capital taxation

10. A simple model • Consider an economy which produces a homogenous output using capital K and labor L, according to the linearly homogenous production function f(K, L). • We have that • fK = r • fL = w • The aggregate supplies of labor and capital are constant. Ensures that factor prices are constant.

11. Cont. • The labor supply, X, of an individual is a product of two stochastically independent random variables D1 and D2. Where D1 describes inborn characteristics and D2 captures factors later in life that explain variations in wages, e.g. promotion and health risks. X = D1D2 EX = ED1 = ED2 = 1

12. Cont. • Private insurance can first be made at the beginning of adult life, i.e. after D1 is known. • Individuals also face another risk C in addition to the wage risk • All individuals have assets K that are invested with a return equal to r. • Before taxation and insurance a person’s income is given by Y =D1D2w – C + rK

13. Cont. • The risk C can be insured in the private market and we will assume everybody buys this insurance. • However, it is impossible to get a private insurance for D1 and (consequently) D2 • Since people are assumed to be risk averse – the government can improve welfare by introducing a tax financed insurance. • One justification for the welfare state. • The government budget constraint is T = wt

14. Cont. • Net income after distribution is Y =D1D2w(1-t) + T – EC + rK • The mean and the standard deviation of Y are given by Y =w – EC + rK SY = (1-t)w S(D1D2)w By redistributing income, the state can improve total welfare. Optimal tax is t = 1

15. Tax competition • Assume a world with n identical countries where goods, capital and people can move freely and without any migration cost. We then have that (by the factor price equalization mechanism) ri = rj = r wi = wj = w • Since people can move we also have that D1D2w(1-tj) +Tj =D1D2w(1-tj) +Tj

16. Cont. • Which, because Tj = wtj, is equivalent to tj(w - D1D2w)=ti(w - D1D2w) or tj =ti • The tax rate in all countries thus have to be the same in all countries. • The equal tax will be zero due to tax competition between countries • A country will have incentive to reduce its tax levels in a situation of equal taxes. • The welfare state does not survive international mobility.

17. Tax externalities • In general, increased mobility makes tax jurisdictions become more interdependent and this interdependence gives rise to both negative and positive tax externalities. • Tax policy in one country might affect the welfare of other countries: • Directly trough the prices faced by foreigners • Indirectly through the effect on foreign governments tax revenues. • Tax externalities introduce a gap between the marginal cost of public funds that is borne by the taxing country and the marginal cost of funds that would be faced if the countries cooperated.

18. A positive tax externality • Mobility generally makes it easier for tax bases to escape taxation by moving to another jurisdiction. • The migration of tax subjects or tax objects • Through a shift in production or sale from domestic firms or markets to foreign firms or markets. • This situation is often referred to as tax competition since each jurisdiction will have an incentive to lower its tax rate in order to attract mobile tax bases. • Conversely, an increase in one country's tax rate will result in an increase in other countries tax revenues: a positive indirect tax externality.

19. Double taxation and tax exporting • Tax exporting and double taxation, can also be viewed as international tax externalities. • Tax exporting refers to the possibility that the tax policy in one country affects the prices faced by non-nationals. This can be viewed as a negative direct tax externality because it shifts some of the tax burden onto foreigners. • Double taxation arise when two countries can tax the same tax base. This is also a negative tax externality and might result in overtaxation. • These effects might counteract the tax competition effect.

20. Political economy issues • Some economists have argued that the public sector has a tendency to overexpand, • Due to the self-interests of politicians and bureaucrats who benefits from large budgets. • If this is correct then tax competition might improves welfare, because the size of government would be excessive in the absence of this competition.

21. International cooperation • One way to avoid the problems described in this lecture is to introduce an international tax authority • Secure international harmonization of taxes • E.g. a minimum tax on alcohol in the EU • The mobility of the tax base is not only determined by factors that is outside the control of the governments. National governments can affect the possibility to move commodities and factors of production in and out of the country trough direct regulation or other unilaterally measures.

22. Cont. • The distribution of tax base entitlements is closely related to the problems of tax externalities • By defining tax rights in such a way as to make it more costly to escape taxation by moving capital to another jurisdiction, these problems can be reduced. The attraction of the residency principle lies in the fact that people are less mobile than capital. • The home country principle removes this problem completely in the model studied earlier.