In 1992, the EU established a single market for capital and labour. While the benefits are often lauded, the worry ever since has been that, in the absence of a fully-fledged harmonisation of the income tax system, tax competition among member countries might undermine the welfare state.
Referring to tax competition among localities in the presence of capital mobility, Oates (1972, p.143) argues that competition may lead to inefficiently low tax rates (and benefits):
"The result of tax competition may well be a tendency toward less than efficient levels 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 programmes that do not offer direct benefits to local business."
In Razin and Sadka (1991) we presented a theoretical framework to demonstrate that, under certain assumptions, e.g. the “residence principle” of international taxation is optimally enforced by member states, there are no gains from tax coordination over the tax competition regime. But the residence principle is not easily enforced and countries instead resort to source-based taxation of income from capital. In this situation, tax competition among countries, may lead to inefficiently low tax rates and welfare-state benefits because of three mutually reinforcing factors.
- First, in order to attract mobile factors or prevent their flight, tax rates on them are reduced.
- Second, the flight of mobile factors from relatively high tax to relatively low tax countries shrinks the tax base in the relatively high tax country.
- Third, the flight of the mobile factors from relatively high tax to relatively low tax is presumed to reduce the remuneration of the immobile factors, and, consequently, their contribution to the tax revenue.
These reinforcing factors tend to reduce tax revenues and, consequently, the generosity of the welfare state, as demonstrated using calibration exercises of tax competition models in the presence of perfect capital mobility for the EU (see Bovenberg et al. 2003, Mendoza and Tesar 2005, and Sorensen 2001). .
If, however, instead of considering capital mobility, one focuses on labour (of various skills) as the mobile factor, the tax competition leads to a non-conventional outcome. In a recent book (Razin et al. forthcoming), we build on Tiebout's (1956) framework of competition among localities. But, we allow for the total population in the host country and its skill distribution to be endogenously determined through migration of various skills. We find that in this context tax competition need not be efficient. With this result in mind, we then study the policies that ensue through coordination among the host countries and compare them to the competition policies.
Our model explained
We model the host countries stylistically as members of the core EU welfare states. The rest of the world is the pool of would-be immigrants. We allow competition (through the tax-cum-transfer system) among the several host countries, treated as "perfect competitors". The rest of the world provides exogenously upward sloping supply curves of unskilled and skilled would-be migrants. We address the issue of whether tax competition among host countries is inefficient, relative to tax coordination, in the presence of migration from within – and outside – an economic union.
We assume that the number of migrants of each skill type that wishes to emigrate rises with the level of utility they will enjoy in their host countries. A possible interpretation for this upward supply is that for each skill type the migration costs vary according to individual characteristics such as age, family size, portability of pensions, etc... This cost generates heterogeneity in reservation utilities and gives rise to an upward sloping supply of migrants. We assume that would-be migrants are indifferent with respect to the identity of the would-be host country – all they care about is the level of utility that they will enjoy. In equilibrium, the utility enjoyed by migrants of each skill type is the same in all host countries.
Being small enough, each host country takes these cut-off utility levels as given.
Competition vs. coordination: The race is not to the bottom
In this section we compare the tax policies that exist under competition and under coordination. Specifically, we ask whether competition can lead to "a race to the bottom" in the sense that it yields lower tax rates and welfare-state benefits, relative to the coordination regime. We carry this comparison via numerical simulations.
Figure 1(a) depicts the tax rates under competition and under coordination (for various levels of the productivity parameter. We can clearly see that competition yields higher, not lower, tax rates than coordination, contrary to the race-to-the-bottom hypothesis. Figure 1(b) shows that benefits in the coordination regime are lower that under the competition regime. Figure 1(c) shows that the number of skilled migrants is higher under coordination than under competition.
Figure 1. Tax competition vs. tax coordination
Similar results were obtained in the case where the unskilled form the majority – that is, tax rates and benefits are lower and the number of unskilled migrants is higher under coordination than under competition.
What is the rationale for this unconventional result? Suppose we start from the coordinated regime and a single host country opts to no longer abide by coordination. One way to improve the welfare of the skilled ruling majority is to adopt a policy that reduces the number of competing skilled migrants, i.e. raising the skilled wage. Raising the tax rate can squeeze out skilled migrants. When all host countries raise their tax rates as they opt out of coordination, the end result is lower utilities (due to the distorting effect of taxes) and too few skilled migrants.
Does the free movement of factors of production lure tax authorities into a race to the bottom? The literature on tax competition with free capital mobility cites several reasons why it may yield significantly lower tax rates than tax coordination. With a population that can move from one fiscal jurisdiction to another, the Tiebout paradigm suggests that tax competition among these jurisdictions yields an efficient outcome, so that there are no gains from tax coordination. This column suggests, however, that when a group of host countries faces an upward supply of immigrants, tax competition does not lead to a race to the bottom; competition may lead to higher taxes than coordination.
Bovenberg , Lans, Sijbern Cnossen, and Ruud de Mooij (2003), “Introduction: Tax Coordination, in the European Union”, International Tax and Public Finance, 10:619-624.
Oates, Wallace (1972), Fiscal Federalism, Harcourt Brace Jovanovitch.
Medoza, Enrique, and Linda Tesar (2005) "Why hasn't tax competition triggered a race to the bottom? Some quantitative lessons from the EU", Journal of Monetary Economics.
Razin, Assaf and Efraim Sadka (1991), "International Tax Competition and Coordination", Economic Letters.
Razin, Assaf, Efraim Sadka, and Benjarong Suwankiri (2011), “The Welfare State and International Migration: Political Economy Based Policy Formation”, MIT Press.
Sørensen, Peter Birch (2001), "Tax coordination in the European Union: What are the issues?” University of Copenhagen,mimeo.
Tiebout, Charles (1956), "A Pure Theory of Local Expenditures", Journal of Political Economy, 64.