Tax competition is a very important tool for constraining the greed of the political class. Simply stated, politicians are less likely to impose bad tax policy if they are afraid that jobs and investment (and accompanying tax revenue) willmove to jurisdictions with better tax policy.
This works to limit revenue grabs by politicians at the state level and it works to control the craving for money on the part of politicians at the national level.
But this doesn’t mean all forms of tax competition are equally desirable.
If a country lowers overall tax rates on personal income or corporate income in hopes of attracting business activity, that’s great for prosperity. If a jurisdiction seeks faster growth by reducing double taxation – such as lowering the tax rate on capital gains or abolishing the death tax, that’s also very beneficial.
Some politicians, however, try to entice businesses with special one-off deals, which means one politically well-connected company gets a tax break while the overall fiscal regime for other companies stays the same (or even gets worse).
That’s corrupt cronyism, not proper tax competition.
With this in mind, let’s consider the growing controversy about tax planning by multinational companies. There’s lot of controversy, both in the United Statesand in Europe, about whether companies are gaming the system.
The most recent kerfuffle deals with Luxembourg, which is accused of having a very friendly regime for business taxation.
Syed Kamall, a Tory member of the European Parliament, has a column in theWall Street Journal Europe about the right kind of corporate tax competition.
It seems to have come as a great shock to many in the European Parliament that Luxembourg may have encouraged multinational companies to domicile there to pay lower taxes. I’m not sure where these members of parliament have been living for the past 20 years.
What worries Syed is that many European politicians want to use the news from Luxembourg as an excuse to push tax harmonization.
…an agenda of EU-wide tax harmonization…is rapidly gaining popularity in some quarters despite being exactly the wrong prescription for Europe. …tax harmonization…would hang the “Closed for Business” sign at Europe’s border. Tax competition across the single market helps keep tax rates competitive and drives inward investment. The Organization for Economic Co-operation and Development has said that “the ability [of companies] to choose the location of economic activity offsets shortcomings in government budgeting processes, limiting a tendency to spend and tax excessively.”
By the way, the OECD is a big proponent of tax harmonization, so it’s especially noteworthy that even those bureaucrats admitted that tax competition constrains greedy government.
You can click here for further examples of OECD economists admitting that tax competition is necessary and desirable, notwithstanding the anti-market policies being advocated by the political appointees who run the institution.
And since we’re discussing the merits of tax competition, we should point out that Mr. Kamall also mentioned those benefits.
The clearest example of that came with the tax reductions enacted by Margaret Thatcher and Ronald Reagan in the 1980s. Those tax-rate cuts in the U.K. and U.S. forced other industrialized nations to cut their average top marginal rate for personal income to 42% today from more than 67% in 1980 simply to remain competitive, according to the Adam Smith Institute. Tax competition has driven down the average top rate for corporate income in the developed world to less than 27% today from 48% in 1980. Tax competition in Europe encouraged many EU members from the former Soviet bloc to enact flat taxes, which have benefitted them substantially. …it’s important for leaders to keep making the case that tax-policy competition within the single market has been good for Europe.
And he correctly warns that tax harmonization would be a vehicle for higher tax burdens.
Imposing uniform rates under a harmonized system would turn the EU into a convoy that can move only as fast as the slowest ship. Europe’s tax rate would be only as low as the highest-taxing member. …A harmonized tax system would encourage companies and investors to seek new solutions outside the EU in order to avoid paying what would inevitably be higher, French-style levels of European taxation.
And if you don’t believe Mr. Kamall, just look at what’s happened over the past couple of years in Europe.
Last but not least, Syed points out that there is a pro-growth way of improving tax compliance.
The best way to cut down on tax avoidance is to cut tax rates and simplify tax codes. That way people and companies would be willing and able to pay their money to Europe’s exchequers, rather than paying accountants to find loopholes.
But that would require politicians to be responsible, so don’t hold your breath.
So what’s the bottom line? Is there a good way of identifying the desirable forms of tax competition that should be defended.
The simple answer is that it’s always a good idea to compete with lower tax rates that apply to all taxpayers. That’s true for tax rates on companies and households.
The more complex (but equally important) answer is that it’s also good to compete by having a properly designed tax system. On the business side, that means expensing instead of depreciation and territorial taxation rather than worldwide taxation. For households, it means having the proper definition of income so that there’s no longer pernicious discrimination against saving and investment.
Misguided tax competition, by contrast, exists when there are very narrow preferences that apply to a small handful of powerful taxpayers.
For more information on the general topic, here’s my video on the virtues of tax competition.
