pondelok, júna 11, 2007

The Economics of Tax Competition

by Rok SPRUK

Once the cradle of the “womb-to-tomb” welfare state and the place of uninterrupted left-wing rule, Sweden recently abolished wealth tax which was setup in 1947, just three years before Sweden’s end of remarkable economic transformation notably called “from rags-to-riches”. Contrary to onerous tax burden, Sweden maintains a moderate 25 percent corporate tax rate in effective terms, offering an attractive environment especially for holding companies. Using the data, we can see that the effective corporate tax rate steadily declined from 1981 when it reached enormous 60 percent effectively. What actually forced Sweden to lower the corporate tax rate and cut onerous tax code? Eventually, global tax competition once again confirmed what Adam Smith wrote on the mobility of labor and capital. Technological advancement and a huge leap forward in IT and internet further increased the capital mobility as borders opened and foreign direct investment increased. You may not necessarily be an economist to find out that capital investment is easier in low-tax jurisdictions such as Ireland or Estonia.

However, corporate tax-cut revolution has not yet spread over the horizon of Canada which maintains one of the highest corporate tax rates in the world, currently standing at 36,1 percent. The federal 22,1 percent rate is not actually that high, but adding the provincial rate which every company has to bear sums up the overall rate ranging from 32 to 39,1 percent. There are also numerous loopholes, exemptions and deductions, further making tax code even more complicated. The real question is: does beautifying a heavily complicated tax code really result in a more transparent and investor-friendly tax climate? The question is no. First, loopholes and exemptions create the so-called “preference incentive” causing a widely spread tax evasion hampering individuals and companies. The first tool under which tax competition operates is the degree of independence which certain geographical areas gain. For example, if federal government enacted tax competition by abolishing the punitive federal corporate tax rate, it could mean that Alberta, Ontario, British Columbia and other provinces could easily compete on creating a favorable and friendly tax environment to companies and individuals. There is, of course, also the principle of comparative advantage which certain area can entail to vibrantly dynamize the competitiveness of its economy. Logically, capital investment would depend on several features such as the prime locus of location in approaching a target market, but investors would preferably choose the location in which tax burden is lower (Alberta) relative to another area, say Quebec. The inflow of direct investment to Alberta would thus naturally force economic policymakers in Quebec to offer more attractive environment to investors by cutting corporate tax rate and creating a favorable environment for doing business. It is worth mentioning that Alberta scored as the second freest economy in North America while Quebec is known for being the least free economy in the region.

In understanding the fundamental of tax competition, it is central to underpin the essentiality of Laffer curve which explains the relationship between tax revenues and tax rate. As we can see from the figure below, whether you set the rate at 0 percent or 100 hundred the sum of tax revenue is zero. Simply, if there are no taxes, then there’s also no tax revenue and vice versa: if tax rate equals 100 percent nobody would work and the government had no basis where tax revenue could pour in. But, there’s an equilibrium point at which the cross-intersection between the rate and revenue is optimal. It could be considered that 50 percent rate is an optimum but the empirical evidence has shown that higher the taxes go, lower the incentives to work, save and invest. Thus, to increase tax revenues, the policymakers should consider easing tax burden impeding the productive behavior. The recent example is Iceland where corporate tax rate was cut from 50 percent in the late 1980s, to 33 percent in the 1990s and 18 percent by 2002. Importantly, lower corporate tax yielded higher revenue which took a sharp offspring from 0,9 percent to 1,5 percent of the GDP. This clearly demonstrates the effect of Laffer curve.

Since the capital formation is a solid engine of growth, it is essential to question the consequences of capital flight, oftenly noted as capital immigration. (1) Tax competition rewards the areas in which tax burden is low by further stimulating the economic performance. On the other side, fiscally punishing tax environments are forced to struggle to keep the companies within their territory. The only way to do this is to reduce the cost burden emerging from punitive tax code as well as to supply the companies with high-quality environment for doing business which does not impede growth performance. (2) Tax competition is a highly appropriate tool in fighting against the indices to impose tax harmonization. Tax harmonization means making tax rates across economically integrated areas equal to unify tax basis as the latter shrinks if taxes are harmonized increasingly. In the EU, France and Germany often raise voice and accuse other nations of fiscal dumping. Taking the modern economic theory and practice into account, it is essential to analyze the consequences of such tax policy looking toward the increasing harmonization of taxes. First, tax burden would increase and onerous tax code would be imposed on companies and individuals. This would tight-up the tax base as the tax rate was growing progressively. Consequently, tax evasion would spark-off and the individuals and companies would find far fewer incentives to infuse the economy with productive behavior. This is what happened in Sweden in 1970s when high tax rates on individual income resulted in continually lower tax revenues and then the policymakers reacted ridiculously by further pushing-up the marginal scale of tax rates. In Germany, progressive taxation together with high tax burden resulted in a brain-drain at the highest level since 1940s. Contrary, lower tax rates on productive behavior mean the broadening of tax base what increases the price of tax evasion since there are no more incentives to hide the company revenue behind tax breaks and certain kinds of exemptions and tax advantages which send a strong shock increasing compliance costs and reducing the amount of time which company could contribute to its primary activities.

Behind the logic of the EU bureaucrats is the concern over the asymmetric tax rates within the EU after its expansion. The aim of the European Commission is thus to harmonize the tax rates on corporate or/and individual income accordingly. The effect of tax harmonization would significantly hurt high-growing economies as their competitive advantage would be significantly disadvantaged by putting more pressure on taxing the individual and corporate income. Inevitably, the probability of productivity growth followed the downturn trend if taxation input impeded its performance. Somehow ironically, the European policymakers mimic the mistaken strategy of increasing revenue through pushing the tax rates upward. You don’t have to be a genius to find out that nobody benefited from tax harmonization but tax collectors, bureaucrats and politicians.

How tax competition empowers the economic performance could be seen in Switzerland where each federal unit (canton) sets its own individual and corporate tax code. On January 1, Obwalden (small canton in central Switzerland) slashed the corporate tax rate to 6,6 percent. It attracted 376 companies in just 11 months. Google, Kraft and IBM have all chosen Zurich as their European headquarters. Google is set to expand its Zurich office this year from around 300 staff to 1,600, making it the biggest Google office outside the United States. Tax competition has thus yielded big dividends as more and more companies are choosing Switzerland for their top destination. Recently, Obwalden wanted to attract individual inflow by sharply cutting tax rates on personal income known as degressive tax system which means “the-more-you-earn-the-less-you-pay” but Swiss Federal Court declared this particular tax system as unconstitutional.
Tax competition could hardly be interpreted as subsidy as many policymakers are sadly mistaken. The real argument in favor of lower taxes is not “benefiting the rich” as it is popularized in contemporary leftist slang, but the offspring of prosperity as everyone; companies and individual benefit from being taxed at a low rate and thus having more disposable income to manage our life and career. In 20 years, competitive tax policy has reduced corporate tax rates significantly. In 1987, Denmark went from 50 per cent to 30 per cent. In 1991, Sweden went from 60 per cent to 28 per cent. In 1992, Norway went from 51 per cent to 28 per cent. In 1993, Finland went from 43 per cent to 25 per cent. All of those countries learned a lesson which returned an economic recovery an economic performance on a higher trajectory.
Businesses compete on a rock-bottom incentive to deliver the best product at the lowest price while regions, provinces, countries and state compete on how to attract direct investment and investment funds escaping punitive tax regimes whose only care is revenue while ignoring economic growth from which we prosper.

Rok SPRUK is a supply-side economist and a classical liberal. He studies economics and business in Slovenia. His main areas of interest, research and work are economic growth, macroeconomics, international competitiveness, international trade and international economics. In the field of business he's focused on strategic management, financial markets, emerging markets, business models and competitive advantages. He runs a blog called Capitalism & Freedom where he posts his observations, views and periodic analysis. He could be reached at: rok.spruk@gmail.com