The Benefits of Tax Competition

July 25, 2011

Tax competition occurs when governments set their tax rates non-cooperatively. This creates incentives which lead governments to undercut one another on tax rates in order to attract investment from abroad while preventing an exodus of capital.

It is often thought that tax competition causes tax rates to be set too low.  The logic perpetuating this view is that competition forces tax rates below their optimal levels. This idea is the motivation for tax harmonization (cooperative tax setting) and tax haven eradication proposals. The European Commission's Taxation and Customs Union website contains a lengthy section dedicated to the supposed harmful consequences of tax competition.

The flaws of this argument lie in its assumption that governments would tax optimally in the absence of competition. (For more on optimal taxation, see Mankiw, Weinzierl, and Yagan, "Optimal Taxation in Theory and Practice," Journal of Economic Perspectives, 23(4): 147-174, 2009.) But public choice theory teaches us to expect that political actors, guided by their own incentives, do not necessarily act to maximize public welfare. In fact, even if governments were benevolent maximizers of public welfare, credible commitment problems can make tax cooperation undesirable (Kehoe," Policy Cooperation Among Benevolent Governments May Be Undesirable," Review of Economic Studies, 1989.)

An example is illustrative. It is perhaps cynical, but perfectly reasonable to assume that most politicians are more concerned with re-election prospects than with general public welfare. These motives tend to lead legislators to vote for spending bills that benefit their constituents and campaign contributors with little regard for costs imposed on people in other constituencies.

Simply put, governments tend to overspend and overtax. Tax competition can help to keep taxes closer to their optimal level, constraining wasteful government excess. Taxes will not be driven to zero through competition, as moving capital and labor abroad does come at a cost. The more mobile they become, however, the more competitive pressure will exist.

International tax competition has been alive and well over the past few decades. However, the U.S. lags far behind. A recent AEI report, Report Card on Effective Corporate Tax Rates, examining international effective average tax rates (EATR) over the past 30 years found that:

"In 1996, the United States' EATR was slightly below the OECD average, 29.2 versus 30.2. In later years, the OECD average improved by almost 10 percentage points to 20.6 while the United States' EATR remained relatively unchanged."

As businesses leave the country to decrease their tax liability and improve their international competitiveness, the U.S. government is under very real pressure to enact beneficial corporate tax reforms:  specifically, lowering the corporate tax rate and moving to a territorial system of taxing foreign earnings.

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