Issues in International
Taxation
UAB 2011 Lecture 1
Gareth Myles
University of Exeter and Institute for
Fiscal Studies
Introduction
• EU policy objectives
• Single market with efficient trade
• Free movement of capital and labour
• Social support (“flexicurity”)
• Tensions
• Subsidiarity
• Competency
• Taxation
• Provides revenue
• Affects efficiency
• Symbolizes sovereignty
Introduction
• These lectures will review economic analysis of
these policy issues
• The topics to be covered are:
• Tax competition
• International taxation
• Fiscal federalism
• This lecture begins with a review of recent
developments in EU policy
Introduction
• The basis of indirect taxation in the EU is a VAT
system
• The key features of VAT:
• Producers can claim back VAT charged on inputs
• In principle only final consumption is taxed
• The theoretical justification for this is described
in lecture 2
• This clarity is undermined by exemptions and
the treatment of small business
Introduction
• In the 1980s the rate of VAT varied quite widely
across EU member states
• Harmonization has been an EU policy objective
since the Neumark Report of 1963
• A harmonization process began in 1992
• This was intended to encourage efficient
operation of the single market
• It represented an enhancement of competence
and a reduction in subsidiarity
Tax Harmonization
• Single market requires harmonization
• Cross-border shopping
• Protectionist use of taxes
• Effect on mobile factors
• 1987 proposal
• Two-rate VAT
• A Standard rate (14-20%) and a Reduced rate (4-9%)
• In 1993 a minimum rate was introduced
• Minimum of 15%, one or two rates of at least 5%
• Zero-rating allowed to continue
• “Approximation” remains long-term goal
Tax Harmonization
1970-1974
1985-1990
2000
Standard
(normal)
Reduced
(essential)
Increased
(luxury)
Standard
(normal)
Reduced
(essential)
Increased
(luxury)
Standard
(normal)
Reduced
(essential)
Germany
11
5.5
-
14
7
-
16
7
France
23
7.5
33
18.6
2/7
23
20.6
2.1/5.5
Italy
12
6
18
19
4/9
38
20
10
UK
10
-
-
15
0
-
17.5
5
Denmark
15
-
-
22
-
-
25
-
Source: Molle (2001)
Table 1: VAT rates in Member States
Harmonization
• Harmonization of excise duties also proposed
• Rejected by Member States
• System of minimum rates introduced in 1993
Cigarettes (per 100)
Wine (per litre)
Petrol (per litre)
Germany
7.67
0.00
0.58
France
8.64
0.03
0.63
Belgium
7.49
0.47
0.55
UK
18.40
2.30
0.81
Spain
4.84
0.00
0.40
Sweden
10.36
3.11
0.59
Source: Molle (2001)
Table 2: Excise Taxes in Euros, 2000
Harmonization
European Commission, 2000
Member States have shown little enthusiasm for the
proposals in Council meetings and […] have been
reluctant to accept the greater harmonisation of VAT
rates and tax structures.
2003 Draft Report of the Committee on Monetary
and Economic Affairs
The European Parliament is strongly committed to the
introduction of the definitive system of VAT, but given
the lack of progress in that regard, there is no urgent
need to harmonise rates.
Tax Principle
• Prior to 1993 the EU operated a destination
tax system
• Goods are taxed in country of consumption
• The destination system requires border tax
adjustments
• The single market was completed in 1993
• This removed borders between member states
• Conflicts with operation of destination system
Tax Principle
• Tax differentials lead to cross-border shopping
• This can enhance efficiency in an ideal economy
• But is costly in practice:
•
•
•
•
Direct waste of resources
Environmental costs
Distortion of regional trade patterns
Undermines freedom of governments
• Since January 1993 a transitional system in
place
• Definitive system intended for 1997 but still not
constructed
Tax Principle
• There are two alternative tax principles
• Destination principle
• Tax in the country of final consumption (destination
country)
• A tax on consumption
• Origin principle
• Tax in the country of production (origin country)
• A tax on production
• The EU has long favoured a move to a form of
origin principle
Tax Principle
• The Tinbergen Report of 1953 analyzed the tax
implications of the single market
• It concluded that an origin system be
implemented
• The move to the origin principle has remained
an EU goal ever since
The Community’s long term objective is moving to a
definitive VAT system, based on the principle of taxation
in the country of origin
(2003 Draft Report of the Committee on Monetary and
Economic Affairs )
Implementation of VAT

HMRC estimate of VAT tax was £15.2bn in
2008–09
 Missing Trader Intra-Community (MTIC) fraud
is a major explanation
 Zero rating of goods at export implies large
scale reclaims of VAT by exporting companies
 If reclaim is accompanied by failure to pay VAT
further down the chain the revenue service can
pay more in refunds than is collected
Implementation of VAT

European Commission in 2004 reported that
losses from fraud were 10 per cent of net VAT
receipts in some member states
 A carousel fraud is operated as follows:




Importers purchase products that are zero-rated
Sell them on with VAT added to another trader
The purchasing trader reclaims the input VAT
The seller does not pay the VAT due and
disappears
Implementation of VAT
Figure 7.1: A simple illustration of carousel fraud
Implementation of VAT

This is due to zero rating of exports
 Without this the importing company would
have been charged VAT by the original
exporter
 The final exporter would not be entitled to any
refund of VAT
 The opportunity for this type of fraud would not
exist
Mobility
• At the centre of EU single market policy is
unhindered mobility of capital and labour
• Mobility between jurisdictions creates tensions
with tax policy
• Subsidiarity is constrained
• Tax differentials undermined by cross-border
shopping
• Adoption of additional EU competence is the
natural solution
• Resisted by some member states
Mobility
• Jurisdictions compete for mobile capital
• Positive tax externalities imply equilibrium tax
rates too low
• Revenues are reduced
• Social policy is threatened
• “Race-to-the-bottom”
• Mobile population can seek benefits
• Recipients arrive
• Contributors leave
• Undermines redistribution
Corporate Taxation
• The rate of corporation tax has important
effects:
• Determines return on corporate assets
• Internal accounting exploits differentials
• Plant location is affected
• Statutory tax rates have fallen
• This has been explained by tax competition
• The EU has implemented policy to control tax
competition
Corporate Taxation
1982
2001
Austria
61
34
Belgium
45
40
Finland
60
28
France
50
35
UK
53
30
Germany
62
38
Greece
42
38
Ireland
10
10
Italy
38
40
Netherlands
48
35
Portugal
55
36
Sweden
61
28
Source: Devereux et al. (2002)
Table.3: Statutory Corporate Income Tax
Corporate Taxation
• Current EU policy is based on the Code of
Conduct for Business Taxation
• Refrain from introducing any new tax measures that
may be harmful
• Amend any laws or practices that are harmful
• Harmful tax laws include:
• A tax rate lower than the country’s general level
• Tax benefits reserved for non-residents
• Tax incentives for activities isolated from the domestic
economy
• Departure from international accounting rules
Observations
• There are many issues in EU tax policy
• This is a reflection of the EU as an evolving
entity
• And one which has a unique structure
• Some policy reforms have begun but have not
been completed
• We remain far from having a finished fiscal
structure
Tax Competition
• Competition ensures efficiency of economic
activity
• Does the same argument extend to
competition between governments?
• Mobility ensures good tax/benefit packages
attract population
• Unattractive jurisdictions will lose population
• The nature of competition is key to the
efficiency of equilibrium
Tax Competition
• Tax competition is the interaction among
governments due to mobility of the tax base
• A tax on a mobile factor will cause relocation
• Capital will locate where the net return is highest
• Labor will seek employment where net wage is
highest
• Loss of tax base by one jurisdiction is a gain
for another
• Mobility causes a tax externality between
jurisdictions
Tax Competition
• Assume that jurisdictions tax capital
• Assume capital is perfectly mobile but
residents are immobile
• With competitive behavior jurisdictions are
“small” and take net return to capital as fixed
• With strategic behavior jurisdictions are “large”
and take account of how tax policy affects the
net return to capital
• In both cases inefficiency occurs in equilibrium
Competitive Behavior
• A small jurisdiction takes the net return to
capital as fixed
• Let f’(ki) be the marginal product of capital in
jurisdiction i where ki is the capital-labor ratio
• Let ti denote tax rate in i and r the net return
to capital outside the jurisdiction
• Costless mobility of capital equalizes the net
return across jurisdictions so arbitrage implies
f ' ki   ti  r
Competitive Behavior
• Since f’’(ki) < 0 an increase in ti reduces ki
• The total income of labor in i is given by output
less the reward to capital plus tax revenue
yi  f ki   f ' ki ki  ti k
• Using the arbitrage condition
yi  f ki   rki
• Income is maximized when f ' ki   r so ti = 0
• No tax should be levied on capital
• The jurisdiction cannot capture any of the return to
capital
Strategic Behavior
• Now assume there are just two countries so
each region is large
• There is a fixed stock of capital k that allocates
between the countries
• Costless mobility equates after-tax returns in
the two countries
f ' k1   t1  f ' k2   t2
• This arbitrage condition determines an
allocation of capital that depends on the tax
rates
Strategic Behavior
• Fig. 18.1 represents the
allocation of capital
between countries
• Assume that country 1
sets a higher tax rate
• The tax differential is
reflected in the
difference in marginal
products
• Country 1 has less
capital in equilibrium
• An increase in tax rate
causes capital to move
to the other country
f ' k1 
f ' k 2 
t1  t 2
01
k1
k1 t1 , t 2 
02
k2
Figure 18.1: Allocation of capital
Strategic Behavior
• Each country maximizes the income of workers
yi  f ki   f ' ki ki  ti ki
• Since ki depends on t1 and t2 there is strategic
fiscal interaction
• Each country chooses the tax rate to maximize
income taking the tax rate of the other country
as given
• The best-response functions of the two countries
are t1  r1 t2  and t2  r2 t1
 
Strategic Behavior
• Fig. 18.2 displays the
best-response functions
• The equilibrium occurs
where r1t2   r2 t1 
• The two countries are
identical so the Nash
equilibrium is symmetric
• The equilibrium values
of the taxes are
t1*  t2*   f ' ' k / 2 k / 2
• Each country has ½ of
the capital stock

t2
r1 t 2 
t1  t 2
r2 t1 

t1
Figure 18.2: Symmetric Nash
equilibrium
Strategic Behavior
• The taxes at the Nash equilibrium are inefficient
• Capital is a fixed factor from the world perspective
• If the two countries coordinated they could capture the entire
return to capital in taxation
• The Nash equilibrium taxes do not achieve this
• The positive fiscal externality results in taxes which
are inefficiently low
• The countries undercut each other to attract mobile
capital – the “race to the bottom”
• Competition between large jurisdictions does not
achieve efficiency
Strategic Behavior
• This argument applies to any tax base which is
mobile
• It also applies to commodity taxation if there is
cross-border shopping
• Cross-border shopping is possible the origin
taxation (taxation in country of production)
• Destination taxation (taxation in country of
consumption) prevents cross-border shopping
but requires borders to be maintained
• Borders are inconsistent with a single-market
in a federation
Size Matters
• Asymmetries in size or technology will lead
countries to set different taxes
• This may benefit some countries at the
expense of others
• If the asymmetry occurs in the number of
residents then small countries gain
• The outflow of capital is less severe for the
large country for any tax increase
• The large country sets a higher tax
Size Matters
• Fig 18.3 shows the
advantage of smallness
• Country 1 has share s >
½ of total population
• Country 1 sets a higher
tax t1 > t2
• R is the net return to
capital
• Income per resident plus
tax revenue satisfies c2 +
g2 > c1 + g1
• Residents of the small
country are better off
f ' k 2 
f ' k1 
c1
g1
t1
t2
R
01
c2
g2
k1* , k 2*
k1
Figure 18.3: Advantage of
smallness
R
02
k2
Public Good Provision
• Different conclusions can emerge if the use of
tax revenue is considered
• Assume a public input is provided with
production function
f(ki, gi)
• An increase in the tax rate now raises gi
• This can give an incentive to set taxes above
the optimum level
Public Good Provision
• The standard model has a positive tax
externality


y2
k 2
  f k2k2 k2  t2
0
t1
t1
• In the modified model
g2  g2 t1,t2 
• The tax externality then becomes




y2
k 2
g 2
  f k2k2 k2  t2
 f g 2  f k2 g 2 k2
t1
t1
t1
Public Good Provision
• Since
g 2
k 2
 t2
0
t1
t1
• A sufficiently strong complementarity can
create a negative externality
• This occurs when
f k2 g 2 
1  f g2
k2

f k2 k2
t2
• In such a case the tax rates will be higher
than the efficient level in the Nash equilibrium
Public Good Provision
• This condition has been tested by BénassyQuéré, Gobalraj, and Trannoy (2007)
• They express it as the requirement on an
elasticity eK/t > 0
• The regression involves US FDI into Europe
on taxes and public input provision
• It is concluded that the elasticity is negative
• So excessive tax rates (a “race-to-the-top”) are
ruled out
Efficient Tax Competition
• There are circumstances in which tax
competition can enhance efficiency
• It can limit wasteful subsidies designed to give
home firms a competitive advantage
• Tax competition is a commitment device
preventing reversion to high tax rates
• Non-benevolent governments are constrained
by tax competition
Race to the Bottom
• Tax competition suggests mobility will drive
down tax rates
• The reduction in tax rates reduces revenue
and limits public expenditure
• The OECD and the EU have both shown
concern about this race to the bottom
• OECD 1998 report (20 recommendations)
• EU Code of Conduct on business taxation which
identifies harmful tax competition
Race to the Bottom
• Tab. 18.1 shows the
corporate tax rate for
some EU and G7
countries
• All countries except
Ireland and Italy have
reduces rates
• Rate in Germany has
fallen from 62 to 38 and
in the UK from 53 to 30
• This seems to be
evidence for the race to
the bottom
1982
2001
Austria
61
34
Belgium
45
40
Canada
45
35
Finland
60
28
France
50
35
UK
53
30
Germany
62
38
Greece
42
38
Ireland
10
10
Italy
38
40
Japan
52
41
Netherlands
48
35
Portugal
55
36
Sweden
61
28
USA
50
49
Table 18.1: Statutory corporate
income tax
Source: Devereux et al. (2002)
Race to the Bottom
• There are many details of tax legislation that result in
the statutory tax rate being different to the effective tax
rate
• Tab. 18.2 shows the effective rate fell by less
• This is evidence that the lower statutory rate has been
countered by a broadening of the tax base
82
84
86
88
90
92
94
96
98
01
Median
statutory
50
48
46
43
39
38
37
36
37
35
Average
effective
43
42
41
38
36
37
36
36
34
32
Table 18.2: Statutory and Effective Corporate Income Tax Rates
Source: Devereux et al. (2002)
• Net effect of rate
reduction and base
broadening in Figure 1
• Revenue remained
constant until the early
1990s
• Strong growth trend
from 1990
• Increase in corporate
profitability
• Revenues not adversely
affected by tax
competition
Tax Revenues (% of GDP)
Race to the Bottom
5
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0
1965
1970
1975
1980
1985
1990
1995
Year
Source: Devereux et al. (2002) (using OECD
data)
(Weighted average for 14 EU countries plus
Canada, Japan and the US)
Figure 1: Corporate Income Tax
Revenue as a Percentage of GDP
2000
Race to the Bottom
0.35
Tax Revenue (% of GDP)
• Data for the UK in Fig. 2
• Might expect UK to be
affected by proximity to
Ireland
• There is no apparent
effect in the data
• Revenues were rising
from late 1990s
0.3
0.25
0.2
0.15
0.1
0.05
0
1980
1985
1990
1995
2000
Year
Source: Economic Trends
Figure 2: UK tax revenue from capital
as a percentage of GDP
Race to the Bottom
• Tax competition is harmful if it leads to
equilibrium rates of tax below the efficient level
• The the fall in statutory corporate income tax
rates is often given as evidence for tax
competition within the EU
• The data shows that corporate tax revenues
as a percentage of GDP have not fallen
• The EU has a voluntary Code of Conduct
designed to lessen tax competition
The Tiebout Hypothesis
• An alternative perspective on competition
between regions
• We usually assume issues of preference
revelation will prevent attainment of efficiency
• Individuals will have no incentive to truthfully
reveal preferences or characteristics
• The provision of public goods is based on a
variety of inefficient mechanisms
• And financed by distortionary taxation
The Tiebout Hypothesis
• Does this change when the economy is
separated into many jurisdictions?
• The Tiebout hypothesis argues that efficiency
will then be achieved
• The argument of Tiebout observes
• Inefficiency arises because of the externalities
between consumers
• This causes free-riding
• The externality is a consequence of a smallnumbers issue
The Tiebout Hypothesis
• The argument is different if there are many
potential communities
• Assume that different communities offer
different packages of taxation and public
goods
• The choice of community reveals preferences
• There is no incentive to choose strategically
• Honest revelation takes place and efficiency is
achieved
The Tiebout Hypothesis
• Hence:
• If there are enough communities with different
provision levels
• And if there are enough consumers with each kind
of preference
• All consumers can then locate in an optimal
community which is efficient in size
• This is the efficiency claim of the Tiebout
hypothesis
• Unlike the Theorems of Welfare Economics
there is no single way to formalize this result
The Tiebout Hypothesis
• It does require that there are no frictions in
housing markets
• It can apply if consumers’ incomes are from
rent so unaffected by community choice
• If income is earned then employment
opportunities must be replicated in all
communities
• It can hold if the number of consumers and
communities is infinite
• If both are finite problems of division arise