Revisiting the debate on tax
competition vs. tax coordination
Assaf Razin and Efraim Sadka
September 2011
1
Classical Tax Competition Ideas
• 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."
2
Residence vs. Source Principles
• 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.
3
Arbitrage Relationship
*
r (1   RD )  r * (1   ND
  RF )
*
*
r (1   ND   RF
)  r * (1   RD
)
 RD
 RF
 ND
= Tax rate levied on residents on domestic-source income
= Effective tax rate levied on residents on
foreign-source income
= Tax rate levied on non- residents on income
originating in the host country
Residence principle
*
*
*
*
 RD   ND
  RF , RD
  ND   RF
, ND
  ND  0
Source principle
*
*
*
 RD   ND , RD
  ND
, RF
  RF  0
4
Efficiency
• Residence principle achieves efficiency in the
allocation of world aggregate investment; i.e.,
production efficiency: mpk= mpk*
• Source principle achieves efficiency in the
allocation of world aggregate savings; i.e.,
mrs=mrs*
• Recall the the Diamond-Mirrlees production
efficiency theorem.
5
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.
6
The Model
•
•
•
•
•
Continuum of host countries
Two labor skill types
Free migration
Perfect capital mobility
Upward supply schedules of migrants of the two
skill types from the rest of the world as a source
• Majority voting on a pay-as-you-go fiscal system
consisting of capital and labor income taxesand
uniform per capita benefits
7
Equilibrium
_
_
_
_
_
VS ( L , K , b)  (1  r ) K S  V S
_
VU ( L , K , b)  (1  r ) K U  V U
_
nm  fU (V U )
*
U
_
nm  f S (V S )
*
S
_
_
K *  s K S  (1  s ) K U
8
Fiscal Coordination
In the coordinated –policy equilibrium the
cutoff utilities
are controlled by the grand policy maker, who
set the common tax rates on capital and labor,
and the level of benefits:
_
_
VS
VU
( L , K , b)
9
Competition vs. coordination: The
race is not to the bottom
• 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.
10
Comparing coordinated and
uncoordinated regimes:
Skilled majority
1
0.8
Tax Rate
0.6
0.4
0.2
tl uncoordinated
tk uncoordinated
tl coordinated
tk coordinated
0
-0.2
-0.4
6.2
6.3
6.4
6.5
6.6
6.7
6.8
6.9
Host country productivity
7
7.1
7.2
11
Taxes: Comparing skilled and unskilled
majority
0.6
0.4
tl coordinated s majority
tk coordinated s majority
tl coordinated u majority
tk coordinated u majority
Tax Rate
0.2
0
-0.2
-0.4
-0.6
-0.8
6.2
6.3
6.4
6.5
6.6
6.7
6.8
Host country productivity
6.9
7
7.1
7.2
12
Taxes
1
Tax Rate
0.5
tl uncoordinated
tk uncoordinated
tl coordinated
tk coordinated
0
-0.5
6.2
6.3
6.4
6.5
6.6
6.7
6.8
6.9
Host country productivity
7
7.1
7.2
13
Migration Volumes
0.8
ms coordinated s majority
mu coordinated s majority
0.7
ms coordinated u majority
mu coordinated u majority
Tax Rate
0.6
0.5
0.4
0.3
0.2
0.1
6.2
6.3
6.4
6.5
6.6
6.7
6.8
6.9
Host country productivity
7
7.1
7.2
14
Excluding Capital Mobility
15
Number of skilled migrants is higher
under coordination than under
competition
16
Gains and Losses associated with the
volume of migration
• Gains from migration to the host country:
the infra-marginal gains due to diminishing
marginal productivity of labor.
• Losses from migration to the host country:
the native-born population share with
migrants the tax collected from capital income
(or fixed factors) financing the uniform
benefit per capita to which the migrants are
entitled.
17
Fiscal Externality
• The native-born decision maker ignores the
fact that a tax-migration policy which admits
an extra migrant raises the well-being (a cost
to the native born) that must be accorded to
migrants by other host countries, in order to
elicit the migrant to come in.
• Consequently, the policy offer too high level of
benefit, levies too high taxes, and admits too
many migrants.
18
Conclusion
• The literature on tax competition with free capital
mobility cites several reasons for a race to the bottom.
• In contrast, with fixed population that can move from
one jurisdiction to another, the Tiebout paradigm
suggests the tax competition yields efficient outcome.
• We identify a fiscal externality associated with
migration which raises the tax rates on labor and
capital, and the volume of migration, for all skill types
to be too high , compared to a coordination regime.
19