Tax Competition
IFC platforms generally facilitate financial transactions with low or no income tax. This puts pressure on dominant countries to reduce their own tax rates. What do economists have to say about the impact of tax competition on consumers and onshore revenue collection?
The term “tax haven” conjures up two unrelated concepts: bank secrecy as a cover for tax evasion and low taxes. A confused public perception of linkage between (wrongful) tax evasion and (generally beneficial) tax diversity and competition undermines clarity in the debate over the role of international financial centres in the global economy. The Organisation for Economic Co-operation and Development perpetuated this misunderstanding in April 2009 when it inexplicably divided its “grey list” (published on G-20 instructions) into “tax havens” and “other financial centres”.
Use of foreign jurisdictions to evade home country tax is unreservedly condemned by the IFC Forum. Tax competition, however, is widely welcomed by most economists and by the IFC Forum. The reasons for this are simple: international tax competition encourages economic growth and efficient delivery of public services. Businesses operate best when in competition. The same is true for governments. Government cartels to maximise income through attacks on (tax) competition should be discouraged, just as similar behaviour to constrain competition between corporations is rightly curbed.
Governments are the ultimate monopoly supplier and so have a natural tendency to inefficiency in the absence of pressures to deliver value for money. This is not to suggest that inefficiencies in government arise from bad faith or inherent incompetence: rather, monopoly suppliers have no inbuilt spur to deliver consumer-oriented service. Democracy is a weak constraint, particularly where a significant electoral group benefits disproportionately from government services. The recent substantial and unchecked growth in the size, pay and perquisites of the U.K. public bureaucracy at the expense of the private sector is a case in point.
Older economic theory feared a “race to the bottom” in country tax rates as mobile taxpayers moved to take advantage of lower rates elsewhere. Concerns were expressed about the risk of collective rounds of tax cutting, depriving countries of funding for essential public goods - roads, schools and hospitals. This argument incongruously assumes that public spending is valuable, yet mobile tax bases do not value it. Mobile taxpayers do value public goods of course - transport and communications, for example. In any event, businesses make locational decisions for many reasons beyond tax, including proximity to markets.
The key reason for discounting “race to the bottom” concerns in modern economic analysis is empirical: the feared effect has simply not materialised in fact. Despite widespread liberalisation of trade and financial markets over the past thirty years the income of Western governments from taxation has risen significantly in absolute terms and has remained broadly static as a percentage of GDP. Exploding another myth, the tax burden has not moved from mobile corporations to immobile workers as is commonly assumed. As the graph below based on OECD statistics shows, while corporate tax rates have declined over the last thirty years the taxes raised from corporations have increased relative to other sources of revenue:
Tax revenue rises when rates are reduced to the optimum level (26% in OECD countries according to a recent study[1]). The reason is that economic (and tax base) growth is faster in countries which apply low tax rates, since productive capital stays in the private sector for reinvestment. Over the period 1950 to 2000 the (low tax) Hong Kong economy produced GDP growth per capita of 800%, despite absorbing an enormous inflow of impoverished refugees from China. The equivalent growth rate in the U.K., for example, was 175%. Although it seems initially counter-intuitive, economists recognise that lower taxes lead to higher tax revenues when the tax base grows with the economy.
A review conducted by one of the leading American economists studying the effect of tax competition, Professor James Hines, confirms the association between low tax and growth across a broad group of OECD countries. Professor Hines found that from 1982 to 1999 countries with low tax rates grew 2.5 times faster than high tax countries.[2] The relationship between low taxes and growth also appears in other comparisons of OECD countries, as the table below shows:
Table 2: Growth rates in selected regimes (per cent)
| Country | Tax (% GDP) 1992 | Tax (% GDP) 2002 | Growth 1992–2002 |
| Ireland | 34 | 30 | 82 |
| New Zealand | 36 | 35 | 36 |
| UK | 35 | 38 | 28 |
| France | 43 | 45 | 21 |
Source: G. Leach, “The negative impact of taxation on economic growth”, Reform, September 2003.
Another common myth is that low tax rates benefit only (or principally) the wealthy individuals and the mobile corporate sector. Interestingly, low paid workers are a key beneficiary of the economic growth fostered by low taxes. Where growth is sluggish, job creation stalls and employers reduce the wages paid to attract workers. Where there is growth, employers face greater demand for labour and must offer higher wages and improved conditions to attract workers.
The public is rightly suspicious of private behaviour which tries to suppress competition to the prejudice of consumers. Initiatives between governments designed to maximise taxes by challenging other jurisdictions with low tax policies (including international financial centres) should similarly be regarded with scepticism. Tax diversity and competition promotes growth and should be encouraged.
[1] Alex Brill and Kevin Hassett, “Revenue Maximizing Corporate Income Taxes: The Laffer Curve in OECD Countries”, American Enterprise Institute, Working Paper #137, 31 July 2007.
[2] James R. Hines, "Do Tax Havens Flourish?", Tax Policy and the Economy, Vol. 19 (Cambridge, MA: MIT Press, 2005), p. 66.