Paper delivered at an international conference “Tax Competition and Competitiveness,” Vilnius

 

One of the most famous concepts in tax policy is known today as the Laffer curve. Popularized by Arthur Laffer in the 1970s, this is the common-sense notion that at some point, an increase in tax rates can become so onerous and the economy may suffer so much that tax receipts decrease. In other words, when tax rates increase, tax revenues fall.

 

This principle crept into the public debate during the Reagan presidency. In fact, President Reagan made the Laffer curve a principal pillar of his economic policy. And we know how successful he was as an economic boom replaced the stagflation of the 1970s in the 1980s. However, Arthur Laffer only deserves credit for popularizing this concept. Many economists[1] in the past have talked, written about, and explained the inverse relationship between high tax rates and low tax revenues.

 

What does the Laffer curve mean in term of economics?”  What does the Laffer curve tell us about taxpayers’ actions? It tells us that “taxes matter and incentives matter.” In other words, individuals react to taxes and that is because there can be no tax that leaves the market exactly as it would be without the tax. When you introduce taxes, people are encouraged to shift their behavior. It means that taxes induce distortions in individual choices. These distortions are of two types:

 

First, when you introduce taxes, people have an incentive to consume more today and consume less in the future. As a general rule, taxes favor consumption over savings. This in turn results in a smaller capital stock and then in lower growth.

 

Second, when you introduce taxes, people have an incentive to work less and to consume more leisure. In this case some people might decide to work fewer hours, while others might decide to go work in the underground economy. This of course is called tax evasion and, along with tax planning, is one of the most common ways taxpayers will react to taxes.

 

Distortions can be more or less severe according to individual preferences and to the level of taxes imposed on taxpayers. In any case, whether the distortions are strong or light, it remains true that taxes reduce the gains to voluntary exchange. In the words of economists, taxes are never neutral. They distort behavior. Of course, the higher the tax rate and the more discriminatory the tax, the greater the economic damage and ultimately the greater the incentive for taxpayers to revolt against taxes.

 

 

Taxpayers’ reactions to taxes can take many forms. Some are legal, some are illegal some are collective and some are individual.

 

1.       We have already talked about one of the most common forms of reaction to taxes – “tax evasion.” Tax evasion is illegal tax dodging. European countries have very high marginal tax rates and very high levels of evasion.  According to statistics gathered in 1999 by the International Monetary Fund, the estimated level of tax evasion in France is 17% of gross domestic product and exactly double what it is in the U.S. There is nothing of course to be surprised about since France has a tax burden of 45.5 percent of GDP (a French taxpayer making a mere $45,000 a year is taxed at the top marginal rate of 54 percent and pays an average value-added tax of 19 percent). In Italy, Denmark and Germany where the top marginal tax rates are respectively 50, 59 and 49 percent, tax evasion has reached 27, 25 and 17 percent of gross domestic product and is still increasing. Despite a 27 percent decrease in its top marginal tax rate in the last 20 years, Sweden still taxes its high-income earners with a 60 percent tax rate and the size of the underground economy there is still over 20% of GDP. Not surprisingly, the IMF estimates that the United Kingdom and Ireland where the top marginal tax rates are 40 percent have the smallest shadow economy (13% of GDP).

 

2.       Tax avoidance or tax planning is another form of revolt. Tax avoidance is any legal method of reducing one’s tax bill. Along with traditional tax planning, one of the forms taken by tax avoidance is capital flight. In the last two decades, globalization has undermined the power of high tax countries quite drastically by decreasing the cost of moving capital around in order to avoid high taxes. Building on technological advances, we have witnessed a rapid increase in the volume of transactions transcending national borders. Capital markets are now global and Capital move around the world from its lowest marginal productivity to their highest--from nations where it is over-taxed to nations where taxes are lower.

 

Ireland is a good example of how the level of corporate taxes influences taxpayer’s incentives to invest capital in other countries. At the end of 1980s, the Irish government cut the top personal income tax rate from 65 percent to 42 percent (the bottom rate was 20) along with its corporate income tax. The general corporate income tax had been 50 percent, but in 1980 the government established a special 10 percent rate for businesses in the Shannon Airport Zone. Observing the resulting boom in foreign investment, the government first broadened the program to include the International Financial Services Center in Dublin, and then began to cut corporate taxes for everyone. By 1996 the corporate rate had been slashed to 36 percent; today the rate is 24 percent and dropping. Ireland is now moving forward with one more tax reform and will implement a uniform 12.5 percent for the domestic and foreign corporate tax rate for all sectors by 2003[2]. The result has been a flood of foreign direct investment. Nearly half of all North American direct investment in Europe goes to Ireland. American multinationals Dell, Gateway, Microsoft, and Oracle all keep their European headquarters in Erin[3].

 

3.       Exit from the unit of government responsible for the tax. In a world where costs and restrictions on labor mobility are falling, citizens dissatisfied with government benefits received, compared to taxes paid, can vote with their feet and move to more favorable economic climates.

 

With the removal of restrictions on internal migration in the EU in 1992, Europeans have also become more aware of tax differences across countries.  While there are still large language and cultural barriers to migration within Europe, there has been an influx of younger skilled workers to cities, such as London, with more opportunities and lower taxes, particularly in fields such as technology and finance.   London’s workforce is about 23 percent foreign-born.[4]  At least 150,000 French citizens now live in Britain.[5] Hundreds of high-growth entrepreneurial French companies have relocated to Britain in recent years.[6] A French government report notes that 30 percent of French engineering graduates leave the country, and there are about 40,000 French nationals in Silicon Valley.[7]

 

Also, high taxes’ impact of course is highly visible in the high-paid celebrity world of musicians, models, actors, and sports stars.  In 1999, French supermodel Laetitia Casta was selected to be the new Marianne, the country’s national symbol of virtue and beauty.  But soon after, Laetitia became notorious by moving to Britain to escape high French taxes.  Casta was not alone.  Many top soccer and tennis players, artists, and models have moved to Switzerland, U.K., the United States, and elsewhere.[8] Celebrity tax avoidance has long been a popular game in Europe.  Luciano Pavarotti moved to Monaco and was chased down by the Italian government.[9]  Tennis star Boris Becker claimed residence in Monaco and later Switzerland and has gotten in trouble with German tax authorities.[10]

 

4.       Tax revolt through the initiative process. One of the most famous examples of this form of tax revolt is Proposition 13 in California in 1978 or Proposition 2½ in Massachusetts in 1980.

 

5.       Illegal collective action, such as a tax strike. Even though this is certainly the most serious weapon in the hands of taxpayers, it has rarely been used. The last major tax strike took place in the U.S. between 1930 and 1933. For more details about this major tax strike see the book wrote by David Beito on tax-limitation movements in the U.S. during of the Great Depression called Taxpayers In Revolt.)

 

 

One of the good things about the different reactions to taxes mentioned above is that they relieve taxpayers from part of their tax burden.  Yet, a world where taxpayers have to evade, avoid tax or engage in tax strikes is not ideal. For instance, legal tax planning, even though potentially decreasing the amount of money that taxpayers have to pay, are still extremely costly for the taxpayer. Firms and individuals spend billions of dollars every year to try to reduce their tax burden, when that money could be spent on productive activities.

 

What about illegal tax revolt? Should we be concerned about tax evasion? After all, taxpayers are only cheating to keep more of what they have rightfully earned. True, but if one believes that the laws should apply equally to all, tax evasion constitutes a problem. So tax evasion is not a good thing in itself. Nevertheless there is a case to be made for tax evasion though depending on the situation. In a low tax environment, it is difficult to justify evasion. In a high-tax environment, it is hard not to.

 

So ideally, we would prefer a world where taxpayers do not feel compel to avoid and evade taxes in order to keep more of their money. And since their revolt is induced by high tax rates, an effective way to deal with tax evasion is to make tax burdens reasonable by asking tax countries to reduce their tax rates.

 

 

There are 2 ways.

 

The first one is to elect politicians who are committed to cutting tax rates; reducing spending and implementing pro-growth tax policies. In other word, this option amounts to counting on willingness of politicians to do the right thing independently of the institutions in place. Unfortunately, this is not an option any taxpayers should really count upon. It is not impossible but it is very unlikely. In the last century, few are the politicians whom have proven to be able and likely to accomplish such a miracle. In the United States, Treasury Secretary Arthur Mellon in the 1920s, then president Kennedy in the 60s and President Reagan in the 80s led the march to tax reforms cutting tax rates drastically. In the 80s following president Reagan’s steps, Lady Thatcher engaged in massive tax rates bringing prosperity to the United Kingdom. Since then, fundamental tax reforms have been implemented in some of the most progressive Eastern European countries bringing growth and hope of prosperity. At the end of 2001, President Vladimir Putin introduced a 13% flat tax on individual income, replacing a complex system with a marginal rate of 30%. Then, he cut the tax rate on corporate profits down to 24 percent and reduced social security levies. Finally, after cutting personal and the Irish government cut corporate taxes down to 18 in December 2001.

 

The second way is through tax competition:

 

The benefits of tax competition are endless. For one thing, tax competition is our most effective weapons to reduce tax rates and promote freedom and prosperity. Economists usually praise the workings of competition because they agree that competition promotes socially beneficial outcomes.

 

For those of you whom have traveled to France, and drove through France, you must have had the terrible experience of restaurants along the French freeways. In these restaurants, the food is disgusting and the price you must pay for one of the worse meal of your life is outrageous. Why is that: Well it is because there is no competition. The government owns the roads and the restaurants on these roads have a monopoly. As long as a restaurant has a monopoly, the owner can without much risk charge a high price for food, and provide a poor service.

 

If suddenly, the owner of these restaurants had to deal with a bunch of competitors, things change. If MacDonald restaurants or Wendy restaurants were allowed along the French freeways, the other restaurants would be forced to behave and prices would go down, the quality of the food would go up, or even better both. In effect, market competition means that the customer is king and everyone benefits from the process.

 

 

Competition between governments serves the same function as competition between restaurants, shoes stores and car dealers. And like other forms of competition, tax competition protects taxpayers against abuses.

 

Tax competition occurs when individuals can choose among jurisdictions with different levels of taxation when deciding where to work, save, invest and shop. These lower tax jurisdictions are what we will call tax havens. These so-called tax havens provide taxpayers with the ability to avoid high tax nations and make it more difficult for government to enforce oppressive tax burdens. When politicians are competing for taxpayers with other politicians around the world, they must exercise a certain degree of budget and fiscal discipline in order to attract jobs, capital and entrepreneurs instead of losing them to another country.

 

Tax competition promotes responsible tax policies. For example, when there is tax competition, politicians have an incentive to move away from capital taxes because of fear that capital might flee to other jurisdictions where it will earn a better after-tax return. And if they don’t do it taxpayers revolt. This is exactly what is going on right now with US firms moving outside of the US to escape from the punitive corporate income tax rate and the fact that US taxes income on a worldwide basis.

 

Tax competition ultimately forces politicians to think about the need to cut taxes. By forcing politicians to be more responsible, tax competition pushes general tax rates down and allows people to enjoy more of the money they earn and a better quality of public services. By pushing general tax rates down, tax competition reduces the incentive to revolt against taxes.

 

Tax competition is a powerful weapon in promoting good tax policy because politicians often do the right thing only when they have no other alternative. And here the lack of alternatives comes from the fact that they are faced with competition from other jurisdictions.

 

Remember, when Thatcher and Reagan cut the tax rates in the 1980s; tax rates around the world started to fall (see Table 1. Top Personal Income Tax Rates, 1980-2000.) This did not occur because policymakers in other nations suddenly became pro-market, but rather because investors and entrepreneurs were shifting their activities to the U.S. and politicians had no choice but to lower their personal and corporate tax rates in order to remain somewhat economically attractive.

 

 

The vast majority of industrial nations have reduced their personal and corporate income tax rates since the 1980s.  The average top corporate tax rate for national governments in 26 OECD countries fell from 41 percent in 1986 to 31 percent in 2001 (see Table 1).[11] As a result, the 35-percent U.S. federal corporate rate is now 4 percentage points higher than the OECD average.  A new survey by KPMG, which takes into account both national and subnational taxes, found that the average 40 percent U.S. federal/state combined corporate rate was a remarkable 8 percentage points higher than the 29-nation OECD average of 32 percent in 2002 (see Figure 5).[12] 

 

The average top individual tax rate for national governments in the OECD fell from 55 percent in 1986 to 41 percent today.[13] This compares to the 39 percent top U.S. federal rate (scheduled to fall to 35 percent by 2006).  A study by James Gwartney and Robert Lawson that included subnational governments found that the average top tax rate in OECD countries fell from 63 percent in the mid-1980s to 47 percent today (see Table 2).[14]

 

Capital gains taxes have also been cut in numerous countries.  Canada, for example, cut its effective individual capital gains rate from 40 percent to 25 percent in 2000.[15] In many countries, such efforts have been spurred by the desire to emulate U.S. high-tech success, which has been fueled by investment flows sensitive to capital gains tax rates, including angel financing, venture capital, and public stock offerings.  Note that a number of countries, such as the Netherlands, Hong Kong, and Taiwan, do not tax individual capital gains at all.[16]  

 

Corporate capital gains taxes are also an important tax factor.  The Netherlands, for example, does not tax corporate capital gains, thus reducing taxation on corporate restructuring.  This and other tax features make the Netherlands an attractive location for holding companies and multinational headquarters.[17] Germany’s recent corporate tax reforms abolished its 50 percent corporate capital gains tax on sales of stakes in other companies because of competitiveness concerns.  These reforms prompted the European Union to express concern that this may constitute “unfair tax competition” because it will attract foreign holding companies to Germany.[18] 

 

Tax competition has spurred other tax reforms.  A group of Nordic countries have installed dual income tax systems that feature a low flat rate on capital income (interest, dividends, and capital gains) while retaining progressive rates on labor income.  Denmark, Finland, Norway, and Sweden implemented such reforms a decade ago.  The Netherlands and Austria have recently implemented similar reforms, and other European countries have moved in that direction.[19] The OECD notes that these “moves toward a lower and flat tax on capital income has often reflected the need to remain competitive on the international capital markets.”[20] Dual income tax systems with lower tax rates on mobile tax bases are a constructive response to the inefficiencies and widespread tax avoidance and evasion that has occurred under Europe’s high tax rates.

 

Another policy response to tax competition has been the reduction and elimination of special taxes on wealth in Europe.  Capital mobility has undermined the ability to collect these redistributionist taxes.  In the 1990s, Norway and Sweden reduced their wealth taxes, and Denmark, the Netherlands, Austria, and Germany abolished them.[21] One survey of 19 countries found that the average wealth tax has fallen 40 percent since the mid-1980s.[22] 

 

Tax competition has also driven down withholding taxes.  These are taxes placed on payments to foreigners of interest, dividends, and other investment returns.  Withholding taxes create an investment disincentive by placing an "exit fee" on repatriated profits.  For example, businesses are dissuaded from building factories in countries that place a high tax on dividends repatriated to the home country.  One survey of 19 major economies found that the withholding tax on bank interest has been more than cut in half in the past decade.[23] 

 

Britain and the U.S. jump-started the worldwide move toward lower tax rates in the 1980s.  Britain cut its corporate tax rate between 1982 and 1986 (52 to 35 percent), with the U.S. following in 1986 (46 to 34 percent).  Substantial cuts followed in Australia in 1988, Canada between 1986 and 1988, France between 1986 and 1993, Germany in 1990, and Japan between 1989 and 1991.[24]

 

Both the direct threat of a disappearing tax base and general intellectual trends led to these reforms.  Countries that have close trade and investment ties will naturally respond more strongly to each other’s tax reforms.  After the 1986 U.S. tax rate cut, Canadian policymakers were very concerned that U.S. corporations would shift profits from their high-tax Canadian subsidiaries to their U.S. headquarters.[25] They could do this fairly easily by increasing their debt financing in their Canadian subsidiaries to shift taxable income out of Canada.  As a consequence, Canada moved quickly to cut its corporate tax rate to avoid losing its tax base.

 

Since the mid-1990s, another round of marginal rate cuts has occurred.  Top personal income tax rates have recently been cut in Germany, the Netherlands, and Canada.[26] Corporate tax rates have recently been cut, sometimes with phase-ins, in Australia, Germany, Canada, and Denmark.[27]

 

Note that with regard to the corporate income tax, the statutory rate is just one factor in the attractiveness of a business tax climate.  The overall, or effective, marginal tax rate is affected by depreciation deductions, investment credits, and other provisions.  Effective corporate tax rates have fallen in the OECD in recent years, but not by as much as statutory rates.[28] Nonetheless, for many corporate decisions statutory rates are the relevant tax factor to consider.  For example, tax advantages gained by shifting corporate borrowing between countries depend upon statutory rates.[29] As one study found, "reported income of corporations can be highly elastic with respect to the statutory tax rate since income can be easily shifted from one tax jurisdiction to another without moving real assets."[30]

 

Aside from broad-based tax cuts, some governments offer special narrowly focused tax breaks to firms scouting for new investment locations.[31] These types of special deals are often made by subnational governments to attract highly valued investments such as computer chip plants.[32] Empirical evidence indicates that these incentives do indeed increase investment inflows.[33] But targeted tax breaks are discouraged by economists, who instead favor broad-based tax reductions. Narrow tax incentives add complexity, unfairness, and increase opportunities for corruption. Also, special incentives are often band-aids for more fundamental policy problems such as excessive regulation. For example, Indonesia and India frequently offer such tax incentives to lure investment, and yet rank 72^nd and 92^nd in the world in terms of basic economic freedoms.[34]

 

In summary, tax competition has caused substantial cuts in individual and corporate statutory income tax rates.  Other reforms have included reductions in wealth taxes, withholding taxes, and taxes on individual interest, dividend, and capital gains.  While these reductions in tax rates have been very beneficial, tax competition has not yet reduced overall tax levels in most countries.  Total taxes as a percentage of GDP rose from 32.1 percent in 1980 to 37.3 percent by 1999, on average, in the OECD.[35]  Therefore, international tax competition has not yet caused Big Government to melt away.  There is still a lot to do but tax competition and the existence of low tax jurisdictions providing and safe harbor to over taxed capital around the world is the surest way to win this battle.

 

 

Of course, whether this global reduction in tax rates is a desirable outcome depends on one’s perspective. Those who want lower tax rates and tax reform favor competition between countries, and between state and local governments. Those who want more power for the government and higher tax rates do not like tax competition and would do anything to undermine it.

 

And that is exactly what the OECD and the European Union – helped by some bureaucrats at the US Treasury – have been trying to do for some time now. High tax nations, in an effort to eliminate the pressure of having to compete with lower tax jurisdictions have directed the OECD to destroy tax competition. In their frenzy they have asked the U.S. to help them force low tax jurisdictions – tax havens -- to raise their tax rates and they have spared not efforts to try to convince low tax countries including the US to participate in a global tax cartel.

 

If the bureaucracies win, and tax havens disappear, all constraints on high tax loving governments will disappear and taxes will rise. Ironically, people will just go underground. In other words, people will not accept oppressive tax rates. So if tax competition is dead and tax rates stay high (or even increase), then people will have no choice but to evade and avoid taxes. Unfortunately, this solution is less desirable than one where tax havens are putting downward pressure on tax rates around the world allowing taxpayers to keep more of their money without having to engage in evasion or avoidance.

 

Returning full circle to our initial discussion of the Laffer curve, governments have a choice: They can collect a modest (but still too much) amount of tax revenue by maintaining reasonable tax systems with rates that are not too oppressive. This is the world created by tax competition and tax havens.

 

Or, governments can stop tax competition and destroy tax havens. They can create what Dick Armey calls a “global network of tax police.” This will allow them to maintain high tax rates. But, when the smoke has cleared, the government will collect only a modest amount of tax revenue. But the collateral damage to the economy and freedom will be so much higher.

 

 

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