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Peer Pressure: Tax competition and developing economies

Michael Keen's picture
A race to the bottom. Graphic by Nicholas Nam/World Bank

Economists tend to agree on the importance of competition for a sound market economy. So what’s the problem when it comes to governments competing to attract investors through the tax treatment they provide? The trouble is that by competing with one another and eroding each other’s revenues, countries end up having to rely on other—typically more distortive—sources of financing or reduce much-needed public spending, or both.

All this has serious implications for developing countries because they are especially reliant on the corporate income tax for revenues. The risk that tax competition will pressure them into tax policies that endanger this key revenue source is therefore particularly worrisome.

Keep Up With the Others
 
Many have argued that tax competition between governments can trim wasteful spending and lead to better governance; the ‘starve the beast’ argument. But the mobility of tax bases across national borders makes this benefit less clear, whether the base relates to labor income, commodity transactions, or most commonly, capital income.

More technically, countries tend, with good reason, to tax things that are not highly responsive to taxation. But international mobility means that activities are much more responsive to taxation from a national perspective than from a collective perspective. This is especially true of the activities and incomes of multinationals. Multinationals can manipulate transfer prices and use other avoidance devices to shift their profits from high tax countries to low, and they can choose in which country to invest. But they can’t shift their profits, or their real investments, to another planet.

When countries compete for corporate tax base and/or real investments they do so at the expense of others—who are doing the same. By failing to exploit the lesser responsiveness of tax base and investment at the collective level than at the national level, countries thus risk mutual harm by eroding a source of revenue that may well have been more efficient than the alternatives available to them.
 
Headline corporate income tax rates have plummeted since 1980, by an average of almost 20 percent. This doubtless reflects a variety of effects at work—changing views on the growth impact of corporate taxation, for instance—but it is a telling sign of international tax competition at work, which closer empirical work tends to confirm.  





And even though revenues have remained steady so far in developing countries and increased in advanced economies—perhaps because, for unrelated reasons, the share of capital in national income has increased—there is nothing to guarantee that this will continue. And some developments could make tax competition more intense: if the OECD-G20 ‘BEPS’ project reduces tax avoidance, for instance, competition through other means could increase.
 
Fiercely Competitive; Fiercely Contentious
 
To better understand these issues and how they might be addressed, the IMF and World Bank recently gathered together a hundred or so tax experts and officials. Embert St. Juste, of the Ministry of Finance in St. Lucia, for instance, noted that the members of the Organisation of Eastern Caribbean States have been competing with increasing fervor over foreign direct investment and tourism. And the Finance Minister of the Republic of Serbia, Dušan Vujović, said that with greater globalization, all countries have been dragged, willingly or not, into the fray.
 
Kimberly Clausing, an economics professor at Reed College, presented new work suggesting that paper profits may be much more sensitive to tax rates than previously thought. She cited a recent paper that finds that for every percentage point drop in the average tax rate in a low-tax jurisdiction, profits reported there by foreign corporations of U.S. multinationals increase by between 3.5 and 7 percentage points. This remains contentious. Paul Ryan from the Irish Department of Finance suggested that the impact, particularly from more advanced economies to less, has been exaggerated. But tax competition is generally seen as a real threat to revenue, most notably for developing countries.
 
There is an answer: use international coordination to stop, or at least limit, the race. That, however, is much more easily said than done.
 
Passive-Aggressive
 
Partial solutions can help but are inherently limited. As Michael Devereux of the University of Oxford stressed, if only some countries coordinate, they can make themselves more vulnerable to competition from those outside the group. And even if all coordinate, they can remain vulnerable if they do not do so over all relevant aspects of the tax system. Nonetheless, partial approaches can help.
 
Some recent proposals would fundamentally change corporate tax systems. Gaetan Nicodeme from the European Commission explained its proposal for a Common Consolidated Corporate Tax Base. Under the first stage of this, businesses operating in more than one European Union country would consolidate their taxable profits across borders so the profits in one country could be offset against losses in another.

In a second stage, their profits within the EU would be allocated for tax purposes across member states by a formula reflecting the proportions of their assets, employment or other indicators of their activities in each. This, however, would not eliminate tax competition, since governments would still have an incentive to use low tax rates to attract investment, workers or whatever else appears in the allocation formula.
 
An alternative system that has attracted considerable attention recently in the United States is the destination-based cash-flow tax (DBCFT) under which taxes are levied based on where goods end up (destination), rather than where they were produced. If adopted universally, and well-designed, this would ease pressures of tax competition. But if adopted unilaterally by one or a few countries, it would amplify profit shifting problems for others. This is because, intuitively, profits from sales elsewhere could then be taken tax-free in those countries, which would likely lead those without a DBCFT to compete more aggressively, or adopt one themselves.
 
Issues of international tax competition are not going away anytime soon, and that there is a lot at stake for developing countries. In the face of possible tectonic shifts in tax systems, such as a move to a destination based corporate taxation, it has become even more important to understand the cross-border impact of national tax policies and how governments react to them.

This remains an issue of debate and study, and both the IMF and the World Bank plan to continue this analysis, including at a high-level event co-organized with the Ministry of Finance of Indonesia. Part of the Voyage to Indonesia leading up to the World Bank-IMF Annual Meetings in 2018, the discussions will focus on the challenges that tax competition poses for the members of the Association of Southeast Asian Nations.


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Comments

Submitted by arturo on

Thank you for keep us posted about tax competitions issues in developing countries.

Submitted by Jacqueline Coolidge on

I agree with most of this, but wonder about who would actually bear the incidence of a DBCFT. Given its similarities to a standard VAT, many fear that it would end up as just another regressive consumption tax, exacerbating the problems of inequality (inequality between individuals/households, not necessarily between nation states).

In this regard, I would note the comment above: "revenues have remained steady so far in developing countries and increased in advanced economies—perhaps because, for unrelated reasons, the share of capital in national income has increased..." How sure are we that the increased share of capital was "unrelated" to the shift in the tax burden from CIT to VAT and other consumption taxes? I thought Piketty made a pretty good case that tax reforms over the past several decades had plenty to do with it.

Submitted by Ata on

Professor Kim Brooks has done some great work studying international tax concerns from an "inter-nation equity" or developing country perspective; her publications can be accessed here: http://ssrn.com/author=110192

Submitted by Paula Ledesma on

Very interesting topic. I have two comments/questions for the author/readers:
1. There are some authors that consider tax competition as a positive issue since those countries decreasing the CIT rate attract MNE to their economies and therefore increase employment rates, build routes, consumption, etc. What would be a contra-argument to this?
2. In regard to DBCFT, "under which taxes are levied based on where goods end up (destination), rather than where they were produced", it may lead to an increase of revenues in those countries with high rates of consumption, increasing inequality with developing countries, that usually have low rates of consumption in relation to the developed ones.

Have a wonderful day!

Submitted by David Chester on

They should tax land values instead of all the rest. Here's why:

Socially Just Taxation and Its Effects (17 listed)

Our present complicated system for taxation is unfair and has many faults. The biggest problem is to arrange it on a socially just basis. Many companies employ their workers in various ways and pay them diversely. Since these companies are registered in different countries for a number of categories, the determination the criterion for a just tax system becomes impossible, particularly if based on a fair measure of human work-activity. So why try when there is a better means available, which is really a true and socially just method?

Adam Smith (“Wealth of Nations”, 1776) says that land is one of the 3 factors of production (the other 2 being labor and durable capital goods). The usefulness of land is in the price that tenants pay as rent, for access rights to the particular site in question. Land is often considered as being a form of capital, since it is traded similarly to other durable capital goods items. However it is not actually man-made, so rightly it does not fall within this category. The land was originally a gift of nature (if not of God) for which all people should be free to share in its use. But its site-value greatly depends on location and is related to the community density in that region, as well as the natural resources such as rivers, minerals, animals or plants of specific use or beauty, when or after it is possible to reach them. Consequently, most of the land value is created by man within his society and therefore its advantage should logically and ethically be returned to the community for its general use, as explained by Martin Adams (in “LAND”, 2015).

However, due to our existing laws, land is owned and formally registered and its value is traded, even though it can't be moved to another place, like other kinds of capital goods. This right of ownership gives the landlord a big advantage over the rest of the community because he determines how it may be used, or if it is to be held out of use, until the city grows and the site becomes more valuable. Thus speculation in land values is encouraged by the law, in treating a site of land as personal or private property—as if it were an item of capital goods, although it is not (Mason Gaffney and Fred Harrison: “The Corruption of Economics”, 2005).

Regarding taxation and local community spending, the municipal taxes we pay are partly used for improving the infrastructure. This means that the land becomes more useful and valuable without the landlord doing anything—he/she will always benefit from our present tax regime. This also applies when the status of unused land is upgraded and it becomes fit for community development. Then when this news is leaked, after landlords and banks corruptly pay for this information, speculation in land values is rife. There are many advantages if the land values were taxed instead of the many different kinds of production-based activities such as earnings, purchases, capital gains, home and foreign company investments, etc., (with all their regulations, complications and loop-holes). The only people due to lose from this are those who exploit the growing values of the land over the past years, when “mere” land ownership confers a financial benefit, without the owner doing a scrap of work. Consequently, for a truly socially just kind of taxation to apply there can only be one method--Land-Value Taxation.

Consider how land becomes valuable. New settlers in a region begin to specialize and this improves their efficiency in producing specific goods. The central land is the most valuable due to easy availability and least transport needed. This distribution in land values is created by the community and (after an initial start), not by the natural resources. As the city expands, speculators in land values will deliberately hold potentially useful sites out of use, until planning and development have permitted their values to grow. Meanwhile there is fierce competition for access to the most suitable sites for housing, agriculture and manufacturing industries. The limited availability of useful land means that the high rents paid by tenants make their residence more costly and the provision of goods and services more expensive. It also creates unemployment, causing wages to be lowered by the monopolists, who control the big producing organizations, and whose land was already obtained when it was cheap. Consequently this basic structure of our current macroeconomics system, works to limit opportunity and to create poverty, see above reference.

The most basic cause of our continuing poverty is the lack of properly paid work and the reason for this is the lack of opportunity of access to the land on which the work must be done. The useful land is monopolized by a landlord who either holds it out of use (for speculation in its rising value), or charges the tenant heavily for its right of access. In the case when the landlord is also the producer, he/she has a monopolistic control of the land and of the produce too, and can charge more for this access right than what an entrepreneur, who seeks greater opportunity, normally would be able to afford.

A wise and sensible government would recognize that this problem derives from lack of opportunity to work and earn. It can be solved by the use of a tax system which encourages the proper use of land and which stops penalizing everything and everybody else. Such a tax system was proposed 136 years ago by Henry George, a (North) American economist, but somehow most macro-economists seem never to have heard of him, in common with a whole lot of other experts. (I would guess that they don't want to know, which is worse!) In “Progress and Poverty” 1879, Henry George proposed a single tax on land values without other kinds of tax on produce, services, capital gains etc. This regime of land value tax (LVT) has 17 features which benefit almost everyone in the economy, except for landlords and banks, who/which do nothing productive and find that land dominance has its own reward.

17 Aspects of LVT Affecting Government, Land Owners, Communities and Ethics

Four Aspects for Government:

1. LVT, adds to the national income as do other taxation systems, but it replaces them.
2. The cost of collecting the LVT is less than for all of the production-related taxes--tax avoidance becomes impossible because the sites are visible to all.
3. Consumers pay less for their purchases due to lower production costs (see below). This creates greater satisfaction with the management of national affairs.
4. The national economy stabilizes—it no longer experiences the 18 year business boom/bust cycle, due to periodic speculation in land values (see below).

Six Aspects Affecting Land Owners:
5. LVT is progressive--owners of the most potentially productive sites pay the most tax.
6. The land owner pays his LVT regardless of how his site is used. A large proportion of the ground-rent from tenants becomes the LVT, with the result that land has less sales-value but a significant "rental"-value (even when it is not used).
7. LVT stops speculation in land prices and the withholding of land from proper use is not worthwhile.
8. The introduction of LVT initially reduces the sales price of sites, even though their rental value can still grow over a longer term. As more sites become available, the competition for them is less fierce.
9. With LVT, land owners are unable to pass the tax on to their tenants as rent hikes, due to the reduced competition for access to the additional sites that come into use.
10. With LVT, land prices will initially drop. Speculators in land values will want to foreclose on their mortgages and withdraw their money for reinvestment. Therefore LVT should be introduced gradually, to allow these speculators sufficient time to transfer their money to company-shares etc., and simultaneously to meet the increased demand for produce (see below).

Three Aspects Regarding Communities:
11. With LVT, there is an incentive to use land for production or residence, rather than it being unused.
12. With LVT, greater working opportunities exist due to cheaper land and a greater number of available sites. Consumer goods become cheaper too, because entrepreneurs have less difficulty in starting-up their businesses and because they pay less ground-rent--demand grows, unemployment decreases.
13. Investment money is withdrawn from land and placed in durable capital goods. This means more advances in technology and cheaper goods too.

Four Aspects About Ethics:
14. The collection of taxes from productive effort and commerce is socially unjust. LVT replaces this extortion by gathering the surplus rental income, which comes without any exertion from the land owner or by the banks--LVT is a natural system of national income-gathering.
15. Bribery and corruption on information about land cease. Before, this was due to the leaking of news of municipal plans for housing and industrial development, causing shock-waves in local land prices (and municipal workers' and lawyers’ bank balances).
16. The improved use of the more central land reduces the environmental damage due to a) unused sites being dumping-grounds, and b) the smaller amount of fossil-fuel use, when traveling between home and workplace.
17. Because the LVT eliminates the advantage that landlords currently hold over our society, LVT provides a greater equality of opportunity to earn a living. Entrepreneurs can operate in a natural way-- to provide more jobs. Then earnings will correspond to the value that the labor puts into the product or service. Consequently, after LVT has been properly introduced it will eliminate poverty and improve business ethics.

Submitted by Joe Powell on

The theory of reducing corporate income tax rates as an incentive to attract more business along with an overall increase in tax revenues and employment is sound. However, there is a caveat-when exercising this practice in less than developed, underdeveloped and developing countries, other factors come into play at different levels
that counteract the positive benefis gained by simply reducing or rearranging the corporate tax rate, i.e., long-term political stability, crime rates, infrastructure health, continued access to markets, etc. These aforementioned factors do not however negate the positive benefits of tax competition among countries whatsoever.

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