Economic Explanations of Non-Zero Taxation

Existing theories in the economic tradition mainly focus on two aspects: the provisions of infrastructure as a (semi)-private good and asymmetric country-sizes. Additionally, economic accounts of tax policy tend to cling to the assumption of welfare maximizing governments and, therefore, disregard the strategic political goals governments attempt to achieve with taxation.

3.1.1 Publicly Provided Infrastructure

Many third generation economic approaches to tax competition argue that a country’s tax burden is not the only important factor driving location decisions of capital owners, but the infrastructure provided by governments also exerts an important influence (Wildasin 1986, Wellisch 1995, Oates 1996). If taxes are seen as the price which must be paid for the publicly provided infrastructure, capital owners and investors will accept this cost (Sinn 2003, p. 30). Hence, from the isolated viewpoint of a single country it seems rational to impose at least some capital taxes. Therefore, a race to the bottom does not occur (Oates and Schwab 1988, Wellisch 1995, Oates 1996). If a functioning infrastructure improves the prospects for capital to generate income, it is rational for owners of the mobile factor to pay the tax enabling the government to provide infrastructure. In such a setting the immobile factor would not have to be taxed excessively and overall welfare would still be higher.

Modelling the capital tax as price for infrastructure is too simplistic, though, because infrastructure can be characterized as an impure public good with only limited rivalry between competing uses. Price setting for consuming one unit is hardly possible and the predictions are, therefore, not valid. To overcome this problem some researchers suggested generalizing the infrastructure argument to the case of congestion costs (Wildasin 1986, Gerber and Hewitt 1987, Boadway 1980, Berglas and Pines 1981). These economists come to a rather optimistic assessment of tax competition, where usage costs can be attributed to capital owners and the equilibrium outcome is not characterized by a race to the bottom.

Yet, predictions heavily hinge on the highly unrealistic assumption that infrastructure is not a public good and governments can determine the cost of using one unit of the good infrastructure. If infrastructure resembles a pure public good with no rivalry in consumption then the immobile factor bears the whole tax burden and no tax is levied to internalize the marginal congestion cost. This outcome equals the simple tax competition model without infrastructure.

Moreover, capital owners must be willing to pay for the usage of infrastructure. This assumption is even more unrealistic and contradicts the underlying logic of tax competition. When capital is fully mobile and governments attempt to attract mobile tax sources by undercutting each others tax rates, they would react in the same way with respect to the price attached to the usage of infrastructure. Capital owners move to jurisdictions with the most favourable conditions. Thus, the race to the bottom prediction would not only apply to tax rates on capital but also to prices for using the provided infrastructure.

Consequently, introducing infrastructure into tax competition models cannot reduce the mismatch between theoretical predictions and empirical developments since the results are purely driven by the assumptions regarding the degree to which infrastructure resembles a public good and the willingness of capital owners to pay the usage costs of infrastructure.

3.1.2 Tax Competition between Unequal Countries

A second stream of the economic literature relaxes the assumption of symmetric countries competing for mobile capital in order to explain persisting variance in capital tax rates. A symmetric account of tax competition eliminates possible terms of trade effects and a conflict of interest between the competing jurisdictions cannot arise. Therefore, scholars study the effect of differences in country size on capital tax competition (Bucovetsky 1991, Wilson 1991, Peralta and van Ypersele 2005).

Within the asymmetric tax competition model, the small country faces a more elastic tax base and undercuts the tax level of the large country in an asymmetric Nash equilibrium. This implies that the tax base of the small country will be larger than in the closed economy case opening the possibility for the small jurisdiction to gain from tax competition. The cost of capital is less sensitive to tax changes in the large region; the mobile capital reacts less elastic. In equilibrium smaller and more open countries implement lower tax rates and undercut the capital tax rates of their larger neighbours. Since firms in smaller countries employ more capital per unit of labour and hence offer higher wages than in large countries, smaller countries can also substitute some of the loss from capital tax revenue by

higher taxes on wage income as wages tend to be higher (Bucovetsky 1991, Wilson 1991, Kanbur/ Keen 1993).

The predictions of asymmetric tax competition find ample empirical support. All else equal, larger countries tend to impose higher tax rates on mobile capital than small countries (Bucovetsky 1991, Wilson 1991, Kanbur and Keen 1993). Still, convergence remains far from perfect even after controlling for country-size (Plümper and Schulze 1999).

In sum, models incorporating asymmetric competition give a first hint into the direction of capital mobility not being uniform across countries. Yet, the mobility purely depends on the size of a country. It remains empirically unclear what size enables a government to implement a non-zero tax rate on mobile capital. Furthermore, we cannot observe zero tax rates on capital – not even for very small countries. Country size is a time-invariant variable and, therefore, very unlikely to change. However, over the last three decades tax reforms have been implemented in almost all countries, tax rates have changed massively, and tax systems vary largely even between countries of the same size.