Government Behaviour

Increasing legal mobility of capital changes the international environment in which policy makers choose domestic tax rates. With less legal restrictions to capital account transactions, owners of mobile tax bases can more easily engage in arbitrage and shift capital to jurisdictions with favourable conditions i.e. low tax rates on mobile assets. This opportunity puts domestic governments under pressure since their ability to gather revenue from mobile factors declines. To attract mobile capital governments have to take tax policies of other countries into consideration when deciding upon domestic taxation. Policy makers find themselves in a prisoner's dilemma where competitive undercutting of tax rates on capital results in a downward

spiral and an equilibrium outcome of zero.³⁴ However, while statutory corporate tax rates have steadily decreased over the last three decades, the empirical literature found no evidence for a race to the bottom in capital taxation.³⁵

Still, lower restrictions to capital account transactions and higher de facto capital mobility force governments to take tax policy making in foreign jurisdictions into account. However, they do not incorporate the tax policy of all other countries equally into the decision making process. Policy makers partly base their decisions on the observation of which countries do well in the international competition for mobile tax sources. They learn from successful examples. In this context, governments have a higher interest in fiscal policies of countries which have success in attracting mobile capital since these jurisdictions present the direct competition.

In addition, companies base their location decisions on signals in order to decrease information costs (Ganghof 1999b). While choosing locations, investors and multinationals face very complex tax codes and exemption rules. They use the other inverstors’ location decisions as signal in order to reduce the costs of gathering information about optimal locations. Countries signal that they provide favourable conditions if they attract net capital inflows. Domestic firms, therefore, use the ability of other countries to attract capital as decision making device for their own location choices.

Following this logic, governments keep their tax rates closer to successful countries to prevent domestic capital from moving to these jurisdictions

34 This well known line of argumentation provides the basis for the tax competition literature.

35 See Devereux et al. (2002), Altshuler and Goodspeed (2002), Hallerberg and Basinger (1998, 1999), Basinger and Hallerberg (2004), Hays (2003).

By and large, international pressures restrict the room of manoeuvre for domestic policy makers. Governments in open economies – trying to secure re-election – are constricted by an international environment in which countries compete for mobile capital. Competition for mobile factors induces fiscal externalities since the internationally available mobile capital base has limits. The share of mobile capital crossing borders between two countries mainly depends on the difference in capital tax rates between the two jurisdictions. Capital outflows (inflows) reduce (increase) the domestic tax base and affect the government’s ability to collect revenue and to implement low tax rates.

International pressures and de facto capital mobility, though, only partially explain the incentives of governments deciding upon domestic taxation.

Because governments' largely care about their chances of being re-elected, tax policy making is also driven by preferences of the electorate with regard to public spending, deficits and redistribution of income.

One of the main tasks of the state is the provision of public goods which markets fail to produce. Therefore, governments have to gather revenue from mobile and immobile tax bases. This fact already prevents most policy makers from completely abolishing taxation on capital. Yet, competition for mobile sources might drive governments to shift some of the tax burden from capital to labour in order to maintain revenue and a satisfactory level of public good provision. Government spending is sticky because long term commitments to social security and pension systems prevent large cuts in public spending.

Moreover, economic integration triggers additional external risks such as sectoral downturns or unexpected losses of income, pushing the demand of

large parts of the electorate for insurance against and compensation of these external risks upwards.³⁶ The pressure on social security systems and in turn on public spending rises. Since spending cannot be significantly reduced, policy makers are unable to largely decrease tax rates both on mobile and immobile factors. The external risks which increase with globalization turn out to be especially severe for dependent employed workers. Since the majority of voters are wage earners, governments are inclined to spend more in order to compensate external risks.

Deficit spending is often not an option either because, first, EU member states have to subject themselves to the EU stability pact. The Maastricht criteria largely prevent new indebtedness. And second, governments are reluctant to create large public deficits because voters interpret public debt as mal-functioning of the domestic economy. Large deficits provide a signal of economic under-performance to the electorate.

Governments find themselves in a political dilemma: On the one hand higher legal capital mobility reduces their ability to collect taxes from mobile factors. On the other hand, policy makers need to supply a satisfactory amount of public goods. At the same time, they face restricted possibilities of shifting the tax burden towards wage earners or increase the public deficit. Thus, the more rigid the budget, the less able governments to reduce tax rates on capital to internationally competitive levels.

36 See Rodrik (1998), Hicks and Swank (1992), Garrett (1995, 1998a,c), Quinn (1997), Swank (1998), Schulze and Ursprung (2002).