Chapter 3: Literature
2. Important Strands of the Literature on Taxation
The vast literature on tax competition can be divided into three broad categories: The early economic literature on tax competition can be referred to as first generation models. These early models assume that governments only dispose of one policy instrument – a source based tax on mobile capital. More or less implicitly, capital is assumed to be fully mobile.
Transaction costs of shifting capital across jurisdictions, therefore, do not exist and – quite unsurprisingly – these models predict that, in equilibrium, tax rates converge to zero.8 The efficiency hypothesis of globalization states that due to the integration of financial and product markets and international competition, countries lose sovereignty over domestic policy making (Andrews 1994, Lee and McKenzie 1989) which results – in the case of capital taxation – in a race to the bottom of tax rates on mobile bases (Scharpf 1997, Tanzi 1995). This race to the bottom argument has been most explicitly stated by Bruno S. Frey (1990: 89): "In equilibrium, the tax rate on capital in each state will be driven to zero".
8 Zodrow/ Mieszkowski 1986, Oates 1972, Wilson 1986, Hoyt 1991, Bucovetsky/ Wilson 1991, Cahmley 1986, Lucas 1990, Razin/ Sadka 1991.
Second generation models take taxation on the immobile factor labour and public good provision into account. The most important results of these studies include a capital tax rate of zero in equilibrium while fiscal authorities shift the tax burden towards labour income. Since it is impossible to replace all capital tax revenue with government income gathered from wage earners these models also predict lower provision of public goods as compared to the closed economy case.9 The main lesson to be drawn from this literature is that the attempt to redistribute from capital to labour is costly and ineffective if capital is mobile (Sinn 2003).10
The question whether the outcome of tax competition improves or reduces a nation's welfare divides the researchers of the second wave. The first group of scholars holds that tax competition produces more efficient results and increases overall welfare because the possibility of tax arbitrage forces governments to provide efficient mixes of taxation and public good provision.11 In comparison, other researchers deem tax competition to result in inefficient allocation of factors and therefore to reduce social welfare.
Scholars in this tradition claim that the fiscal externalities of tax competition create inefficient solutions and public goods are under-provided as compared to the closed economy case where the provision was optimal.12
9 Sinn 2003, Rodrik 1997, Schulze/ Ursprung 1999, Webb 1998, Bretschger/ Hettich 2002, Steinmo 1996.
10 See also MacDougall 1960 and Richman 1963, Perrson / Tabellini 1995, and Quadrini 2005 who provides simulation results showing the magnitude of capital tax reductions and burden shift to labour taxation.
11 These models assume governments to be revenue maximizers and are based on Tibout's (1956) model of local competition. For more detailed accounts see Zodrow/
Mieszkowski 1986, Ottaviano/ van Ypersele 2005, Brennan/ Buchanan 1980, Rauscher 1996/ 1998, Edwards/ Keen 1996, Fischel 1975, and White 1975.
12 See Oates 1972, Wilson 1986, Zodrow/ Mieszkowski 1986, Hoyt 1991, Bucovetsky/
Wilson 1991, Chamley 1986, Lucas 1990, Wilson 1986/ 1999, Wilson/ Wildasin 2004, Bucovetsky 1991, Razin/ Sadka 1991, MacDougall 1960, Richman 1963.
The under-provision hypothesis is one of the most frequently cited results in the tax competition literature (Oates 1972, Wilson 1999).13 Due to fiscal externalities, international tax competition cannot produce efficient outcomes because the externalities cannot be internalized and the allocation of factors across jurisdictions must necessarily be inefficient (Wildasin 1989, Gordon 1983, 1986, Inman and Rubinfeld 1996, Sinn 2003).14
The predictions of first and second generation models meet contradictive empirical evidence.15 Both efficient and statutory capital tax rates remain far from converging to zero. One reason for the apparent gap between theoretical prognoses and observed evidence may well be that it is still too early for tax competition to fully work. However, the attempt of isolating theory from reality checks can hardly be convincing. With almost no remaining capital controls, with an evidently large number of countries with open capital accounts and with low transaction costs of physically moving capital, competitive pressures are unlikely to mount further in the future.
13 Concerning the under-provision of public goods hypothesis some scholars suggest that if tax competition results in a shift of tax burdens to immobile factors then total government spending does not have to decrease necessarily (Rodrik 1997; Schulze/
Ursprung 1999, Webb 1998; Bretschger/ Hettich 2002, Steinmo 1996, Radaelli 1998).
Schulze and Ursprung (1999) and Keen and Marchand (1997) argue that globalization leads to shifts in expenditure structure and revenue generation. Expenditure disadvantages non-productive and immobile groups such as immobile and non-skilled workers, retired people and consumers.
14 For discussion of externalities see also Mintz/ Tulkens 1996, Mintz1999, Huizinga/
Nielsen 1997a,b, Friedlaender/ Vandendorpe 1968, Keen 1989, Hamada 1966, Soerensen 1991, Bucovetsky 1991. Sinn (1997 and 2003) further develops the argument of externality induced inefficiency in his critique of competition between nation-states (systems competition) based on the selection principle. He mainly holds that ideal market conditions tend to exist in private competition but not in competition between states. From his perspective governments have the function to correct deficiencies of the market. In a nutshell the selection principle directs the state to limit itself to the provision of those public goods with decreasing returns to scale. If states are designed according to the selection principle, no efficient competition equilibrium for capital taxes exists and international tax competition must be ruinous and most of the tax burden is shifted to the immobile production factors.
15 See footnote 6
The mismatch between theoretical predictions and empirical observations led to more complex and refined models of taxation and tax competition.
These third generation models try to explain the absence of significant reductions in tax revenues collected from taxing mobile capital. Researchers particularly point to different domestic economic, institutional, and political constraints hindering governments from implementing low tax rates on corporate and capital income. They also suggest that the features of different political systems can account for variation in tax systems since they might prevent tax reforms designed to adapt domestic tax policy to international pressures.
3. Generation Three Models: Explanations of Non-Zero