Political and Institutional Explanations

In a last step, I add some political and institutional variables to the right hand side of the model to account for characteristics of the political system and partisan effects. Specifically, I introduce the political colour of the largest government party as well as the average partisanship of foreign governments taking possible indirect foreign constraints on domestic tax policy making into consideration (Basinger and Hallerberg 2004). In addition, I include procedural and institutional restrictions to the power of the executive, the maximal polarization between positions of legislative and executive parties, and dummy variables for legislative and executive elections to account for possible electoral business cycle effects. Table 14 presents the empirical results.

First to note, the estimates for the important theoretical variables remain stable and mostly replicate the findings from the baseline model (Tables 10 and 11). Still, including all variables induces problems of inefficiency due to collinearity of some of the concepts. As a consequence, the significance levels for all variables in the full models drop, although the size and direction of the coefficients are mostly unchanged. We can infer that tax competition impacts domestic policy making but the willingness and ability of governments to play the tax competition game is restricted by domestic conditions, especially societal demands for tax symmetry, the structure of the domestic capital and budget rigidities.

Turning to the discussion of the included political variables, we detect that neither elections nor ideological polarization significantly affect domestic tax policy making. The coefficients are found to be statistically insignificant for all dependent tax rates and the tax ratio. Executive constraints exert a

positive significant effect on effective tax rates on capital and wage income as well as on marginal corporate taxation supporting the findings and arguments of others (Hallerberg and Basinger 1999, Wagschal 1999a,b) stating that institutional constraints and veto players hinder governments from implementing large tax cuts intended to adapt capital taxation to internationally competitive levels. More and higher executive constraints prevent the implementation of reforms which in this case include reforms of the national tax system. Because the effect is somewhat stronger for capital than for labour tax rates, tax asymmetry decreases with the strength of executive constraints.

Partisanship of domestic and foreign governments represent the last variables to be considered. The colour of the national government, surprisingly, but in line with Basinger and Hallerberg (2004), exerts no or almost no significant impact on domestic decisions upon taxation.

Partisanship of the domestic policy maker only affects the effective capital tax rates with a relatively low significance level. Specifically, more right wing governments appear to implement lower effective tax rates on the mobile factor which confirms expectations in the literature holding that right wing governments on average tax and spend less than left wing policy makers (Garrett 1995 among others). Since the coefficient turns insignificant when more political variables are included (Model 24) the support remains weak

The political colour of governments abroad seems to have a stronger impact on domestic taxation, yet the direction of the influence is somewhat ambiguous. Conforming to the empirical results of Basinger and Hallerberg (2004), my results reveal that the higher the number of countries governed

by right-wing parties, the larger the negative effect for domestic effective capital tax rates. Domestic policy makers appear to expect right-wing governments abroad to cut effective capital taxes more strongly than left-wing policy makers in power. And they, therefore, follow the overall political trend. Though, the estimate for marginal corporate tax rates turns out to be significantly positive contradicting the stated argument. One can hardly think of a convincing explanation for the finding that domestic governments increase marginal corporate tax rates if more states are led by right-wing governments, especially since we cannot find a significant coefficient for partisanship of domestic leaders on corporate taxation. The spatial lag of partisanship does not significantly influence labour taxation which in combination with the effect on effective capital tax rates leads to greater tax asymmetry when right-wing parties dominate governments abroad.

Institutional constraints to executive policy making are the only political factor exerting a consistent effect on all dependent variables. Higher constraints hamper the implementation of tax reducing reforms and the effect turns out to be strongest for capital taxation. The more the executive is constraint by other political actors and institutional factors, the less able governments are to adapt tax rates to international competitive levels. Still, the effect for labour taxation remains much smaller and less significant, so that the tax gap increases if more restrictions to the executive are in place.

Overall, the inclusion of political and institutional variables does not or only marginally add to the explanatory power of the empirical model. The R-squared for labour taxation and the tax ratio do not grow at all as compared to the models in table 13 and for capital taxation this goodness of fit

measure increases only by 1 percent, even though in table 14 six additional explanatory variables are added to the right hand side of the estimation equation. Although political and institutional constraints might slightly limit the discretion of governments over tax policy making, the factors, on which governments base their – opportunistic and rational – choice of tax instruments – tax rates abroad, the structure of the domestic capital, societal demands for equity and public spending – dominate decisions upon the domestic tax system.

Table 14: The Effect of Political and Institutional Variables Independent Variables: FDI

weighted Fairness: Pre-tax Gini -44.090***

(15.362) Share of highly mobile

capital (t-1) Budget rigidities (t-1) 1.191***

(0.267) Share of elderly people 2.249***

(0.452) Unemployment (t-1) -0.346**

(0.137) SL Capital mobility -1.402***

(0.437) Trade openness (t-1) -0.049

(0.038)