Trends in Tax Reforms and Tax Levels in OECD/EU Countries

with exception of the smallest countries Luxembourg and Switzerland (OECD-SOPEMI 1994, 1997).

When goods and financial capital can move freely across jurisdictions, real capital is following. More and more firms have transferred their operations to countries with low wages and taxes due to increasingly intensive international product and cost competition. The more liberal the trade relations and the lower the relative transportation costs, the easier the relocation of production becomes (Sinn 2003, p. 2). The improved possibilities for capital to freely move to jurisdictions providing favourable conditions put domestic tax systems under pressure. With high capital mobility the incentives for capital owners to shift capital to low-tax countries grew massively which triggered competition for mobile capital bases. In short, globalization induced international tax competition.

3. Trends in Tax Reforms and Tax Levels in OECD/EU Countries

The large number of tax reforms implemented in many countries over the last 20 years as a reaction to international competitive forces reveals how important the issue of tax arbitrage has become in real politics. Tax competition started with the tax reform act of 1986 in the US where the

nominal corporate tax rate was cut by 12 percent from 46 to 34 percent.

Canada as direct neighbour followed this trend closely and implemented successively lower tax rates on corporate profits. More recently Canada cut corporate taxation further back in several steps from 28 to 21 percent between 2000 and 2005.

Following this major tax reform in the US the average tax burden imposed by EU countries on US firms fell by more than 12 percent between 1986 and 2000. Top corporate tax rates (on retained profits) significantly declined between 1980 and 2004 for EU countries and fell by more than 13 per cent points. Within the OECD average statutory corporate tax rates fell by 15 percent until 2005.

Countries reacted quite differently to the increased competitive pressures.

Even though most countries cut marginal corporate tax rates, marginal rates remain at very different levels and effective tax rates on capital vary largely.

Germany substantially changed its corporate tax law in several steps. In 1994 Germany introduced the so called "Location Preservation Act"

(Standortsicherungsgestz, StandOG, §32c ESt) which reduced corporate tax rates from 50 to 45 percent. The tax rate was cut further to 40 percent by the

"Tax Relief Act" (Steuerentlastungsgesetz, StEntG 1999/2000/2002) in 1999. For retained profits the tax rate was decreased again from 40 to 25 percent by the "Tax Reduction Act" (Steuersenkungsgesetz, StSenkG 2000) which came in effect in January 2001. The newly elected Grand Coalition put another major corporate tax reform on top of their governmental program. Nominal corporate tax rates are to fall from about 39 percent to slightly less than 30 percent.

Arguably, smaller countries felt the competitive pressure of tax competition even earlier. Ireland, for example, reacted significantly to the changes in capital mobility and aggressively engaged in the competition for mobile tax sources. The Irish government created special free trade zones to bring in investment. Since Ireland joined the EU in 1973 the corporate tax rate fell to 10 percent for a limited number of sectors. In 1987 Ireland extended this low tax policy from originally manufacturing and special services to financial services within the international financial service centres in Dublin and at Shannon Airport. This resulted in massive financial inflows. Several tax reductions followed in recent years, from 2000 to 2005 general statutory corporate rates fell from 24 to 12.5 percent in several steps.

The Netherlands and Belgium largely lowered the tax burden for financial services. They charge financial companies with the normal rate but allow them to make deductions of up to 80 percent of their revenues which reduces the effective tax rate in the Netherlands to 7 percent (Mennel and Förster 1999). In a recent corporate tax reform in 2005, Belgium cut statutory tax rates on retained corporate income from 39 to 33 percent without abolishing any of the deduction possibilities diminishing effective tax burdens even further.

Sweden and Austria have given up the principle of synthetic income taxation and tax interest income substantially less than personal income. The move to a dual income tax system in Scandinavian countries underlines the consequences of tax competition. Country studies for Sweden (Mutén 1996, Steinmo 2003a) and Austria (Genser 1996) demonstrate that these tax reforms were also triggered by massive tax evasion in the period prior to the reform and tax revenues actually increased after these reforms. In 2005

Austria implemented another large tax cut for corporate income, tax rates fell from 34 to 25 percent. ²

Even though top corporate tax rates significantly fell between 1980 and 2004 in all OECD countries, they remain still on average close to 30 percent – far away from a predicted zero tax rate – and vary greatly in 2004 between 36 percent in Canada and 8.5 percent in Switzerland. This distribution of marginal corporate tax rates largely overlaps with the distribution of tax rates in 1975 where top rates on corporate income varied between 8 percent in Portugal and 51 percent in Germany. Corporate tax rates were merely cut at the top end of the distribution. Portugal even increased marginal tax rates on corporate income between 1975 and 1994. In addition, governments mostly followed up capital tax cuts by measures intended to reduce tax credits as well as exemption and deduction possibilities. This widely adopted strategy lead to a surprisingly stable tax burden on capital leaving government revenue from taxing mobile sources largely unchanged (Swank and Steinmo 2002).

Similar developments can be observed for taxation of the immobile factor.

While top rates on personal income were mostly decreased along with marginal corporate tax rates, social security contributions rose steadily in most OECD countries burdening the factor labour with higher costs (Genschel 2002).³ Top personal income rates fell on average in all OECD countries from 64 percent in 1975 to 37 percent in 2004, whereas average

2 See Ganghof (2000), Dehejia and Genschel (1999) and Genschel (2000) for more complete accounts of tax policy changes

3 Manow and Seils (2000) show that Germany reduced the personal income tax burden while at the same time increasing social security contributions.

effective tax rates (own calculations according to Volkerink and De Haan 2001) on labour in the OECD increased from 29 percent in 1975 to 38 percent in 2004. Gordon Brown, the British Chancellor, for example, presented on March 21, 2007 the new budget for the UK which incorporates a moderate reform of corporate and income taxes. Mr. Brown himself assured his fellow MPs that the reform would be fiscally neutral. With respect to personal income taxes he reaches this neutrality by cutting back the basic tax rate while increasing contributions to the National Health System (NHS) simultaneously.

Still, this overall trend does not diminish the persisting variance in domestic taxation of wage earnings. The distribution of effective tax rates on labour in OECD countries did not alter significantly between 1975 and 2004.

Whereas effective labour tax rates in 1975 ranged between 17 percent in Iceland and 47 percent in Sweden, they amounted to 19 percent in Iceland and 55 percent in Sweden in 2004. If anything at all, we can observe a slight upwards shift in effective labour tax burdens. However, the variance of domestic tax rates on immobile sources still remains very large. Burden shifts from capital to labour remained moderate or even insignificant in some countries. This observation strongly contradicts predictions of second generation models which claimed that labour would have to bear the full or at least large parts of the capital tax burden.

These empirical facts indicate that tax competition might not be the only driving force and different domestic settings and constraints impact the governments’ taxation decisions.

Figure 2: Mean Top Corporate Tax Rate, Mean Efficient Labour and Capital Tax Rate of 22 OECD Countries

1975 1980 1985 1990 1995 2000 2005

12

tax rate: yearly mean of 23 OECD countries

year marginal corporate tax rate

AETR on labour

AETR on capital

Figure 2 displays the mean top rate on retained profits of corporations and the mean effective labour and capital tax rates (own calculations based on the formula suggested by Volkerink and De Haan 2001) for 23 OECD countries between 1975 and 2004. While top corporate tax rates were successively reduced from the mid-1980s onwards, effective labour tax rates grew steadily. However, effective rates on capital did not decrease significantly. They remained relatively steady over time and rather increased a little since the early 1970s.

The mobility of resources limits the capacity of governments to redistribute income (Stigler 1957). The loss of revenue in corporate tax rates has partly been counterbalanced by an upwards trend in labour tax rates. The shift of the tax burden from capital to labour income results from the fact that labour markets are less integrated than capital markets and labour is less mobile.

Yet, for both, capital and labour tax rates, as well as the tax mix between the two, we can observe a persisting large variance across OECD countries.