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The free-market case against tax competition

Sep 24,2018 - Last updated at Sep 24,2018

LONDON — The global race to cut corporate tax rates accelerated in 2018. According to the OECD’s latest annual review of tax policies across developed economies, the average rate of taxation on corporate profits has fallen from 32.5 per cent in 2000 to below 24 per cent today.

This trend is understandable. With private-sector investment remaining stubbornly weak, governments are desperate to hold on to whatever piece of the pie they can. It is better to tax firms lightly and keep them in your jurisdiction than it is to forego that revenue entirely.

After all, other things being equal, firms that are considering building a new factory or other facility will be attracted to countries with a more preferable tax regime. Likewise, firms facing a higher corporate tax rate in one country may decide to move their operations elsewhere. Or, rather than transferring personnel and disrupting supply chains, they may find a way to register profits in a lower-tax jurisdiction, typically by moving some head office functions there.

To many economic liberals and traditional conservatives, such “tax competition” is a good thing, because it is assumed that lower taxes will unleash market forces, thereby fueling innovation and growth. Moreover, advocates of this view do not think that governments should be taxing business in the first place. Because a tax on corporate profits reduces the amount of money that a firm has to invest or raise wages, they regard it as a levy on a firm’s employees rather than its owners.

But tax competition should concern economic liberals. Not only does it strengthen monopolistic trends and erode fair and transparent competition among firms; it also deprives governments of the money needed to sustain the public goods; education, healthcare, infrastructure and the rule of law, upon which firms rely. And there is little evidence that the corporate-tax burden actually does fall on employees rather than on capital. The non-partisan US Congressional Budget Office and the Institute for Taxation and Economic Policy, among others, have demonstrated clearly that over 80 per cent of the impact of corporate taxation falls on shareholders, not workers.

Still, market liberals would argue that corporate taxes “distort” behaviour and hamper wealth creation. But this is simplistic, at best. For starters, tax competition among jurisdictions is quite different from competition among firms in the market. When governments try to attract investment with subsidies, tax holidays, special exemptions and accelerated depreciation schedules, they create distortions that undermine comparative advantage. Firms will be more focused on wrangling the best financial incentives than on investing in areas with the highest potential productivity gains, and economic dynamism will suffer as a result.

Moreover, tax competition drives market concentration and monopolisation, because it tilts the playing field in favor of incumbent multinational corporations, and against smaller potential competitors. Larger firms have the resources to exploit tax havens for profit-sharing and tax avoidance, whereas small- and medium-sized companies generally do not. It is little wonder that multinationals have managed to reduce their tax burdens at a much faster rate than smaller firms in recent years.

Tax competition encourages free-riding on public goods, while eroding governments’ capacity to provide such goods. Like individuals, firms are not wholly responsible for their own success. They would be nothing without access to a healthy, educated workforce, public infrastructure and legal systems that enforce contracts, patents and intellectual property.

In fact, government spending on public goods is probably more economically efficient than lower taxes. Corporations are already sitting on a sizeable cash surplus; but, rather than invest in workers, equipment, or research and development, they have been buying back their own shares. In the United States, this practice has accelerated since the enactment of corporate tax cuts in December 2017.

Finally, corporate profits sometimes stem from rent-seeking and other valueless activities that absolutely should be taxed. There is reason to doubt that a great deal of commercial activity, gambling, selling and advertising alcohol, financial speculation and so forth, generates any net economic benefits at all. At best, many corporations are profiting from “distributional” activities that extract existing wealth from the economy. But even those that do create real value by providing new or improved goods and services still only benefit a subset of society. In any case, these firms should be taxed to pay for public goods.

Ultimately, governments will have to harmonise elements of their tax systems if they ever want to get ahead of these economically destructive trends. A deal between the European Union and the US could open the way for a broader international tax regime. But with Transatlantic relations at their lowest point in decades, the prospect of that happening any time soon is remote. In the meantime, tax competition will continue to erode market competition, while denuding governments of the money needed to invest in the public goods needed to ensure firms’ profitability over the long term.

 

Simon Tilford is chief economist at the Institute for Global Change. Copyright: Project Syndicate, 2018.
www.project-syndicate.org

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