Does Tax Competition Exist?

September 1st, 2010

As I have noted, there is a popular argument among advocates of tax havens that these jurisdictions provide a positive influence on the world through so-called “tax competition.”  Mostly these proponents toss the phrase into their arguments with the misguided hope that those hearing it will not think too hard about it, because at the end of the day, it doesn’t make much sense.

As far as I can tell, the most comprehensive definition of tax competition was put forward by Richard Teather, a tax specialist from the UK, in “The Benefits of Tax Competition.”  Teather defines tax competition as “deliberate reductions in effective tax rates” to “attract foreign capital investment.”  Teather argues European governments, fearful that tax havens would suck them “into a spiral of competitive tax reductions that would result in investment income being tax free,” have responded by “seeking either to force [tax havens] to raise taxes or to emasculate their tax-efficient status.”

I actually don’t have a problem with this argument.  Foreign direct investment—that is when a citizen of one country makes a capital investment into a company in another—occurs through legal, generally transparent channels.  In this case, a county’s tax-rate is an expense to the investor, just as brokers’ fees and labor are costs, too.

Of course, there also must be benefits.  The investor needs to have a reason to buy capital in a particular country, other than a favorable tax-rate.  For example, Lebanon has very low corporate and income tax rates and has scored a whopping 91.6% on the Heritage Foundation’s index of fiscal freedom in celebration of this fact. But you probably wouldn’t want to invest in a software company in conflict-ridden Nabatiyeh, in Southern Lebanon. Lebanon still faces a significant risk of another confrontation with Israel in the medium term and reports showing Hizbullah has received deliveries of medium-range ballistic missiles haven’t helped ease those tensions.

It’s pretty clear from this example that an investor’s choice of where to place his capital is based on a broad range of inputs, not just tax. Perhaps it is for this reason that there isn’t much evidence supporting the claim that low-tax jurisdictions entice more FDI than others.  According to the UN Conference on Trade and Development, in 2009 FDI flows into Switzerland, which has a low 22% corporate tax rate, represented 9.6% percent of fixed capital formation.  Some high tax jurisdictions, such as Germany, where the top corporate tax rate is 38%, FDI represented a lower 6% of fixed capital.  But in other high tax jurisdictions, such as the UK (with a 30% tax rate) FDI flows represented a much higher 14.1% of fixed capital. Or FDI into Belgium, which has a 35% corporate rate, represents a gigantic 33.8% of capital formation.

As I said, I don’t have a problem with tax competition as it relates to FDI, but in other instances this argument is applied to something else entirely. This I do have a problem with.

Often proponents of tax havens will indirectly argue that citizens can transfer income that was legitimately earned in one country to a low-tax jurisdiction and pay the lower rate in the name of “tax competition.” This is not tax competition. This is tax evasion.  It is illegal for a reason.  If Lebanon offers a favorable business environment that includes a low tax-rate to potential investors, then I have no problem with it.  If the Cayman Islands offers a way for investors to earn income in the United States and then pay (lower) taxes in the Caymans, then it is a problem.

Think about it like this.  If you are a company, you can offer a good (or a set of goods) at a particular price.  Assuming a competitive market, you base your price on a variety of factors, including your costs.  This applies to countries.  The United States can afford to offer its citizens and investors a variety of goods—security, infrastructure, a skilled workforce—at a certain cost. A tax rate.  You cannot choose to take advantage of those goods at a different price, just like a shopper can’t pay the price for a standard car, but take home the one with leather seats and a sun roof.

I haven’t seen any evidence that tax competition exists.  The theory might sound good, but tax haven proponents haven’t pointed to any statistics to back the argument up. Second, and more importantly, it’s incredibly dangerous to blur the line between these the concept of tax competition as it pertains to (legal) portfolio diversification and (illegal) tax evasion.  They have nothing to do with one another and semantics do matter.  I am all for having a real debate about this—with statistics and facts.  But academic integrity demands that we be clear on our choice of words and definitions.

Written by Ann Hollingshead

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