Tax competition spurs globalization - Worldview - countries develop low-tax strategies to lure business

GLOBALIZATION is steadily and inexorably knitting separate national economies into a single world economy. Basic economic forces so far have outweighed political efforts to slow this trend. Efforts to buck the effects of economic integration have ranged from anti-globalization protests to Congressional efforts to prevent American companies from reincorporating abroad.

The economic forces behind globalization include rising trade and investment flows, greater labor mobility, and rapid transfers of technology. Those trends have been spurred by the deregulation of financial markets, reductions in trade barriers, and lower communication costs.

Most economists support globalization because it raises the incomes of people worldwide. Another lesser-noticed benefit is that it makes it harder for governments to sustain excessively high tax rates. When economic integration increases, individuals and businesses gain the freedom to take advantage of low tax rates abroad. As a result, countries with high tax rates face large economic losses when borders are opened because people and capital flow out. As capital and labor become more mobile, international "tax competition" increases.

Smart nations are treating international tax competition as an opportunity, not a threat. Ireland, for example, has had remarkable economic success as a result of its low-tax strategy adopted in the 1980s. This country of 3,800,000 people has attracted more foreign direct investment than either Japan or Italy in recent years. The main draw has been a low 10% corporate tax rate. Ireland has boomed from investment inflows and now has a per-capita income level higher than Great Britain or France.

Some nations are responding to tax competition in defensive and unproductive ways. High-tax countries have prodded international organizations, such as the Organization for Economic Cooperation and Development (OECD), to curtail tax competition. The idea essentially is to create a high-tax cartel by limiting the advantages offered by low-tax countries. In addition, many nations are adding layers of complex roles on businesses to discourage them from investing abroad, rather than reducing tax burdens so that businesses want to invest at home. The U.S. falls into this category since it has one of the highest corporate tax rates. Nevertheless, America continues to put off long-needed reforms.

Rising international tax competition is a reality that Federal policymakers must respond to in a thoughtful and productive way. Fundamental tax reforms should be pursued to encourage investors and businesses to invest in the U.S. in order to generate rising American incomes.

Since the 1970s, most countries have reduced or eliminated exchange controls, allowing citizens to buy foreign securities and foreigners to invest domestically. Financial markets have been deregulated in many nations, thus making investment abroad more attractive than ever. The result has been an explosion in cross-border investment. Net world flows of investment capital soared from a few hundred billion dollars per year in 1990 to roughly two trillion dollars per year today. Countries that want to attract these flows must get the economic fundamentals right by establishing a stable currency and having trustworthy legal roles. Indeed, dozens of nations have made market reforms during the past decade or so. As a result, more countries offer better investment opportunities than in the past. International investors have become more sensitive to differing national tax rates as their investment options have increased.

Consider also that many businesses used to invest abroad simply to gain access to fixed resources, such as oil deposits. Today, many industries--such as finance and services--are footloose and can be located anywhere. Thus, corporations have greater ability to move their operations to low-tax jurisdictions. Numerous studies have confirmed the importance of taxes to investment decisions. For instance, one analysis found that four European nations with favorable tax regimes--Ireland, Luxembourg, the Netherlands, and Switzerland--accounted for nine percent of European output, but attracted 38% of U.S. investment there during the late 1990s.

Skilled workers are increasingly footloose as well. Governments have focused on keeping income tax rates low to avoid losing skilled labor in industries such as high-tech. For example, Canadian "brain drain" from technology industries to its lower-tax southern neighbor, the U.S., has been an important concern of Canadian policymakers in recent years. With the removal of internal migration restrictions in the European Union in 1992, Europeans have become more sensitive to tax differences between countries. There has been an influx of young, skilled technology and finance workers to cities, such as London, that have more opportunities and lower taxes.

Ireland is an interesting case study of taxes and migration. For years, young Irish people sought a better life in the U.S. and elsewhere, but corporate tax cuts, followed by individual tax reductions, reversed the pattern of out-migration. Ireland now records a large net immigration, as young people stay at home to work for the many computer and technology firms that currently populate the nation.

Tax competition is greatly visible in the high-paid celebrity world. Celebrity tax avoidance is a popular game in Europe. Top French soccer players, artists, and models have moved to Switzerland, Britain, and the U.S. Singer Luciano Pavarotti relocated to Monaco to avoid high Italian taxes. Tennis star Boris Becker, who has claimed residence in Monaco and Switzerland, has been in trouble with the German tax authorities, having to pay a huge settlement in October, 2002. While tax cheats should be prosecuted, policymakers must get the message that a reduction in high tax rates is the best way to retain top talent and the entrepreneurs who add greatly to any nation's economy.

Global tax reduction

Many governments have responded to increased labor and capital mobility by cutting tax rates. The average top personal income tax rate in the 30 major countries of the OECD dropped from 67% in 1980 to 47% by 2000. The average corporate tax rate in the OECD fell from 38% in 1996 to 31% by 2002. The combined Federal and state corporate tax rate in the U.S. is 40%. Clearly, we need to cut corporate taxes to catch up to our major trading partners. Indeed, the U.S. corporate tax rate is currently the fourth-highest among the 30 OECD nations.

Many countries have reduced capital gains taxes as well. For instance, Canada and Germany lowered their capital gains tax by allowing individuals to exclude 50% of their gains from taxation, effectively cutting the tax rate in half. While the capital gains rate in the U.S. is 20%, Austria, Belgium, the Czech Republic, Germany, Greece, Hong Kong, Mexico, the Netherlands, New Zealand, and Switzerland all have a zero individual capital gains tax rate. Reducing capital gains rates is important because start-up firms often rely on private equity from "angel" investors and others who fund risky companies. The payoff for these investors comes from a big capital gain on the few start-ups that succeed.

Tax cuts have been an efficient response to increasing tax competition. Unfortunately for their economies, some governments have adopted other policies that make their tax codes less efficient. In particular, many nations have enacted layers of complex tax rules on international businesses to prevent them from migrating abroad. The U.S. tax rules on international businesses are some of the most complex in the world. There is increasing concern that Federal tax rules are making American companies less competitive in global markets. Indeed, one of Pres. Bush's top economic advisors, Glenn Hubbard, has noted that, "from an income tax perspective, the United States has become one of the least attractive industrial countries in which to locate the headquarters of a multinational corporation."

Essentially, Federal rules force American firms to pay U.S. taxes on their foreign operations in situations where competitors based abroad do not pay tax on their similar operations. About half of OECD countries have "territorial" tax systems that do not impose taxes on firms' foreign operations. By contrast, the U.S. imposes taxes on the worldwide income of American companies, making them less competitive in foreign markets. That uncompetitiveness was highlighted by the 1998 Daimler-Chrysler merger, which established the merged corporation's headquarters in Germany, in part for tax reasons. There has been a marked increase in the number and size of American firms swallowed up by foreign companies because the U.S. is not a good tax location for multinational headquarters.

Recent threats by companies such as Stanley Works to reincorporate abroad should be a wake-up call that major business tax reforms are needed. Some have called firms such as Stanley "unpatriotic," but that simply shoots the messenger. We know that our corporate tax rate is higher than other major countries and that our tax code is far too complex. Policymakers should move ahead with a long-term solution to enact major reforms.

Tax competition benefits

In 1956, economist Charles Tiebout examined the provision of services by local governments and observed that competition among local governments for mobile residents enhanced the overall welfare of the country. To avoid losing residents, governments had to tailor spending and tax levels to suit local preferences. Individuals sorted across jurisdictions according to their demand for pubic goods relative to local tax levels. For example, households that desire well-financed public schools may choose to reside in counties with higher property taxes. Others may move to jurisdictions with lower taxes and more-limited government services.

The competitive process among governments is akin to market competition for products. Market competition encourages production efficiency. Tax competition provides an incentive to improve government efficiency. Because of globalization, tax competition among national governments has become similar to competition among local governments. The Federal government is no longer a monopoly--Americans now are able to invest abroad, retire in a low-tax Caribbean country, or move their business to low-tax Ireland. Accordingly, the Federal government needs to reform the tax code and provide services more efficiently to encourage Americans and their money to stay at home.

Some people don't see it that way. The U.S. is a member nation of the Pads-based OECD, which has launched an initiative to curtail what it calls "harmful tax competition." The OECD favors policies that would serve to harmonize taxes at high levels, akin to an oil cartel fixing high prices. The way the OECD sees it, it is a "distortion" if a country like Ireland attracts "too much" investment. Yet, governments routinely pursue other policies, such as education improvements, that make their economies more attractive for business location. It is not clear why nations should not have the freedom to make their tax codes as attractive as possible.

The Bush Administration has tried to tame the OECD's harmful tax competition project to some extent. Former-Treasury Secretary Paul O'Neill stated that "I felt that it was not in the interest of the United States to stifle tax competition that forces governments--like businesses--to create efficiencies." In the House, then-Majority Leader Dick Armey argued that the U.S. should not support "a global network of tax police."

The United Nations has come out for restricting international tax competition. A high-level 2001 UN report suggested creating an International Tax Organization that would push countries to "desist from harmful tax competition." If created, such a body would most likely become a taxpayer-funded lobbying group for higher taxes around the world. The UN report suggested creation of a "global source of funds" to build an international bureaucracy from a "high yielding tax source." Surely, the last thing we need is another layer of government on top of the three layers we already have in the U.S.

The OECD maintains that "countries should remain free to design their own tax systems as long as they abide by internationally accepted standards in doing so." These "standards" might prevent the adoption of major tax reforms in the U.S. and other nations. For instance, if such standards were in place, they would potentially prevent the replacement of the income tax with the type of consumption-based tax system that many have proposed in Congress in recent years, like the flat tax.

In the late 1990s, there was great interest in replacing the income tax with a consumption-based tax system. Proposals included various retail sales tax proposals and the flat tax. While Washington's interest in reform waned in the last years of the Clinton presidency, the Bush Administration plans to move ahead with reform. O'Neill has promised a major tax simplification plan in coming months, and other top Bush advisors strongly support reform. U.S. tax reform is the best response to the increasing pressures of international tax competition.

Tax systems such as the flat tax are "consumption-based" because they do not double-tax savings and investment as the income tax does. For example, if a business invests in a new machine, it would deduct its cost right away under the flat tax. By contrast, the income tax forces firms to write off investment over many years under complex depreciation rules. For individuals, a consumption-based tax would relieve double taxation on savings. People would be taxed when they earn wages, but when after-tax money is saved, it would not be subject to further taxation.

Such reforms would greatly simplify the Federal tax code and increase investment and economic growth. A consumption-based tax would require a much-lower tax rate than today's high income tax rates, thus giving a strong incentive for businesses and individuals to keep their investments in the U.S. Lower tax rates and a simpler consumption tax base would also reduce wasteful tax evasion and tax avoidance behavior.

If the U.S. moves ahead with tax reform, other nations would probably follow suit, as they did when the U.S. cut rates in the 1980s. As tax systems around the world become more efficient, economic output and incomes should rise. Tax competition among countries should be a win-win policy, as it restrains governments and helps spur global economic growth.

Chris Edwards is director of fiscal policy studies, Cato Institute, Washington, D. C.

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