Tax competition may be broadly defined toinclude the tax policy influence that countriesexert on each other. If neighboring countriesare prospering under low tax rates, citizensand policy experts may demand the samefrom their own government. Consider Ireland.In 2000 that small country of 3.8 million peo-ple attracted more foreign direct investment(FDI) than either Japan or Italy.
The maindraw for foreign investors has been a 10 per-cent corporate tax rate on manufacturing,financial services, and other activities.
As aresult, Ireland has boomed and now has one of the highest standards of living in the world.
AUnited Nations report called Ireland “themost dynamic country in the developed worldin terms of recent growth and competitive per-formance” and hailed its change from “a back-ward low-productivity economy into a centerof technology-intensive manufacturing andsoftware activity.”
But such tax cut success stories concernsome economists who view tax competitionas distortionary. It is thought that if differenttax rates cause capital and labor to migrateacross borders, those resources may not endup in their most productive uses. So Irelandis receiving “too much” investment becauseof its low tax rates, according to that view.But that loses sight of a larger issue: high taxrates shackle economic growth. Thus, to theextent that tax competition creates pressureto reduce tax rates globally, all countries gainfrom increased growth and higher incomes.Opposition to international tax competi-tion is wrapped in the language of economicsbut seems to stem mainly from political con-cerns. In particular, some people worry thattax competition reduces governments’ abilityto redistribute income. When borders areopened, businesses and individuals that aretaxed heavily to pay for redistribution willrationally look to better locations for work-ing and investing. A high-profile 1998 reportfrom the Organization for EconomicCooperation and Development on “harmfultax competition” calls such tax avoidancebehavior “free riding” that “may hamper theapplication of progressive tax rates and theachievement of redistributive goals.”
Like many of the OECD report’s argu-ments, that one is internally contradictory.Redistribution involves taxing some peopleat high rates and others at low rates. The “freeriders” would seem to be the latter group,who pay a less than proportionate share of their income in taxes. In our view, interna-tional tax competition may indeed hamperincome redistribution, but that is a beneficialoutcome because redistribution has pro-gressed to a remarkably high degree in mostindustrial countries.
In addition to OECD and other interna-tional efforts to dampen tax competition,governments are taking numerous defensivemeasures on their own. For example, they areimposing layers of complex tax rules on theforeign operations of corporations. In thisregard, the United States enacted its “subpartF” regime in 1962 and has beefed up thoserules a number of times since. Other coun-tries have followed suit with similar rulesdesigned to limit the benefits of investmentin foreign countries that have lower taxes.But the U.S. rules are usually considered themost complex, and they damage the ability of U.S. companies to compete abroad. Suchrules are merely Band-Aids that cover theneed for more fundamental tax reforms.This study examines the growth of globalcapital and labor mobility, the global fall intax rates since the 1980s, the basics of U.S.international tax rules, the responsiveness of investment flows to taxation, tax competi-tion theory, and government responses to taxcompetition. It concludes by examining poli-cy options for the United States, includingreplacing the individual and corporateincome taxes with a low-rate consumption-based tax system.
Growing Capital and LaborMobility
World economies have become moretightly integrated in recent decades. Rapid
Opposition tointernational taxcompetition iswrapped in thelanguage of eco-nomics but seemsto stem mainlyfrom politicalconcerns.