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Globalization is knitting separate nationaleconomies into a single world economy. That isoccurring as a result of rising trade and invest-ment flows, greater labor mobility, and rapidtransfers of technology. As economic integration increases, individualsand businesses gain greater freedom to take advan-tage of foreign economic opportunities. That, inturn, increases the sensitivity of investment andlocation decisions to taxation. Countries feel pres-sure to reduce tax rates to avoid driving away theirtax bases. International “tax competition” isincreasing as capital and labor mobility rises.Most industrial countries have pursued taxreforms to ensure that their economies remainattractive for investment. The average top per-sonal income tax rate in the major industrialcountries of the Organization for EconomicCooperation and Development has fallen 20 per-centage points since 1980. The average top cor-porate income tax rate has fallen 6 percentagepoints in just the past six years. Rising tax competition has caused governmentsto also adopt defensive rules to prevent residentsand businesses from enjoying lower tax ratesabroad. In the United States, such tax rules arehugely complex and affect the ability of U.S. com-panies to compete in world markets. Other defen-sive responses to tax competition include proposalsto harmonize taxes across countries and to restrictcountries from offering tax climates that are toohospitable to foreign investment inflows. Those defensive responses to tax competitionare a dead end. They do nothing to promote eco-nomic growth or reform inefficient tax systems. Amore constructive response to tax competitionwould be to learn from foreign reforms and adoptpro-growth tax policies at home. The UnitedStates should be a leader but has fallen behind ontax reform. For example, the United States nowhas one of the highest corporate tax rates amongmajor nations. The chairman of the president’sCouncil of Economic Advisers, Glenn Hubbard,believes that “from an income tax perspective, theUnited States has become one of the least attrac-tive industrial countries in which to locate theheadquarters of a multinational corporation.” As international capital and labor mobilityrises, the risks associated with not having an effi-cient federal tax structure increase. This countryshould respond to rising tax competition by mov-ing toward a low-rate consumption-based system.
International Tax Competition
 A 21st-Century Restraint on Governmen
by Chris Edwards and Veronique de Rugy
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Chris Edwards is director of fiscal policy studies and Veronique de Rugy is a policy analyst at the Cato Institute.
Executive Summary
No. 431April 12, 2002
 
Introduction
In past decades, many governmentsshunned inflows of foreign investment andrestricted their citizens’ investments abroad.But a sea change in political attitudes towardforeign investment has occurred since the1970s. Most governments today activelyencourage inflows of foreign investmentbecause they recognize that it is a key factorin maximizing economic growth.Foreign investment exploded with theremoval of capital controls and the deregula-tion of financial markets in major economiesin the 1970s and 1980s. Many developingcountries followed suit in the 1990s. Reformsincluded allowing foreign currency exchange,allowing the purchase of foreign securities,and allowing foreigners to buy domesticsecurities and acquire domestic firms. As hasbeen widely observed, advances in technolo-gy and communications have spurred capitaland labor flows, with the Internet and othertools opening up global investment andwork options for individuals and businesses. High tax rates are more difficult to sus-tain in the new economic environment. Thatis particularly true for taxes on capital, whichinclude taxes on business profits and taxeson individual receipts of dividends, interest,and capital gains. Basic economic theory sug-gests that high taxes on capital create anincreasing drag on growth as capital mobili-ty increases. High taxation of capital causescapital flight, thus reducing domestic pro-ductivity, wages, and incomes.
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MartinFeldstein, James Hines, and Glenn Hubbard,the chairman of president’s Council of Economic Advisers, have made that pointwith respect to the corporate income tax:Many economists argue that it isinefficient to use corporate incometaxes to raise revenue in openeconomies. If capital is internation-ally mobile, the burden of corporatetaxes falls largely on other immobilefactors (such as labor), and the taxsystem would be more efficient if these other factors were insteadtaxed directly.
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 Two centuries ago Adam Smith similarlyrecognized that heavy taxes on mobile“stock,” or capital, would cause a loss toworkers and the economy:Secondly, land is a subject whichcannot be removed, whereas stockeasily may. The proprietor of land isnecessarily a citizen of the particularcountry in which his estate lies. Theproprietor of stock is properly a citi-zen of the world, and is not necessar-ily attached to any particular coun-try. He would be apt to abandon thecountry in which he was exposed to avexatious inquisition, in order to beassessed to a burdensome tax, andwould remove his stock to someother country where he could eithercarry on his business, or enjoy hisfortune more at his ease. By remov-ing his stock he would put an end toall the industry which it had main-tained in the country which he left.Stock cultivates land; stock employslabour. A tax which tended to driveaway stock from any particular coun-try, would so far tend to dry up everysource of revenue, both to the sover-eign and to the society. Not only theprofits of stock, but the rent of landand the wages of labour, would nec-essarily be more or less diminishedby its removal.
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What is new since Smith’s time is the greaterability of corporations and individuals to movethemselves and their investments across bor-ders. In closed economies, high taxes on capitalincome and skilled workers stunt economicgrowth. As economies open up, such bad taxpolicy causes even larger economic losses due togreater impacts on investment and labor flows.
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As a result, tax competition is becoming moreimportant all the time.
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High taxes oncapital create anincreasing dragon growth as cap-ital mobilityincreases.
 
 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.
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 The maindraw for foreign investors has been a 10 per-cent corporate tax rate on manufacturing,financial services, and other activities.
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As aresult, Ireland has boomed and now has one of the highest standards of living in the world.
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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.”
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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.”
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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.
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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
Capital Mobility
World economies have become moretightly integrated in recent decades. Rapid
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Opposition tointernational taxcompetition iswrapped in thelanguage of eco-nomics but seemsto stem mainlyfrom politicalconcerns.

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