Tax competition is a governmental strategy of attracting foreign direct investment and high value human resources by minimizing the overall taxation level.
In the past the governments had more freedom in setting their taxes as the barriers to free movement of capital and people were high. The gradual process of globalization is lowering these barriers and results in rising capital flows and greater labor mobility.
In this situation politicians have to keep tax rates “reasonable” in order to dissuade workers and investors from moving to a lower tax environment. Most countries started to reform their tax policies to improve their competitiveness. It has to be said that the tax burden is just one part of complex formula describing national competitiveness. The other criteria like total labor cost, labor market flexibility, education levels, political stability, legal system stability and efficiency are no less important.
Governments typically react with stick-and-carrot policies like:
- reduction of both personal and corporate income tax rates
- tax breaks/holidays (i.e. time limited tax exemptions)
- rising the barriers to free movement of capital
- not allowing companies hiding in tax havens to bid for public contracts
- political pressure on lower tax countries to “harmonize” (i.e. rise) their taxes
There seems to be reasonable argument that defensive policies have only short term effect. The more proactive reaction to tax competition is to promote other pro-growth policies and reform the tax system.
European Union (EU) makes special case in the study of tax competition. The barriers to free movement of capital and people were reduced close to nonexistence. Some countries (e.g. Ireland) utilized their low levels of corporate tax to attract large amounts of foreign investment while paying for the necessary infrastructure (roads, telecommunication) from EU funds. The net contributors (like Germany) strongly oppose the idea of infrastructure transfers to low tax countries. EU integration brings continuing pressure for consumption tax harmonization as well. EU member nations must have a value-added tax (VAT) of at least 15 percent (the main VAT band) and limits the set of products and services that can be included in the preferential tax band. Still this policy does not stop people utilizing the difference in VAT levels when purchasing certain goods (e.g. cars). The contributing factor are the single currency (Euro), growth of e-commerce and geographical proximity.
The political pressure for tax harmonization does not end on EU borders. Some neighboring countries with special tax regimes (e.g. Switzerland) were already forced to some concessions in this area.
Related terminology
Last updated: 05-07-2005 12:56:56
