The disadvantages of a reduction in taxes and “race to the bottom” – the arguments against tax competition

The immediate effects of a reduction in taxes are a decrease in the real government income and an increase in the real taxpayers income. In the longer term, however, the loss of government income might be mitigated, depending on the response of tax-payers. Furthermore, the long-term macroeconomic effects of a reduction in taxes are not predicable in general, because they depend on how the taxpayers use their additional income and how the government adjusts to its reduced income [Fox, 2007].

Commonly formulated thesis state that an uncontrolled reduction in taxes could lead to negative budget effects, the so-called “race to the bottom.” This process could cause a significant decrease in the gov-ernments income, as well as the reduction in some govgov-ernments spending and public functions, especially the reduction in social spending. Decline in the redistributive role of the government budget could lead to a situation where the citizens themselves will have to make a choice between a lower level of public services and higher taxes. This situation could be unfavourable, especially when it comes to the European Union Member States. There are two reasons for this [Hybka, 2002, p. 7]:

1) the budgets of EU countries are based largely on income taxes, 2) the share of tax revenue in GDP is significantly different in EU

countries.

Another negative aspect of tax competition is a tendency to in-crease the tax burden of labour comparing to other factors. The high level of labour taxation increases production costs and slows down economic growth. Moreover, analyses carried out by the European Commission indicates that the increase of the labour taxation burden is one of the reasons for unemployment [Commission…, 1997, p. 3].

The tax competition connected with a decrease in taxes and the so-called “race to the bottom” contributes to disadvantageous effects.

“Race to the bottom” is a tax competition between governments. Each government may benefit from higher tax revenues by having high tax rates on corporate profits, but governments can benefit individually

with lower corporate income tax rates relative to other jurisdictions in order to attract businesses to their own jurisdictions. In order to main-tain equilibrium, each of the other governments would have to lower their corporate income tax rates to match that of the government that first lowered the tax rate. The end result is that each government adopts a lower corporate tax rate and therefore, collects less revenue overall. Assuming the foundational premise is correct, the optimal option for all governments would be an agreement to maintain tax harmonization [Harmful…, 1998].

The main predictions of the theoretical tax competition literature is to evaluate how the observed patterns relate to them. The standard tax competition models of Zodrow and Mieszowski (1986) and Wilson (1986), predict a race to the bottom for small open economies, which despite a clear downward trend cannot yet be observed. Allowing for the countries to be large enough to influence each other’s tax policies, Hoyt (1991) finds that tax competition leads to inefficiently low tax rates, which is consistent with recent tax rate cuts. The more aggres-sive rate reductions in smaller countries are in line with Bucovetskys (1991) and Wilsons (1991) models of tax competition between asym-metrical jurisdictions predicting a sharper drop for smaller countries [Loretz, 2008].

The most commonly used arguments against tax competition are [Krajewska, 2010, p. 140]:

1) the reduction of public revenue, as a result of lower taxes, could lead to the reduction of government expenditure and the supply of public goods as well as to reduce the redistributive function of public finance,

2) the government’s budget reduction decreases the competitive-ness of the economy because of the lower investment in infra-structure, science and education, research and development, which may lead to increase public discontent and affect the economy mainly by the deterioration of investment,

3) the government may try to compensate the reduction of public revenue by increasing the tax burden on labour, which leads to an increase in unemployment; another government action is a consumption tax hike, which leads to a reduction in consumer demand,

4) the tax competition between countries encourages entrepreneurs to make a capital transfer to a country, where the taxes are lower, which resulting in loss of potential budget revenue and

“free riding” of taxpayers, who benefit from public goods in their own country, but they avoid paying taxes,

5) the tax competition involving the reduction in taxes is not the only one way to improve the investment attractiveness of the country, because it is also important to improve the infrastruc-ture, improving public education, increase investment in re-search and development, improvement of the law system and public administration.

In order to determine whether it is harmful to tax competition, the Committee on Fiscal Affairs OECD has defined the criteria to assess whether the tax incentives are harmful. In addition to this, the Com-mittee has developed a dealing procedure in case of harmful practices.

Indicated by the Committee’s criteria are [Orziak, pp. 9394]:

– low income taxes or relinquishment of corporate income taxes in the country,

– separation of the tax system from the domestic economy, – lack of transparency in the system,

– lack of effective exchange of information between the tax au-thorities of different countries.

The idea of tax competition prevention is supported in the coun-tries with relatively high taxes. Instead councoun-tries that score high in the international competitiveness ranking have a rather negative approach to all activities, including those undertaken at the OECD [Mitchell, 2000].

As the world economy becomes more integrated and technology improves, it is becoming much easier to avoid excessive taxation. The taxpayer mobility means that countries with high tax rates are likely to lose revenue, making it harder for their policymakers to fund expen-sive government programs. Supporters of the OECD initiative tend to see the effort as an attempt by governments “to regain the capacity to finance redistribution through tax revenue.” As Michel Vanden Abeele, the Director General of the European Commission's Taxation and Customs Union put it, “protection of adequate tax revenues is of particular concern in order to guarantee the survival of the fair and caring society” [Mitchell, 2000].

Strong discontent among supporters of limiting tax competition re-sults in the so-called tax haven or offshore haven. Tax havens can be defined as a separate territory (country or part of the country), where the tax burden is very low or the government does not collect the taxes from all or some of the economic activities carried out by non-residents [Orziak, pp. 9394]. Tax havens such as Cyprus, Lichten-stein, Monaco and Gibraltar provide taxpayers with an opportunity to avoid taxation by transferring the business or capital to a tax haven.

Both, the OECD and European Commission have recognized the risk to fair competition in the existence of tax havens and take actions to curb the capital outflow to the tax haven [Hybka, 2002, p. 7].

3.2. The advantages and opportunities of tax competition