Globalization and Tax Policy

Rebecca Neumann, with Jim Alm and Jill Holman

VERC Conference on the Implications of Integration

for Globalization

Wilfrid Laurier University

April 30 – May 1, 2008

Introduction

Common perception that globalization implies governments lose their ability to choose tax policies independently of other jurisdictions.

– Tax competition in which overall tax collections decline as national governments compete to attract or retain their tax bases.

Our Questions:– How does globalization affect the ability of a national government to tax its

factors of production?– How does globalization affect the response of factors as local governments

set tax rates in order to meet a particular revenue constraint?

Approach:– Two-country, two-good, two-factor model is used to examine the magnitude

of tax responses for various degrees of factor mobility.

Overview of the Presentation

I. Globalization - definitionsII. Taxation and Globalization – expected effects

Primary Issues Recent Trends / Evidence

III.Our Contribution to the Debate Model Setup and Scenarios Compare factor immobility to factor mobility

IV. Conclusions Is globalization good or bad for taxation?

Globalization

Liberalization of trade and capital flows. Internationalization of production and sales. New developments in information and

communications technologies Growing importance of e-commerce. Our working definition – increased ability of

factors to move across countries and across regions within a country.

Taxation and Globalization

A common perception is that globalization implies that governments lose their ability to choose tax policies independently of other jurisdictions.

– Tax competition may increase (vanishing taxpayer).– Tax harmonization may increase.

Standard argument is that if factors of production can move easily from one location to another, then the ability of a government to tax these factors is greatly diminished.

– Bovenberg (1994), Gordon and Bovenberg (1996), Frenkel, Razin, and Yuen (1996).

Argued in particular for capital. Some empirical evidence suggests factors do respond to these types of tax considerations.

– Mintz (1992), Grubert (1998), Hines (1999).

Taxation and Globalization – Expected Effects

Level of tax rates is likely to decline– If tax bases are mobile, move from high-tax to low-tax regions.– Tax competition to attract and retain tax bases.– Negative externality imposed on other regions by one region cutting its tax rates. – Tax competition could lead to a ‘race to the bottom’ in which overall tax collections decline

precipitously.

Composition of taxes could change– Tax burden on mobile factors should fall (capital and skilled labor).– Tax burden on immobile factors should rise (unskilled labor, physical capital, property).– May see greater reliance on charges/fees on specific services, sin taxes, green taxes, lotteries.– May lead to greater regressivity in taxes.

Harmonization (tax coordination)– To reduce negative fiscal externalities.– Convergence in tax rates and in definitions of tax bases.

Diminished autonomy of governments– Jurisdictions cannot set tax rates independently of other jurisdictions.

Trends in Tax Rates and Revenue

Mixed Evidence– Mendoza, Milesi-Ferretti, Asea (1997): effective tax rates

not converging over time nor focused on less mobile factors.

– Carey and Tchilinguirian (2000): Find some convergence and increased burden on labor for OECD countries.

– Ault (1997), Messere (1998): Industrial countries retain remarkable and sustained diversity in tax systems.

– Government Spending in industrialized countries has grown.

– Some of the most open international economies, e.g., Sweden and Denmark, have high tax collections (57% and 53% of GDP respectively).

Trends in Tax Rates and Revenue

Table 1.2. Statutory corporate income tax rate: 1982-2006*

Trends in Tax Rates and Revenue

Trends in Tax Rates and Revenue

Table 1.12. Taxes on corporate income as a percentage of GDP

Unweighted OECD average over time

Trends in Tax Rates and Revenue

Our Approach

Standard two-country, neoclassical, representative agent, open-economy, infinite horizon model.

Governments can impose taxes on consumption, labor, and capital.

Solve for a set of equilibrium conditions to examine the magnitude of tax responses as factors are able to move more freely across national borders.

– Model is solved numerically.– Parameterize the model using values appropriate for the U.S. and an OECD

aggregate. Factor mobility as a response to globalization.

– Direct mobility – compare no factor mobility to mobile factors.– Indirect mobility – changing the elasticity of substitution of factors used in production.

Calculate the responsiveness of the tax bases (consumption, labor, capital) to a 10% change in the home tax rate on consumption, labor, or capital.

Our Approach

Gravelle and Smetters (2006) highlight the importance of imperfect product substitution with a fixed world capital stock. They conclude that imperfect product substitution limits the degree to which capital moves across borders. Effectively acts to make capital less mobile even when direct capital flows can occur.

Incidence of a capital tax then falls on domestic capital or is exported to foreign capital.

Others have shown the importance of the accumulation of capital (e.g., Mutti and Grubert, 1985; Mendoza and Tesar, 2003) as well as the labor-leisure tradeoff (e.g., Goulder, Shoven, and Whalley, 1983; Mendoz and Tesar, 2003) on tax-competition conclusions.

Produced capital goods may limit the incidence falling on domestic capital. Gravelle and Smetters extend their model to include produced capital and confirm

that this may reduce the burden on labor; the capital tax burden is exported in their model.

Labor-leisure tradeoff allows substitution into leisure to reduce incidence of a capital tax falling on labor when capital is mobile.

Basics of model

Standard two-country, open-economy, neoclassical model.– Home produces and exports X. – Foreign produces and exports Y.– Production of X and Y requires labor and capital.– Factors are fully employed and are paid the value of their marginal

products. RA in each country acts as the representative household and the

representative firm. – Households consume both X and Y.– RA in each country allocates time between leisure and labor.– Identical utility functions.– RA also makes a capital accumulation decision.– Home and foreign goods are produced with the same technologies.

The government in each country can impose taxes on consumption, labor, and capital.

Model with Immobile Capital and Labor

Home produces X using only domestic capital and labor according to a Cobb-Douglas production function:

Foreign produces Y using only foreign capital and labor according to a Cobb-Douglas production function:

X can be consumed or invested in X-sector capital. Home accumulates capital for use in home production. Capital in place depreciates at rate .

Labor is allocated to domestic production. Home leisure is

Utility functions take a nested Cobb-Douglas, CRRA form. Home utility is:

1xx LKX

** 1** yy LKY

xx LH 1

)1(

1),,( )1)(1()1(

xyxxyx LCCHCCu

Model with Mobile Capital and Labor – Direct Factor Mobility

Factors may substitute for one another. Nested CES function within a Cobb-Douglas function of total capital and labor:

X can be consumed or invested in X-sector capital (by home or foreign agents). Home accumulates capital for use in home production and for use in foreign production.

Labor can be allocated to home or foreign production. Home leisure is then

Utility functions take a nested Cobb-Douglas, CRRA form. Home utility is:

yxx LLH 1

)1(

1),,( )1)(1()1(

yxyxxyx LLCCHCCu

LLLKKKyLxLxkxk LLKKX

1

** ]))(1()([]))(1()([2

*

*

***

*

**

1

****** ]))(1()([])(1()([2 LLLkKKyLyLyKyK LLKKY

yx KKK

Government Revenues

Home government imposes taxes on production within the country as well as on consumption of both goods. Factor taxes are source-based.

Home government revenue in real x units is:

yx

ycyxcxxLxlxxKxkxxLxLxxKxkx CP

ePCLFKFLFKFg

*******

Results – Direct Factor Mobility

Direct factor mobility– Capital and Labor are mobile across the two

countries and are substitutes in the production of goods X and Y.

Consider a tax of 10% on domestic capital or domestic labor. Compare responses when factors are immobile to responses when factors are mobile.

Factor Responses when Factors are Immobile versus Mobile

Percentage Change in Base moving from Immobile Factors to Mobile Factors

10% Tax on Domestic Capital

23.21% Tax on Domestic Capital (Revenue Neutral)

Percentage Change in Cx 2.74% -1.83% Percentage Change in Cy -0.50 -1.15 Percentage Change in Kx -51.47 -63.24 Percentage Change in Lx -49.98 -49.24 Percentage Change in K 6.68 -5.14 Percentage Change in L -0.23 0.83 Change in g -51.61 0 Percentage Change in U 0.31 -0.53 Percentage Change in U* 0.54 0.23 Percentage Change in X 2.45 -0.80 Percentage Change in Y -0.07 -0.13

Tax Base Responses to Home Country Taxes: Immobile vs. Mobile Factors

Percentage Change in Base

Response to a 10% Tax on Kx – Immobile Factors

Response to a 10% Tax on Kx – Mobile Factors

Percentage Change in Cx -5.78% -3.20% Percentage Change in Cy 0 -0.50 Percentage Change in Kx -14.06 -16.59 Percentage Change in Lx 1.02 1.12 Percentage Change in Ky -0.05 Percentage Change in Ly 0.56 Percentage Change in K -8.32 Percentage Change in L 0.84 Change in g 2.48 1.20 Percentage Change in U -0.93 -0.62 Percentage Change in U* -0.72 -0.18 Percentage Change in X -4.51 -2.17 Percentage Change in Y 0 -0.07 Response to a 10% Tax on Lx

– Immobile Factors Response to a 10% Tax on Lx – Mobile Factors

Percentage Change in Cx -9.70% -7.26% Percentage Change in Cy 0 -2.26 Percentage Change in Kx -1.14 -0.81 Percentage Change in Lx -1.16 -6.24 Percentage Change in Ky 0.13 Percentage Change in Ly 5.21 Percentage Change in K -0.34 Percentage Change in L -0.51 Change in g 4.77 2.33 Percentage Change in U -0.98 -1.06 Percentage Change in U* -1.23 -0.03 Percentage Change in X -1.14 -0.82 Percentage Change in Y 0 0.13

Results – Government Revenue

Government revenues are cut in half when factors are mobile versus when they are immobile and only home capital is taxed at the same rate.

If the home government can tax both home and foreign capital in home production, then home government revenues are unaffected by factor mobility.

Results – Indirect Factor Mobility

Indirect factor mobility– Consider increasing globalization as increased substitutability of

factors in production across the two countries.

Government revenue declines as factor mobility increases.– Low substitutability, decline in government revenue is small.– High substitutability, decline in government revenue is larger.

Thus, when there are smaller substitution possibilities in production, the response of government revenues to increased factor mobility is smaller.

Substitutability of Factors

K and L mobility on Govt Revenue

0

0.005

0.01

0.015

0.02

0.025

0.03

-1.5 -1 -0.5 0 0.5 1 1.5

Factor mobility

Go

vern

men

t re

ven

ue

Conclusions

Some shifting of factors to avoid relatively higher tax burden on domestic production. Those factors that are free to move do relocate to avoid taxation.

Little evidence of a vanishing taxpayer. Government revenue declines but the government

retains the ability to collect taxes. Increased factor mobility does in fact increase the

response of tax bases to tax rates, in turn reducing the ability of the government to collect taxes. But the government retains the ability to collect significant revenue even in the face of increasing globalization.

Conclusions

Is globalization good or bad for taxation? – One view:

Governments are needed to correct the shortcomings of the market (welfare state). If globalization curbs this ability, then globalization is harmful. Tax competition reduces the ability of governments to provide public goods.

– Another view: Government intervention is inefficient and inequitable

(Leviathan view of government). If globalization limits the ability of governments to meddle in markets, then globalization is beneficial. Tax competition reduces the size of government and government waste.

Conclusions and Extensions

Evidence of the effects of globalization is unclear. – Little empirical (or even theoretical) evidence that governments cannot collect taxes, that they are

losing fiscal autonomy, that tax rates and bases are converging quickly, that tax systems are becoming more regressive, and that expenditures are falling in total or changing in composition.

Discussion leaves out consideration that globalization both limits and expands the choices governments can make.

– With increased globalization, governments may have more power to influence locational decisions of firms, workers, and consumers. Those governments that succeed will be those that are better able to match taxes with expenditures and better able to give taxpayers the services they wish for the taxes they pay.

– Not only negative fiscal externalities.– May also be positive effects: expenditure competition. Individuals value the goods/services that

governments provide and are willing to pay for them. Individuals will ‘vote with their feet’ and move to jurisdictions in which governments provide services residents value.

Government decisions are circumscribed by the possibility of a vanishing taxpayer but governments will still exist, will still impose taxes, and will still make expenditures.