Is International Tax Competition only about Taxes? A Market-Based Perspective
Attracting multinational firms is a priority for many countries, leading to a fierce tax competition among governments over the last two decades. But what determines the extent of this tax competition? This research shows that, beyond considering the regional tax environment, a country pays attention to the economic dynamism of its competitors.
The decline of corporate tax rates
Corporate income tax rates have fallen substantially worldwide over the past decades. As can be seen in Figure 1, between 1995 and 2015 (corresponding to the period of our analysis), the statutory tax rate in both developed (EU-OECD) and developing (non-OECD) countries declined by nearly one-third, from about 35% to 24%. Researchers attribute this shift towards lower taxes on profits to tax competition between countries eager to retain and attract capital, notably foreign direct investment, in an increasingly integrated world economy. This trend is not likely to persist with the adoption in 2024 by 141 countries of a global minimum tax rate with a 15% minimum effective tax rate on corporate profits, ensuring that a minimum of tax is paid no matter the location of MNEs. Downward pressures due to tax competition should therefore be mitigated with this floor imposed by Pillar II of the OECD Base Erosion and Profit Shifting. The aim of this paper is to contribute to a better understanding of the drivers of international tax competition.
Fig.1. Corporate tax rates over time and across income groups.
The drivers of international tax competition
The existing empirical research investigates this issue by testing whether a country’s corporate income tax rate is partly determined by the corporate tax rate of other countries. In doing so, this literature finds substantial evidence for the existence of tax competition between governments. If this strand of research has strongly improved our understanding of tax competition, however, it neglects a key insight from the recent theoretical tax competition literature: that relative market size should also matter. Recent tax competition models acknowledge that countries are not symmetric.
A country with a large market can afford to impose a higher corporate income tax rates than a smaller country because it offers a more attractive environment due to its larger market.
These models suggest, in a world where foreign direct investment tends to be market-seeking, that a government ought to perceive, all other things equal, faster growth in neighboring countries as a threat, leading it to adjust downward its corporate tax rate to maintain its attractiveness for foreign direct investment. The first contribution of this paper is to investigate empirically the relevance of this theoretical proposition, by considering market-based (indirect) tax competition as another determinant of corporate tax rates.
While tax competition amongst developed countries has been investigated in a large number of papers, the same cannot be said in the case of developing countries. This is a puzzling omission given that corporate tax rates in these countries have also strongly fallen in the last decade. Our second contribution is to shed light on the extent of tax competition in the developing regions of the world.
The role of faster growth in neighboring countries
Starting with stylized facts, we depict the relationship between changes in corporate tax rates and the market size of neighboring countries for two broad income groups. Figure 2 shows that this relationship is clearly negative in EU-OECD countries whereas there is no obvious pattern in non-OECD countries.
Fig. 2. Correlation between CTRs and spatial lag of market size Note: values have been adjusted for country-specific fixed effects and time trends.
In line with those stylized facts, our key result based on an econometric analysis is that corporate tax rates are lower when the growth performance of geographically close countries is particularly strong. This relationship is especially robust in EU and OECD countries and in several developing regions. Further investigations indicate that this market-based spatial effect is stronger if neighboring countries are developed, large, and open to capital flows. In contrast to previous research, we have not found strong evidence of direct competition over corporate tax rates.
All in all, our results suggest that market-based considerations of relative international attractiveness is a driver of tax competition for FDI.
Tax competition or ‘political yardstick’ competition
At first glance, our findings are compatible with models of ‘political yardstick’ competition where voters partly evaluate the policies and performance of their government based on those of neighboring countries. Higher growth in a foreign country associated with a decrease in its corporate tax rate could then lead neighboring countries to mimic this tax policy in the hope of achieving a similar positive outcome. Alternatively, corporate tax rate cuts could be part of a common policy-making trend. The discriminating factor between these two theories and our conceptual framework is financial openness. Tax competition for FDI cannot logically happen between financially closed countries, whereas yardstick competition and policy diffusion are indifferent to financial openness. By distinguishing between two groups of countries, based on average financial openness, our results unquestionably support a tax competition explanation.
Methodology
Using a variety of sources, we have created a database of statutory corporate tax rates covering a large number of developed and developing countries for the period 1995–2014. Our largest sample includes 38 EU-OECD countries and 76 other countries. We look at tax competition within geographical regions as well as within free-trade zones, given that regional economic integration ought to be stronger in such sub-sets of countries. The tax competition literature, including the extension that we propose, fundamentally rests upon the concept of spatial dependence.
The standard econometric model that is used in the literature is a spatial autoregressive (SAR) model in which the corporate tax rate is assumed to be influenced by its spatial lag (i.e. the corporate tax rate of other countries). However, this model may be misspecified because it does not account for other potentially relevant spatial effects. If our hypothesis is correct, the correct econometric model of tax competition ought to include, not only the spatial lag of corporate tax rates, but also the spatial lag of (the log of) GDP. A spatial econometric model including a lagged dependent variable (LDV) and spatial lags of the explanatory variables as well as the dependent variable is a time-space Durbin Model (SDM).
Applications and beneficiaries
Overall, our results indicate that a government wishing to attract inward foreign direct investment and limit outward FDI is likely to consider the spatial economic environment when setting its corporate tax rate. More specifically, policymakers, appear to perceive the growth performance of their neighboring countries as a threat to their attractiveness when these countries are open to capital flows and have large markets. Having in mind that countries differ in their market size and attractiveness and that the corporate tax rate can be used to compensate for those asymmetries is important to develop an agreement on a global minimum tax rate under Pillar II of the OECD Base Erosion and Profit Shifting which does not benefit mainly larger countries. This could depend on whether Pillar II compresses or not the distribution of effective tax rates. If Pillard II leads to compressing worldwide effective tax rates into a smaller range, it will be more difficult for some countries (namely developing and small countries) to maintain their attractiveness.
- Discipline: Economics
- Keywords: Tax competition, country size, foreign direct investment, multinational firms, spatial lag
Azémar, C., R. Desbordes and I. Wooton (2020) “Is International Tax Competition Only About Taxes? A Market-Based Perspective”, Journal of Comparative Economics, 48, pp. 891-912. https://doi.org/10.1016/j.jce.2020.05.002
