The Liberalizing Impact of Jurisdictional Competition

Economic rivalry between governments, especially tax competition, is a very important tool for constraining the greed of the political class. Simply stated, politicians are less likely to impose bad policy if they are afraid that jobs and investment (and accompanying tax revenue) will move to nations with better laws. Jurisdictional competition can exist inside a nation, with American states and Swiss cantons being notable – and mostly noncontroversial – examples. 

Competition between nations is very controversial, by contrast, especially tax competition. High-tax nations, along with international bureaucracies controlled by those nations (such as the Organization for Economic Cooperation and Development and European Commission) would like to stifle this liberalizing process. So-called tax havens are the main target of efforts to replace tax competition with tax harmonization. 

Proponents of tax competition say it provides a much-needed check on excessive government. Politicians, after all, have little incentive to control spending and reform programs if they think that higher taxes are an option. So how do we control their appetite for more revenue? There’s no silver bullet solution, but part of the answer is tax competition and tax havens. Politicians are less likely to over-tax and over-spend if they’re afraid that the geese that lay the golden eggs can fly across the border. In other words, tax competition is a necessary but not sufficient condition to promote good policy.

The (Modern) Historical Record

The angst of politicians is understandable. Consider what happened after Ronald Reagan lowered the top federal income tax rate in the United States from 70 percent to 28 percent, and after Margaret Thatcher lowered the top tax rate in the United Kingdom from 83 percent to 40 percent. Those reforms led to an economic renaissance in the two nations, but these tax cuts also encouraged similar tax-rate reductions all over the world as politicians in other nations felt pressure to improve their tax systems so that there was not a big exodus of jobs, investment, and money to the U.S. and U.K.

The same thing happened with corporate tax rates, except Ireland probably deserves most of the credit. Ireland’s corporate tax rate was slashed from 50 percent to 12.5 percent over about a 15-year period starting in 1987. The “sick man of Europe” became the “Celtic Tiger” because of rapid growth, which was good news, but it also has been good news because pro-growth reforms in Ieland triggered a competitive battle as other nations cut their corporate rates to retain jobs and investment.

Thanks in part to tax competition, there’s also been a flat tax revolution. More than two dozen nations now have single-rate tax systems, mostly triggered by Estonia’s reform in the 1990s. The other Baltic nations copied Estonia and now this pro-growth system is very common among the nations that used to be part of the former Soviet Empire. 

Academic researchers have looked at the issue of why the western world became rich and other regions lagged. The answer, at least in part, is that there was lots of decentralization in Europe. And this is what facilitated a big burst of prosperity.

Lawmakers also felt pressure to lower or eliminate death taxes and wealth taxes, as well as to reduce the double taxation of interest, dividends and capital gains. Once again, tax havens deserve much of the credit because politicians presumably would not have implemented these pro-growth reforms if they didn’t have to worry that investors and entrepreneurs might shift money to a confidential account in a well-run nation like Luxembourg or Singapore.

All of these examples of tax competition have been facilitated by globalization. It’s now much easier for jobs and investment to cross national borders. This forces politicians to be especially sensitive to the impact of potential tax changes. In other words, governments no longer can act like monopolists, assuming that taxpayers have no choice but to submit to punitive tax regimes.

The (older) Historical Record

Academic researchers have looked at the issue of why the western world became rich and other regions lagged. The answer, at least in part, is that there was lots of decentralization in Europe. And this is what facilitated a big burst of prosperity.

What makes this especially noteworthy is that, during the dark ages, nations like China were relatively advanced while Europeans were living in squalid huts. And China had what was perceived to be an “efficient” and centralized administrative system, something that modern advocates of centralization say is a prerequisite for advancement. So why, then, did Europe experience the enlightenment and industrial revolution while the empires of Asia languished? Simply stated, Europe benefited from the fact that governance was decentralized. This meant jurisdictional competition, diversity of governmental structures. More specifically, governments were forced to adopt better policies because labor and capital had significant ability to cross borders in search of less oppression.  

Good Process and Good Policy

One of the main benefits of tax competition is that it promotes good tax policy. Public finance economists generally prefer low rates over tax rates and also recognize that it’s not good to place higher burdens on saving and investment compared to consumption.

Politicians, however, often are tempted to impose high tax rates and lots of double taxation because that’s a way of “taxing the rich” in order to get money that can be used to give benefits to a broader population of voters. This may be smart short-run politics, but it’s not good economic policy. Even small reductions in growth will magnify over time, resulting in significantly lower levels of economic output.

Vernon Smith pointed out that jurisdictional competition, “…is a very good thing... Competition in all forms of government policy is important. That is really the great strength of globalization …tending to force change on the part of the countries that have higher tax and also regulatory and other policies than some of the more innovative countries.”

Tax competition, by contrast, inhibits this tendency of politicians to impose destructive tax policy. And since lower tax rates and reductions in double taxation are key ways of reducing the harmful impact of tax systems, the process of jurisdictional competition has been very beneficial to the global economy.

Nobel Prize-winning economists certainly seem to understand that jurisdictional competition is a good idea.

George Stigler noted that, “Competition among communities offers not obstacles but opportunities to various communities to choose the type and scale of government functions they wish.”

Gary Becker wrote that, “…competition among nations tends to produce a race to the top rather than to the bottom by limiting the ability of powerful and voracious groups and politicians in each nation to impose their will at the expense of the interests of the vast majority of their populations.”

James Buchanan similarly stated that “…tax competition among separate units…is an objective to be sought in its own right.”

Milton Friedman famously noted that, “Competition among national governments in the public services they provide and in the taxes they impose is every bit as productive as competition among individuals or enterprises in the goods and services they offer for sale and the prices at which they offer them.”

Edward Prescott paraphrased Adam Smith, observing that “…it’s fair to say that politicians of like mind seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise taxes. This is why international bureaucracies should not be allowed to create tax cartels, which benefit governments at the expense of the people.”

Edmund Phelps has warned that, “…it’s kind of a shame that there seems to be developing a kind of tendency for Western Europe to envelope Eastern Europe and require of Eastern Europe that they adopt the same economic institutions and regulations and everything.”

Douglas North opined that, “…international competition provided a powerful incentive for other countries to adapt their institutional structures to provide equal incentives for economic growth and the spread of the ‘industrial revolution.’”

Friedrich Hayek wrote that, “Competition between local authorities or between larger units within an area where there is freedom of movement…will secure most of the advantages of free growth.”

Vernon Smith pointed out that jurisdictional competition, “...is a very good thing... Competition in all forms of government policy is important. That is really the great strength of globalization …tending to force change on the part of the countries that have higher tax and also regulatory and other policies than some of the more innovative countries.”

The Battle against Tax Competition 

Politicians from high-tax nations have launched an attack against international tax competition. Using the Paris-based Organization for Economic Cooperation and Development (OECD) as their vehicle, they are pushing an agenda based on a theory that presumes that all tax competition is bad and that taxpayers should never have the ability to benefit from better tax laws in other jurisdictions.

According to this theory, known as “capital export neutrality,” there should be harmonization so that taxpayers never have an opportunity to make choices that would reduce their fiscal burdens. There are two ways to make this happen.

On the other hand, the United States is a tax haven for foreigners. People from other nations (technically, “nonresident aliens”) generally can invest in stocks and bonds and not be taxed on any interest or capital gains. And since that money isn’t taxed, there’s no requirement to provide any data to the IRS. All of which means that there’s no information to share with foreign governments.
But that’s only part of the story. 

Direct tax harmonization exists when all nations agree to have the same tax rates. The requirement that all European Union nations have a value-added tax of at least 15 percent would be an example of this approach. And when all nations have the same tax rate for a type of economic activity, taxpayers obviously cannot lower their tax burdens by shifting economic activity to another jurisdiction.

Indirect tax harmonization exists when nations have the ability to impose and enforce “worldwide taxation,” which means that their tax authorities can obtain all the information needed to tax their citizens on any cross-border economic activity. And when worldwide taxation is enforceable, taxpayers obviously cannot lower their tax burdens by shifting economic activity to another jurisdiction.

The OECD and high-tax nations have mostly focused on the second form of tax harmonization, which is why there’s been such a strong push to undermine the strong human-rights laws regarding financial privacy in places such as Switzerland and the Cayman Islands. High-tax governments want the ability to track capital around the world so they can impose additional layers of tax.

Though there also have been periodic efforts for direct tax harmonization, particularly in the European Union where there is considerable cartel-like equalization of excise taxes and (as noted above) value-added taxes. In addition, the EU has tried several times to explicitly harmonize corporate tax rates. Today, the EU is pursuing a “common consolidated corporate tax base” in hopes of undermining tax competition for company investment, and the OECD has a similar “base erosion and profit shifting” initiative that also is designed to enable higher tax burdens on companies.

American Hypocrisy 

The policies of the United States are very hypocritical on the issue of tax competition. On one hand, America has a very aggressive worldwide tax system and the United States has been very aggressive in bullying other jurisdictions into enforcing bad American tax law. The so-called tax havens have been coerced into signing “tax information exchange agreements” (TIEAs) with the United States, though these pacts don’t actually involve any “exchange” since these jurisdictions don’t try to tax outside their borders. The Foreign Account Tax Compliance Act (FATCA), adopted back in 2010, uses the threat of a protectionist 30 percent tax on financial flows to force all nations (even places like France with very high tax burdens) into acting as deputy tax collectors for the IRS.

On the other hand, the United States is a tax haven for foreigners. People from other nations (technically, “nonresident aliens”) generally can invest in stocks and bonds and not be taxed on any interest or capital gains. And since that money isn’t taxed, there’s no requirement to provide any data to the IRS. All of which means that there’s no information to share with foreign governments. But that’s only part of the story. Many American states have incorporation laws that are extremely attractive to foreigners who want confidential structures to conduct business and manage investments. Indeed, some American states don’t even bother collecting information on ownership, so there’s no information to share with foreign governments. 

This combination – good federal tax law and good state incorporation laws – makes the United States a very attractive place for foreigners seeking to escape excessive tax burdens. And it also happens to be a boon for the American economy. According to the Commerce Department, foreigners have more than $13 trillion of indirect investments in the United States.

Good vs Bad Tax Competition

Tax competition is a very necessary and valuable liberalizing force in the global economy. It has produced good results, as measured by significant reduction in tax rates and reduced levels of double taxation of saving and investment.

This doesn’t mean, however, all forms of tax competition are equally desirable. If a country lowers overall tax rates on personal income or corporate income in hopes of attracting business activity, that’s great for prosperity. If a jurisdiction seeks faster growth by reducing double taxation – such as lowering the tax rate on capital gains or abolishing the death tax, that’s also very beneficial. Some politicians, however, try to entice businesses with special one-off deals, which means one politically well-connected company gets a tax break while the overall fiscal regime for other companies stays 

Conclusion 

Politicians have an unfortunate tendency to over-tax and over-spend. Fortunately, tax competition is an external constraint that discourages destructive tax policies. But if high-tax nations and international bureaucracies succeed in their campaign against low-tax jurisdictions, it’s quite likely that nations will go back to the confiscatory tax rates that did so much damage to global growth in the 1970s. This is why tax harmonization schemes from the OECD and EC are contrary to the interests of both taxpayers and the economy.