September 18, 2000 | Backgrounder on Taxes
A spectre haunts the world's governments. They fear that the combination of economic liberalization with modern information technology poses a threat to their capacity to raise taxes.1
Globalization is making it harder for governments to overtax, because it is increasingly easy for taxpayers to shift their productive activities to lower tax environments. This is what is known as tax competition. Unfortunately, not everyone favors this development. The Organisation for Economic Co-operation and Development (OECD), a Paris-based international organization with 29 member nations from the industrialized world, has urged its member states to stop "harmful tax competition."2
In "Towards Global Tax Co-operation: Progress in Identifying and Eliminating Harmful Tax Practices," the OECD is calling on its members to eliminate low-tax policies that attract foreign investment.3 It is also trying to dictate tax policy in non-member nations by pressuring 41 low-tax nations and territories (called "tax havens" in the report) that have "harmful tax regimes"4 to sign an agreement to remove their low-tax policies and repeal their attractive financial privacy laws. If they do not, the report recommends that OECD members exercise financial protectionism against them.
Such an effort contradicts international norms and threatens the ability of sovereign countries to determine their own fiscal affairs.5 The OECD proposal, which is backed by officials in the primarily high-tax nations that form the core of its membership, would create a cartel by eliminating or substantially reducing the competition these high-tax nations face from low-tax regimes. The United States, a member of the OECD and its biggest source of funds, should put a stop to this ill-advised effort by unequivocally stating that it will not impose financial sanctions against the 41 blacklisted countries. (See Table 2.)
Critics have characterized this OECD effort as "an attempt by governments of high-tax countries to protect their tax revenues."6 Indeed, some opponents of tax competition have estimated that successful implementation of the proposed initiative could mean a tax increase that is "likely to be in the hundreds of billions, if not trillions, of dollars worldwide."7 Needless to say, a return to the profligate fiscal policies like those of the 1960s and 1970s would threaten the economic advances that have occurred over the past 20 years.8
Some policymakers from high-tax OECD nations appear so desperate to hold tax revenues hostage that they ignore the interests of less-developed countries. As one Canadian tax expert points out, the OECD proposal targeting the so-called tax havens would pit "wealthy--and white" industrialized nations against "predominantly black, poor" countries.9 Indeed, some politicians are so greedy for tax revenue that the G-7 nations, the seven most powerful countries in the world, urged that taxes be enforced "with the same laws used against the laundering of drug proceeds."10
But such efforts miss the point. The fact that low-tax nations are magnets for jobs, capital, and entrepreneurial talent is a development that should be celebrated, not persecuted.11 Governments should not be sheltered from competition. Globalization is helping to create more prosperity by forcing businesses to be more productive. The same competitive forces should be allowed to impose fiscal discipline on government.
A cartel would have adverse consequences for U.S. taxpayers and threaten national sovereignty, financial privacy, technological development, and the rule of law. America should not participate in a regime that undermines one of its most significant competitive advantages--a low-tax environment compared with other industrialized nations. Instead, U.S. policymakers should make the economy even more competitive by reducing tax rates. Ultimately, lawmakers should enact a flat tax, a reform that would lure more economic activity to America's shores as well as substantially reduce incentives to either avoid or evade the tax system.
The OECD's "Towards Global Tax Co-operation" report on efforts to eliminate low-tax competition and financial privacy is, at its core, a response to globalization. As one European bureaucrat explains, "differences in national tax systems are becoming increasingly evident and are therefore having an increasing influence on economic decisions concerning, for example, investment, savings, employment and consumption."12 And just as banks, pet stores, and car companies treat customers better when they know there is a competitor down the block, governments treat taxpayers better when they know economic activity can cross national borders.13
Today, individuals may be able to choose among many countries in deciding where to work, to shop, to invest their financial capital, to allocate the production activities of the enterprises they control and so on. In these decisions, they take into account the impact of taxes, especially as long as the tax systems of different countries diverge as much as they do today.14
This taxpayer mobility--the ability to "vote with one's feet"--means that countries with high tax rates are likely to lose revenue, making it harder for their policymakers to fund expensive 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."15 As Michel Vanden Abeele, the Director General of the European Commission's Taxation and Customs Union puts it, "protection of adequate tax revenues is of particular concern in order to guarantee the survival of the fair and caring society."16 Needless to say, lawmakers who support these programs prefer that tax competition did not exist.
The OECD's Disdain for Tax Competition
The fact that tax rates affect economic decisions is not an outcome that most policymakers welcome. In part, they fear the loss of revenue, which affects their ability to spend.1 Yet some of them think tax competition is economically counterproductive, as statements from various OECD publications show:
1. Dow Jones Newswire, "Caribbean Leaders to Discuss Offshore Banking Blacklist," July 3, 2000.
2. OECD, "Towards Global Tax Co-operation," p. 5.
4. OECD, "Harmful Tax Competition: An Emerging Global Issue," p. 14.
5. Ibid., p. 16.
6. Ibid., p. 14.
The only way to stop taxpayers from fleeing to lower tax environments, however, is to have all governments agree to maintain high tax rates--in effect, by establishing a tax cartel. The OECD proposal is just the latest development in an ongoing battle between taxpayers and their governments. Under the guise of "tax harmonization," for example, high-tax nations in the European Union have been working for years to impose a cartel on taxpayers.17
The creation of a tax cartel may be just the beginning of a process that results in higher taxes and a more costly government--policies that will adversely affect U.S. taxpayers. In order to understand why eliminating tax competition is bad public policy, it is important to understand what tax competition is and is not, and how it benefits people around the world.
Competition exists when rivals offer similar or better products at lower prices. In the business world, competition leads to innovation, lower prices, and good service. In effect, competitive markets mean the "customer is king." Competition serves the same role when the taxpayer is the consumer and governments must learn not to overtax lest they drive economic activity away.18
Government officials who fear tax competition are like the owner of a town's only gas station who suddenly has to deal with a bunch of competitors after years of being able to charge high prices while offering poor service. The residents of the town are like the world's taxpayers. The competition lowers the price of gas and auto repairs and makes their lives better.
This is the central reason why tax competition is a good thing. As a response by Switzerland in a 1998 OECD report noted, "competition in tax matters has positive effects. In particular, it discourages governments from adopting confiscatory regimes, which hamper entrepreneurial spirit and hurt the economy, and it avoids alignment of tax burdens at the highest level."19 Moreover, as one academic expert notes, "Competition will often have a `negative effect' on less competitive suppliers in a market, but the losses incurred by them, while real, are not `harm' in the proper sense."20 A British newspaper notes that tax competition is only damaging
in the absurdist sense that any government that finds itself in competition with a lower-tax regime can condemn its competitor as "harmful." Accept this and you introduce an irresistible upward bias in international taxation. Bad news for the tax havens, for sure, but scarcely better for the citizens of some of the tax hells that we hear rather less about.21
Perhaps most important, tax competition is not about governments. It is about people and whether they enjoy more freedom and have more opportunity.22 Tax competition tilts the balance of power away from government and towards taxpayers.23 Or, as The Wall Street Journal opined,
Tax competition between states is a good thing. The power of individuals and companies to vote with their feet is one of the most potent weapons against overweening government. Any attempt to deprive them of places to run must surely be considered an attack on freedom and a threat to prosperity.24
of Lower Taxes
Ample evidence exists that economic activity is drawn to low-tax regimes.25 People work, save, invest, and take risks in order to improve their after-tax income. This insight is particularly relevant to international investment flows since, as an expert from the University of California in Riverside observes,
[A]rbitrage in capital markets causes rates of return to converge; but it is the net rates of return after taxes that tend to converge, not gross rates of return, so that businesses in jurisdictions with high taxes must offer and generate correspondingly higher gross rates of return on capital, to continue to attract investment.26
Consider the example of an investor looking at two potential business opportunities. In Country A, a project might generate a 10 percent return, while in Country B, a similar investment is expected to yield a 7 percent return. On paper, this would suggest the investor would take advantage of the opportunity in Country A. But what if Country A has a 50 percent tax and Country B has no tax? In that case, the investor will choose to invest in the project in Country B. This choice is made because the actual after-tax return in Country A falls to 5 percent, less than the 7 percent after-tax profit that could be earned in Country B.
This does not mean, of course, that all investment will flow to low-tax nations. It does mean that investors will steer away from projects in Country A unless the expected pre-tax return is sufficiently large to compensate for the tax burden. In non-economic terms, this means that where there are two equally attractive projects, investors will choose the project that is subject to lower tax rates.27
Taxation is not the only government policy that influences economic decisions. It may not even be the most important one. Excessive regulation, corruption, inflation, and protectionism also make an economy unattractive to entrepreneurs and investors.28 Other factors include property rights, flexible labor markets, and government spending.29 If the OECD project is any indication, however, government officials clearly think tax policy plays a dominant role in economic decisions.
The United States is a good example. Compared with Europeans, Americans enjoy low taxes, which seems to have a notable impact on economic performance. The United States has experienced faster economic growth, which has resulted in the creation of 30 million net new jobs since the mid-1970s compared with 3.5 million in all of Europe (almost all of which were government jobs).30
British sports millionaires like cricketer Ian Botham, Formula 1 driver Nigel Mansell, and golfer Ian Woosnam live in the Channel Islands or the Isle of Man, two of the so-called tax havens.31 Boris Becker and Luciano Pavarotti have taken up residence in Monaco.32
Fruit of the Loom moved its headquarters to the Cayman Islands, saving almost $100 million in taxes each year.33
U.S. insurance companies are moving some of their operations to Bermuda to avoid America's 35 percent corporate income tax.34
Many Scandinavians and Germans have bank accounts in Luxembourg.35
234. Tom Naylor, at a United Nations Panel Discussion on June 10, 1998; see www.imolin.org/ungapanl.htm.
242. U.S. Department of Treasury, Financial Crimes Enforcement Network, "FINCEN FAQs," at www.ustreas.gov/fincen/faqs.html.
249. Ron Paul, Tom Campbell, Bob Barr, and Walter Jones, "Report Together with Dissenting Views [To accompany H.R. 3886]," International Counter-Money Laundering and Foreign Anticorruption Act of 2000, House Banking Committee, Report No. 106-728, July 11, 2000.
256. Raymond Baker, "Money Laundering and Flight Capital: The Impact on Private Banking," Testimony to The Permanent Subcommittee on Investigations, Senate Governmental Affairs Committee, U.S. Senate, November 10, 1999.
274. Jonathan Talisman, "Remarks to the GWU/IRS Annual Institute on Current Issues in International Taxation," December 10, 1999, at www.ustreas.gov/press/releases/ps289.htm.