1. Tax Competition and the Enlargement of the EU

2. In the debate about potential benefits of differentiated tax systems in the current and future EU member countries arguments against tax competition rely predominantly on the models originated by Zodrow and Mieszkowski (1986) and Wilson (1986), and surveyed by Wilson (1999). These models show that in the situation when governments can only attract more capital by lowering capital tax rates tax competition leads to under-provision of public goods.

3. However, these models assume that countries levy tax on capital in order to finance the provision of public goods for their citizens whose welfare increases in the level of public goods provided to them. It is not surprising that under such system a higher tax rate represents no benefits to capital which therefore moves to countries with lower tax rates decreasing welfare in the countries with higher tax rates.

4. Furthermore, models of tax competition that assume that tax revenues are used for the provision of so called industrial public goods nevertheless suppose that governments are flexible in setting the levels of provided industrial public goods and that they set these levels in a way to maximise the utility of citizens. Bayindir-Upmann, Thorsten (1998), Fuest, Clemens (1995), Rauscher, Michael (1997), Rauscher, Michael (1998)

5. However, public goods like infrastructure, education, national defence or effective police and legal system have to be built up over many years and thus their levels cannot be adjusted instantaneously.

6. Finally, the models of tax competition with industrial public goods consider a number of small identical jurisdictions which take the world rate of return on investment as given. In the context of the EU enlargement it might however be more interesting to analyse how the distribution of capital located in two unevenly- developed groups of countries could change after the creation of a single market.

7. Hence, the problem of potentially harmful tax competition in the enlarged EU is reconsidered in this paper assuming a two- country framework where capital tax revenues are used exclusively on the provision of industrial public goods while countries differ in the levels of industrial public goods accumulated over time.

8. There is an industrial public good which consists of a stock of industrial public goods accumulated over the years (G S ) and of industrial public services financed through capital taxation (G T ) with G T = T*K where T is a tax rate on a unit of capital employed in the given country, thus G = G S + T*K.

9. A two-country framework is modelled where a more developed country has a larger stock of government provided goods than a less developed country, G S > G S * where * denotes the less developed country.

10. Capital is normalised to unity and perfectly mobile across the two countries K = K, K * = 1 – K while labour force although of equal size in both countries L = L * = 1 is mobile only within a single country.

11. There is a single aggregate good which is produced according to a neoclassical production function Y(K,G,L) exhibiting constant returns to scale, with Y K,Y G,Y L > 0, Y KK,Y GG,Y LL 0. Initially, more capital is located in the more developed country, that is K > (1 – K).

12. As capital is perfectly mobile within the two countries after tax profit per unit of capital has to be the same in both countries, that is Y K – T = Y K * – T * where subscripts indicate derivatives.

13. Differentiating the capital market arbitrage condition with respect to the tax rate in the less developed country and solving for K T* gives

14. In case of a production function of the form Y = K  G  with  +  < 1, the denominator can be split into two parts which can be both shown to be negative as where G > KT while (1 –  ) > .

15. Hence, a change in T * leads to a decrease in K as long as 1 – Y KG * (1 – K) < 0. In case of a production function of the form Y = K  G  with  +  < 1, this condition can be rewritten as Zodrow and Mieszkowski (1986) reach the same result, they however arbitrarily assume that this condition is not fulfilled.

16. This result implies that in case of a sufficiently high (1 – K) or a sufficiently low G and increase in the tax rate in the less developed country can actually induce a capital inflow into this country. Differentiating the right hand side of this condition with respect to  leads to

17. This term is positive as long as that is as long as Assuming that this condition is fulfilled an increase in the efficiency of the public sector (  ) improves the chances that an increase in the capital tax rate will lead to a capital inflow into the given country.

18. Hence, tax competition does not necessarily have to lead to a race to the bottom as it is often feared. The model thus emphasizes the importance of the size and the effectiveness of the public sector which are often omitted from the tax competition debate. These conclusions seem to be in line with empirical evidence which does not confirm any significant decreases in corporate income taxation despite deepening economic integration

19. Schulze and Ursprung (1999) surveyed a large number of empirical studies that examine the relationship between economic integration and corporate income taxation. They conclude that although a moderate downward trend in capital tax rates in the 1980s can be observed capital tax revenues have remained stable while governments continue to levy substantial capital tax rates

20. Devereux, Griffith and Klemm (2002) analyse the development of taxes on corporate income in EU and G7 over the 1980s and 1990s. They show that while statutory tax rates fell over the 1980s and 1990s tax bases were on average broadened between the early 1980s and the end of the 1990s. Furthermore, although tax revenues on corporate income have declined as a proportion of total tax revenue since 1965 they have remained broadly stable as a proportion of GDP

21. Observed decreases in corporate tax rates might furthermore be attributed to ceasing of the inefficient industrial public good provision while an increased reliance on personal income taxation might be explained as an effort not to finance public goods benefiting citizens through corporate income taxation. In order to confirm this interpretation a precise empirical analyses of public expenditures is necessary but such study is difficult to perform.

22. Hines (1999, p. 309) states that one of the reasons why no significant link between taxes and FDI might be found is that governments imposing high tax rates may indirectly compensate firms with difficult-to-measure investment incentives such as worker training and infrastructure.

23. Welfare Maximisation Lets assume that there exists a locally stable equilibrium such that that is

24. In this situation the government of the less developed country trying to maximise the level of capital inflows would not have an incentive to adjust T *. However, the optimal provision of public goods in autarky is given by Y G = 1 as in this case domestic production maximising governments increase capital tax rates until the marginal product of industrial public good provision equals its marginal cost.

25. If governments instead of capital inflows maximised the domestic output net of capital taxes without engaging in any wasteful public expenditures that is Max T* (Y* – T * (1 – K)) then

26. This equation clearly does not hold for Y G = 1, hence, industrial public goods would certainly not be supplied in an optimal quantity. Substituting for K T* gives

27. However, as industrial public goods benefit both capital and labour (Y KG, Y LG > 0) they should also be financed both through capital and labour taxation so that G = G S +  TK +  TL where L = 1.

28. Taking this assumption into account differentiation of the capital market arbitrage condition with respect to the tax rate in the less developed country now implies that

29. In case of a production function of the form Y = K  G  with  +  < 1, the denominator can be split into two parts which can be both shown to be negative. Hence, a change in T * leads to a decrease in K as long as 1 – Y KG * ((1 – K)  +  ) < 0. This condition can be rewritten as or as

30. This result shows that for certain parameter values an increase in the tax rate in the less developed country can induce a capital inflow into this country while in its effort to attract more capital the less developed country might actually over-provide industrial public goods.

31. For example if  = 0.3,  = 0.2, G S * = 0.05, (1 – K) = 0.246575 and T* = 0.163252 then 1 = Y KG * ((1 – K)  +  ) while Y G * = 0.9. This does however not imply that these values constitute the equilibrium for the whole model.

32. Capital Tax Harmonisation Does this model provide any support for capital tax harmonisation in the EU? No. Firstly, the optimal autarky condition for industrial public good provision Y G = 1 is in this model associated with a different optimal tax rate (T O ) in each country as

33. implies that A harmonised tax rate would therefore by itself not result into an optimal provision of public goods in each country if autarky situation is taken as a reference point.

34. And secondly, Y KG > 0 implies that an increase in G S makes the given country a more attractive location for investment. Hence, if capital tax rates were the same in both countries, more capital would be located in the country which offered more industrial public goods.

35. Furthermore, capital tax revenues in the less developed countries would be lower, hence the union would have to rely on fiscal transfers from the more developed countries in order to equalise the stocks of industrial public goods and thus capital in all member states.

36. Conclusions The simple model presented in this paper shows that when government goods are provided in a way that actually benefits capital tax competition does not necessarily have to imply a race to the bottom. Depending on the productivity of public goods, governments might have an incentive to increase capital tax rates in order to augment the supply of industrial public goods and thus to attract more capital.

37. The model furthermore implies that when tax rates in two regions are harmonised before the stock of accumulated industrial public goods is the same in both regions then it is impossible for a less developed region to build up its stock of public goods without fiscal transfers from the more developed region.