Economic Openness, Tax Erosion and decentralization

A large number of contributions that address the impact of international tax competition on public finance variables reveal that economic integration may introduce significant constraints on national public policies. Yet, in these cases, the public sector is usually considered as a monolithic entity and the impact of economic integration analysed ‘as if’ states were unitary. On the other hand, those studies that investigate the link between decentralization and government size disregard the possibility that the vertical structure of the public sector may be affected by economic integration, thus analysing the issue ‘as if’ states were closed. This paper tries to build a bridge between these two strands of literature, addressing in a unified empirical framework the relations among economic integration, national tax revenues and the decentralisation of the public sector.2 In particular, we maintain the hypothesis that economic integration produces first a direct impact on central tax revenues and then an indirect impact on the vertical structure of the public sector, i.e. decentralisation. The main justification lies on the possibility that following increasing tensions on the use of central tax bases and on the levels of central public spending caused by wider economic integration, the central government might find convenient to decentralise both tax and spending powers as a way to spread responsibilities among government levels. In order to verify this hypothesis, we develop an econometric strategy in two steps using a sample of OECD countries. In the first stage, economic integration is directly used as a determinant of the size of central tax revenues, measured by the implicit tax rates (ITR) developed by Mendoza et al. (1994) and updated by Gastaldi (2008) to introduce the distinction between ITRs on mobile and immobile capital. This feature avoids conflating taxes on corporations and on immovable properties under the same heading of ‘capital tax rates’, as instead usual in the standard version of the approach. Indeed, the expected reactions of these two forms of ‘capital taxes’ to economic integration might be significantly different and additional information may therefore beconveyed by separating the implicit tax rates on the corresponding tax bases. In the second stage, a measure of erosion of central tax revenues (henceforth tax erosion) will be derived (defined as the elasticity of ITRs with respect to economic integration) and used as a determinant of the decentralisation of the public sector, maintaining the hypothesis that more tax erosion at central level will cause higher decentralisation levels. The results of the empirical analysis show that economic integration actually erodes implicit tax rates on mobile tax bases, while producing no effects on other ITRs. The measure of tax erosion is then found to have a significant explanatory power in shaping the degree of decentralisation.