Globalisation, capital mobility and convergence of effective tax rate

A large strand of literature is now dealing with whether increased economic integration is potentially able to affect tax and spending policies by part of national governments. The literature on tax competition suggests that capital taxation would be lower the higher is the degree of international capital mobility. In an extreme version of this model – that has become popular as the race-to-the-bottom hypothesis – capital mobility would make a great part of tax revenue to disappear in the attempt of governments to create favourable conditions for investments when mobility erodes the tax bases. In a milder version, governments would be “disciplined” to use resources efficiently, the reason why this outcome is also referred to as the efficiency hypothesis (especially by the political science literature). On the other hand, some authors argue that countries with a large exposure to international trade and capital mobility would increase the size of the public sector, in order to face the additional risk embodied in opening their markets (e.g. Rodrik, 1998), a feature that is known as the compensation hypothesis. Whether the compensation or the efficiency hypothesis has the best explanatory power is therefore a matter of empirical analysis. In dealing with this issue, the greatest part of the literature has paid attention to the consequences on the spending side of the public budget, mainly to investigate the ‘welfare retrenchment issue’. Much less empirical evidence is available on the direct test of the main implications of the tax competition theory – i.e. whether taxes on mobile capital bears a negative relation with economic integration. Furthermore, where available, the existing literature agrees neither on a common indicator of the tax burden nor on a common definition of economic integration. This paper explicitly addresses this issue in a renewed perspective. After reviewing the existing econometric literature on the relation between tax burden and economic integration, the paper updates the approach of effective tax rates (ETRs) introduced by Mendoza et al. (1994) introducing a distinction between ETRs on mobile capital and ETRs on immobile capital. This fills a gap of the empirical literature, usually compounding taxes on corporations and taxes on immovable property under the same heading of ‘capital tax rates’, even though the expected reactions of these two forms of ‘capital’ to economic integration might be significantly different. In a third paragraph, an econometric analysis relating ‘tax burden’ and some measures of trade openness and capital mobility is performed. While the convergence of effective tax rates on mobile capital is partly driven by economic integration, relatively more immobile tax bases should not be affected by openness. In particular, there is no particular reason to expect that taxes on immobile capital should converge across countries as, by definition, immobile capital cannot easily move from one country to another. The same line of reasoning may apply, to some extent, to labour (at least unskilled) and consumption. Conversely, if any, intense tax competition on one tax base might induce more dispersion of other tax bases, if countries act under a tax revenue constraint. This would lead to a either a positive or no relation of the coefficient of variation of immobile capital, labour and consumption with capital mobility. The results of the analysis are encouraging. Evidence is provided that capital mobility affects the convergence of tax rates on mobile capital, making more difficult for countries to differentiate taxes on mobile tax bases. Far from being support for the race-to-the-bottom hypothesis, the paper argues that there is a significant push towards the homogeneity of tax burdens on mobile capital, which is – to some extent – support for a milder version of the ‘efficiency hypothesis’. Moreover, results suggests that countries that cannot differentiate the tax burden on capital (because of its mobility) may more easily succeed to differentiate the tax burden on labour (which is a relatively immobile factor). Indirect support to this conclusion also comes from the irrelevance of outward FDI in driving the convergence of taxes on both immobile capital and consumption. The more plausible explanation is that both taxes on immobile capital and consumption may constitute a sort of backstop to the convergence of tax rates on capital. In the case of consumption, it must be also considered that effective tax rates on consumption are already more homogenous across countries, compared with capital and labour, and this leaves much less space to converge.