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| From Tax Competition to Tax Cooperation |
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July-September 2005 |
In 1991, statutory corporate tax rates were 50% in Germany, 34% in France, 36% in Italy, and 40% in the Czech Republic, Hungary and Poland. By 2004, these rates had fallen to 38.3% in Germany, 28% in the Czech Republic, 19% in Poland, 17.7% in Hungary, while rising slightly to 37.3% in Italy and to 35.4% in France.
Although tax bases were expanding during this period in a number of countries, effective tax rates, i. e. theoretical tax rates for a given investment when accounting for both statutory tax rates and allowances, have been declining in most countries of the European Union. This trend has raised the fear that the burden of public expenditures is being increasingly supported by other tax payers, especially less mobile tax payers such as workers and consumers, or that social protection is being progressively reduced to the lowest levels supplied in the EU. At the same time, advocates of tax competition highlight its role in curbing public expenditures or making it more efficient.
Research carried out at the CEPII yields a qualified view on this debate. The sensitiveness of capital flows to tax differentials was first studied, using bilateral Foreign Direct Investment (FDI) flows amongst eleven OECD countries. This first set of analyses shows that, although they appear as second order determinants, tax differentials significantly affect FDI flows: other things equal, a one percentage point rise in the effective average tax rate in one country induces a 3% fall in inward FDI. The impact of tax differentials is also found to be non-linear, as FDI is all the more affected the greater tax differentials are. This fits in with the fact that information concerning taxation is imperfect and noisy. Moreover, FDI inflows are more affected (negatively) by higher tax rates than (positively) by lower tax rates in the recipient country. This could induce a convergence towards low tax rates, but not towards zero taxation.
Interestingly, the evidenced sensitiveness of FDI flows to tax differentials seems to be limited to homogeneous investors and recipients. Indeed, a second study, focusing on intra-EU FDI flows, shows that tax differentials do matter for FDI flowing within the EU15, but fails to find any significant impact for EU15 investments in the New Member States. It is possible that FDI to new member states has not yet reached its long-run pattern, as privatisation programmes have only recently been completed. However these results seem at least to qualify the argument that corporate tax cuts in new member states might by themselves attract a large amount of private capital.
In fact, the research carried out at the CEPII highlights gravitational variables as the main determinants of FDI. This is consistent with business surveys showing that the prime motivation for FDI is market access. Hence, large and well located markets tend to attract more FDI. In such a framework, tax differentials might be sustainable, as long as they compensate for location or market disadvantages. More specifically, following the economic geography literature – and therefore assuming the existence of agglomeration economies - tax differentials should follow a bell-shape curve depending on trade integration: for low levels of integration, large countries have no location advantage compared to small ones because centralising production in the large country (in order to take advantage of agglomeration economies) is not worth it compared to trade costs. When trade costs fall, then the large country obtains an agglomeration rent, i.e. it can set a higher tax rate without discouraging private capital inflows. Finally, when trade costs are very small, the location rent disappears and sustainable tax differentials fall. This hump-shape relationship between tax differentials and trade integration has been evidenced by the CEPII for the EU15, on the basis of Head and Mayer’s trade integration indices. Furthermore, the analysis shows that trade integration amongst EU15 countries has not yet crossed the threshold at which more integration leads to reduced tax differentials. This means that large EU countries can still sustain higher tax rates than smaller ones in the EU.
Another argument for sustained tax differentials is the provision of public inputs. Indeed, good infrastructure, high level educational services, or a well organised judicial system are generally viewed as impacting positively on attractiveness, and this is confirmed by the CEPII’s econometric work on the determinants of FDI. In a theoretical study, the CEPII has shown that, to the extent that firms are heterogeneous in terms of the use of public inputs, EU countries could perhaps differentiate vertically between high-tax/high-expenditure countries and low-tax/low-expenditure ones. However, this research also highlights possible expenditure shifting from household-related expenditures (such as social protection) towards business-related ones (infrastructures, R&D).
On the whole, the research carried out at the CEPII suggests that some corporate tax differentials could still be sustainable within the European Union. It tends to support tax co-operation but rejects tax harmonisation. Tax co-operation would include a unification of the corporate tax base with a single apportionment formula in order to avoid tax competition being distorted. It could also include enhanced co-operation on tax rates for countries of similar size and having chosen the same type of vertical differentiation, or the setting of tax benchmarks depending on a number of geographic and economic factors.
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BÉNASSY-QUÉRÉ, A., FONTAGNÉ, L. & LAHRÈCHE-RÉVIL, A. “How Does FDI React to Corporate Taxation?” , International Tax and Public Finance, Forthcoming 2005
BÉNASSY-QUÉRÉ, A., GOBALRAJA, N. & TRANNOY, A. “Tax Competition and Public Input”, CEPII Working Paper N°2005-08, June 2005
BÉNASSY-QUÉRÉ, A. & PISANI-FERRY, J. “Impôt sur les sociétés : concurrence ou harmonisation ? “, in LE CACHEUX, J. & SAINT ETIENNE, Ch. “Croissance équitable et concurrence fiscale”, Conseil d’Analyse Economique, 2005
BÉNASSY-QUÉRÉ, A. & D. PRADY “Less Tax in the East”, in La Lettre du CEPII N° 232, March 2004
GILBERT, G., LAHRÈCHE-RÉVIL, A., MADIÈS, Th. & MAYER, Th. « La concurrence fiscale : conséquences internationales et locales sur l’imposition des entreprises », in LE CACHEUX, J. & SAINT ETIENNE, Ch. “Croissance équitable et concurrence fiscale”, Conseil d’Analyse Economique, 2005
HEAD, K. & MAYER, Th. “The Empirics of Agglomeration and Trade”, in Henderson, V. & Thisse, J.F. (eds.), Handbook of Regional and Urban Economics volume 4, 2004, Amsterdam: Elsevier, chap. 59, pp. 2609-2669
LAHRÈCHE-RÉVIL, A. “FDI and Taxes within an Enlarged Europe”, mimeo, June 2005 |
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