Why is There No Race to the Bottom in Capital Taxation?

TLDR

Tax competition generally lowers taxes on mobile capital while raising taxes on relatively immobile labor. The article investigates why capital taxation does not exhibit a race‑to‑bottom by examining fiscal competition under budget constraints and equity norms. The authors employ a political‑economic model that incorporates tax competition, public expenditure, and equity into government utility, and test its predictions with data from 23 OECD countries (1975‑2004). The model shows that governments do not fully eliminate mobile‑capital taxes; the least constrained government cuts rates only slightly below those of more constrained rivals, and empirical data from 23 OECD countries confirm this pattern.

Abstract

This article explains the absence of a race to the bottom in capital taxation by analyzing fiscal competition under budget rigidities and tax equity constraints (fairness norms). We outline a political economic model of tax competition that treats the outcome of tax competition as one argument in the governments utility function, the others being public expenditure and tax equity. In accordance with previous theoretical research, tax competition tends to cause a reduction in taxes on mobile capital and an increase in the tax rates on relatively immobile labor in our model. Yet, our model predicts that governments do not fully abolish taxes on mobile capital. Instead, the government being least restricted by budget constraints and equity norms cuts tax rates to levels slightly below the lowest tax rates of those countries, in which governments are more constrained, where effective constraints are country size, budget rigidities and fairness norms. Analyzing data from 23 Organization for Economic Co-operation and Development countries between 1975 and 2004 we find empirical support for the hypotheses derived from our theoretical model.