**3. Empirical evidence of tax competition**

#### **3.1. Trends in corporate income taxes**

Since the development of the basic tax competition model, many extensions have been added by changing one or several assumptions of the basic model; for complete list and details, see Zodrow [1]. Some of those modifications support the results of the basic model and find inefficiencies due to tax competition, while others find efficiency enhancing effects of tax competition. The extensions that assume heterogeneous rather than homogeneous jurisdictions and include trade among members of the union or trade with the rest of the world find harmful effects to tax competition. The modification of the model which assumes variable labor supply

Another departure from the ZM model is the existence of "interregional externalities." In this case, the actions that one region's government takes to increase the welfare of its own residents lead to reductions in the welfare of residents in other regions. In the tax competition literature, this externality is often described as a "fiscal externality," which occurs through the effects of one region's public policies on the government budgets in another region [18]. For example, when a region lowers its tax rate on mobile capital, it gains capital at the expense of other regions, causing their tax bases to fall and, hence, their tax revenues to decline. Because governments are assumed not to possess unlimited taxing powers, the presence of such exter-

However, other extensions of the basic model, such as the existence of international trade with the presence of agglomeration economies [19] and international public good spillovers do not support the conclusion of the ZM model. Adding the combination of labor mobility and population scale economies to the model yields interesting results. With scale economies, underprovision of local public services tends to decline and disappears entirely in the limiting case of a pure public good [1]. Therefore, this extension contradicts the proposition of the

A special niche in this discussion is reserved for public choice literature, which traditionally argues that jurisdictional governments in the union do not act to maximize the welfare of their residents but to achieve their own objectives that are typically positively related to the size of the budget. Under this view, government bureaucrats strive to maximize the budgets of their agencies and increase their own power and prestige. In the public choice literature, tax competition is not a source of inefficiency. On the contrary, tax competition serves a valuable social purpose in constraining government officials who are naturally predisposed to raise revenue to serve their own rather than public interests. To Brennan and Buchanan for instance, "… tax competition among separate units … is an objective to be sought in its own right" ([4] p. 186). In this context, tax competition plays an important role in limiting budgetmaximizing behavior of government officials. It restricts the growth of public finance and

The results of the tax competition literature are mixed to such a degree that it is difficult to draw unambiguous conclusions. It is obvious that the key point of the basic tax competition model (as well as those extensions that reinforce its conclusions) is that tax competition is harmful and leads to inefficient underprovision of public services. On the other hand, some of the extensions to the basic model suggest that tax competition may be desirable as it limits

(instead of fixed) also does not change the results of the basic model.

nalities reinforces the message of the ZM model (Wilson [2]).

basic tax competition model.

26 Taxes and Taxation Trends

curbs the expansion of a Leviathan state.

the undue expansion of public budgets.

As a consequence of the difficulty to develop one and conclusive theory, the empirical literature on tax competition burgeoned in recent years. However, meta-analysis reveals that results are as diverse as those in theoretical analyses [3]. First, the empirical evidence of tax competition and "race to the bottom" depend on the choice of parameters. Second, the findings are not conclusive. For example, there is mixed evidence if rate reductions in the face of increased international capital mobility are actually occurring. At first glance, the reduction of CIT rates is undisputable. CIT statutory rates1 have decreased substantially in the EU over the past 22 years, with the average rate falling from 35% in 1995 to 22% in 2017, which constitutes a fall of 37.4% from 1995 to 2017 in EU 28 countries [20]. As indicated in **Figure 1**, the decrease of CIT rates in new EU member states (those who joined EU in 2004 and later) is even more substantial. The average statutory rates have decreased from the average rate of 31% in 1995 to 18% in 2017. This constitutes a fall of 43.6% or an average annual rate of minus 3% during the same period. In old EU member states (EU-15), statutory rates fell at an average annual rate of −2% as shown in **Figure 2**.

As indicated in **Figure 3**, in OECD countries combined central and local government, average statutory rates have fallen by 25.6% from an average CIT rate of 32.5% in 2000 to an average

**Figure 1.** Statutory corporate income tax rates for new EU member states. Source: European Commission. Data on Taxation (2017).

<sup>1</sup> Statutory, or nominal, tax rates are rates stated in a tax law (statute, code) expressed usually in percentage terms to be applied to a tax base, for example, taxable income.

**Figure 2.** Statutory corporate income tax rates for old EU member states (EU-15). Source: European Commission. Data on Taxation (2017).

CIT rate of 24.2% in 2017 [21]. The statutory rates have fallen in virtually each OECD member state with an exception of Chile where CIT rate has increased by 10% points. The largest fall in the CIT statutory rate has occurred in Germany, albeit from a very high level of 52% in 2000 to 30.2% in 2017, while the change of CIT rate in the United States was incremental (−0.43% points).

However, this evidence becomes less remarkable when base-broadening measures<sup>2</sup> are taken into account leading to much less conspicuous fall in average effective tax rates. As shown in **Figure 4**, average effective tax rates measured as CIT revenue as a % of GDP has stayed overall even. They have decreased by 15% from 2000 to 2014 or at an average annual rate of −1.12%, with the effects of the economic boom and recession standing out.

These trends support previous findings by Grubert that the greatest declines in tax rates were in small, open and relatively poor countries—the countries that are arguably most vulnerable to the effects of tax competition, like new EU member states [22]. These results suggest that the rate reductions predicted by the theory of tax competition are actually occurring. Indeed, governments engage in two-dimensional tax competition. They concurrently compete over effective marginal tax rates for capital and over statutory rates for profits [23]. Evidence from Belgium suggests of regional tax competition taking place between different regions, with a lower effective tax rate (ETR) in the peripheral region of Wallonia than in Flanders [24].

However, it should be noted that reasons other than the tax competition for mobile capital might explain the fall in statutory CIT rates. In particular, this result can be explained by

**Figure 3.** Statutory corporate income tax rates in OECD countries. Difference from 2000 to 2017. Source: OECD (2017).

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<sup>2</sup> Like taxation of previously untaxed items such as short-term capital gains.

CIT rate of 24.2% in 2017 [21]. The statutory rates have fallen in virtually each OECD member state with an exception of Chile where CIT rate has increased by 10% points. The largest fall in the CIT statutory rate has occurred in Germany, albeit from a very high level of 52% in 2000 to 30.2% in 2017, while the change of CIT rate in the United States was incremental (−0.43%

**Figure 2.** Statutory corporate income tax rates for old EU member states (EU-15). Source: European Commission. Data

into account leading to much less conspicuous fall in average effective tax rates. As shown in **Figure 4**, average effective tax rates measured as CIT revenue as a % of GDP has stayed overall even. They have decreased by 15% from 2000 to 2014 or at an average annual rate of

These trends support previous findings by Grubert that the greatest declines in tax rates were in small, open and relatively poor countries—the countries that are arguably most vulnerable to the effects of tax competition, like new EU member states [22]. These results suggest that the rate reductions predicted by the theory of tax competition are actually occurring. Indeed, governments engage in two-dimensional tax competition. They concurrently compete over effective marginal tax rates for capital and over statutory rates for profits [23]. Evidence from Belgium suggests of regional tax competition taking place between different regions, with a lower effective tax rate (ETR) in the peripheral region of Wallonia than in Flanders [24].

However, it should be noted that reasons other than the tax competition for mobile capital might explain the fall in statutory CIT rates. In particular, this result can be explained by

are taken

However, this evidence becomes less remarkable when base-broadening measures<sup>2</sup>

−1.12%, with the effects of the economic boom and recession standing out.

Like taxation of previously untaxed items such as short-term capital gains.

points).

on Taxation (2017).

28 Taxes and Taxation Trends

2

**Figure 3.** Statutory corporate income tax rates in OECD countries. Difference from 2000 to 2017. Source: OECD (2017).

a pooled effect based on the median result taken from each primary study was found. It amounts to semi-elasticity for company taxes on FDI (percentage reaction of FDI to one per-

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As stressed by Cnossen and many others, even confined to the tax system of one country, the defects of the corporate income tax are numerous as it causes distortions of asset mix, capital allocation, financing and payout decisions, and the choice of organizational form [1, 34]. The main problem with capital taxation is that effective corporate tax and personal tax rates on investment returns vary depending on the choice of financing [35]. Investment can be made either through equity or debt. As a rule, debt finance is favored against equity finance because interest payments are deductible under most tax systems. The tax-favored status of debt discriminates against corporations that face difficulties in attracting debt [35]. Therefore, newly founded corporations have to sustain higher capital costs because of taxation than older, established corporations with either easier access to debt financing or sufficient retained profits to finance new investments.

The corporation's dividend policy produces yet another example of discrimination. Profits can be either distributed to shareholders as dividends or retained. When earnings are retained, the shareholders, instead of receiving dividends, benefit from an increase in the market value of the company. As a result of this bias in favor of retentions, equity funds may be locked in within certain companies rather than allocated between companies in the most efficient manner by financial markets [36]. Broadly, debt finance is favored against equity finance, and individual investors are discriminated relative to corporate investors. Therefore, differential tax rates and other tax structure features inherent to CIT distort investment decisions that should be based solely on economic costs and gains. Those features produce worldwide implications

As shown in **Figure 5**, OECD member states have widely diverging statutory CIT rates that may have externality effects on other member states. Statutory rates vary from 8.5% in

Different tax regimes have a direct bearing on tax avoidance. The main difference between tax evasion and tax avoidance is usually illegality of the former. Avoidance usually implies using and somewhat bending the tax laws in order to pay the least possible amount of taxes. It covers a broad range of behaviors. One example is to pay a tax professional to alert one to the deductibility of income earned from already undertaken activities. Another example is to change the legal form of a given behavior, such as reorganizing a business from one form of corporation to another, recharacterizing ordinary income as capital income or retiming the

centage point change in the tax burden) of 1.68 in absolute terms [3].

**4. Distortionary effects of differential tax regimes**

**4.1. Distortionary effects of corporate income tax**

through the operations of multinationals.

Switzerland to 35% in the United States.

transaction to alter the tax year it falls under [37].

**4.2. Tax avoidance**

**Figure 4.** Corporate Income Tax Revenue as percentage of GDP, OECD countries. Source: OECD (2017).

the reforms undertaken by policy makers to adopt base-broadening, rate-reducing measures consistent with persisting reform recommendations to improve the efficiency, equity, and simplicity of the tax system [25]. Besides, reductions in statutory rates can also be explained as an attempt to minimize a country's vulnerability to the use of transfer pricing by multinational enterprises to move deductions to high-tax countries and receipts to low-tax countries [26]. This is consistent with tax avoidance problem caused by capital mobility and tax rate differentials discussed in the following sections.

## **3.2. Tax rates and foreign direct investment**

Since the 1980s, the relation between FDI and corporate taxation policy has been widely studied, and the pioneers in research have focused primarily on the FDI flows sensitivity to capital tax rate [3]. Despite abundant literature, the consensus on the effect of the corporate taxation on FDI in todays' globalized economies has not been reached. Some of the studies find no impact of tax reduction on FDI, but the other studies argue about the negative relationship between taxation policies and FDI gravity.

Hunady and Orviska examine EU countries (except Estonia due to the unavailability of certain data) in the period between 2004 and 2011 and find no statistically significant effect of statutory corporate tax rate on the flow of FDI [27]. Similarly, Kersan-Skabic using data on EU transition economies fails to find evidence that tax rates significantly affect the long-run elasticity of FDI [28]. Studies of Daniels and Egger based on data from the US and other OECD countries basically do not confirm a precise impact of tax rates on the long-run elasticity of foreign investment [29, 30].

There exist even fewer studies which find any positive effect of corporate taxes on FDI. Herger finds that tax elasticity varies depending on the FDI strategy (with vertical FDI being in general more responsive) [31]. Salihu and Faria focus on emerging economies and they show that there is a positive relationship between FDI and the avoidance of corporate tax [32, 33]. Their research is based on Malaysian companies. The findings indicate that investors seek to avoid taxes in both host and parent countries.

The heterogeneity of empirical findings led to a need for concise and comprehensive review of the existing empirical evidence. In the meta-analysis undertaken by Feld and Heckemeyer, a pooled effect based on the median result taken from each primary study was found. It amounts to semi-elasticity for company taxes on FDI (percentage reaction of FDI to one percentage point change in the tax burden) of 1.68 in absolute terms [3].
