**2. Tax competition theory**

There is an extensive literature on the theory of tax competition. The modern literature on tax competition began with Oates's discussion on the potential efficiency problems associated with competition for capital by local governments [2, 11]. Under certain assumptions, small jurisdictions competing for mobile capital reduce tax rates to such level that leads "to less than efficient levels of output of local services" ([1] p. 654). In a small jurisdiction, competition leads to the abandonment of taxes on capital income altogether which produces "race to the bottom" ([1] p. 651). Oates' concludes that this behavior is inefficient that rests on the idea that this a zero-sum game. When all governments behave this way, none gain and consequently communities are all worse off than they would have been if local managers had made decisions based on marginal costs [2]. More recent interest in the topic was prompted in part by fears that tax competition among the increasingly economically integrated EU nations will over time significantly reduce the level of capital income taxation to the extent of announcing the death of CIT [12]. Thus, governments must solely rely on financing their expenditures from the taxes on immobile factors of production (labor/land) and on consumption taxes, which have their own constraints and disadvantages.

the governments. On the one hand, governments seek to attract investment into the country, or region, or locality, and therefore offer incentives to potential investors often in the form of preferential tax treatment. In doing so, governments engage in harmful or wasteful tax competition. On the other hand, governments need to collect enough tax revenue in order to provide a sufficient level and quality of public services and fulfill other functions demanded by the public. This calls for a rather complicated balancing between those objectives. Loss of revenue may lead to suboptimal provision of public services or require difficult policy decisions on the higher level of government or at the supranational level, including tax coordina-

Theoretical studies in public economics provide the conditions for the economic effects of tax competition to be either harmful or useful [1–3]. Those conditions are varied and often hard to reconcile in theoretical models. In empirical research, they lead to inconclusive results. Negative economic effects of tax competition include "base erosion" of taxes on mobile factors of production that ultimately leads to the underprovision of public services and frustrates governments' efforts to redistribute income. The useful effects of tax competition are largely supported by the initiators and followers of public choice theory who find in tax competition efficiency-increasing effects. It limits the tendency of local governments to overexpansion and constrains the growth of a Leviathan state [4, 5]. Empirical literature on tax competition leaves

This chapter attempts to synthesize growing scholarship on the economic effects of tax competition and includes the review of the latest trends in CIT, foreign direct investment (FDI), and profit shifting. The topic is of high relevance since tax avoidance and evasion through base erosion and profit shifting continue unabated for some time and may be on the rise due to the ever more sophisticated tax-reducing techniques used by multinationals and increas-

The sections that follow will (1) review the theory of tax competition including "basic tax competition model" and its extensions, (2) present recent trends in corporate income tax rates and revenue in the EU and OECD countries, (3) survey empirical literature on tax competition, including evidence of the relationship between tax rates and FDI, and (4) outline what is known about the magnitude of tax avoidance through base erosion and profit shifting.

There is an extensive literature on the theory of tax competition. The modern literature on tax competition began with Oates's discussion on the potential efficiency problems associated with competition for capital by local governments [2, 11]. Under certain assumptions, small jurisdictions competing for mobile capital reduce tax rates to such level that leads "to less than efficient levels of output of local services" ([1] p. 654). In a small jurisdiction, competition leads to the abandonment of taxes on capital income altogether which produces "race to the bottom" ([1] p. 651). Oates' concludes that this behavior is inefficient that rests on the idea that

tion and tax harmonization.

24 Taxes and Taxation Trends

us with a similarly diverse picture [1, 3].

ingly mobile individuals [6–10].

Finally, the last section concludes.

**2. Tax competition theory**

"Basic tax competition model" has been built by Zodrow and Mieszkowski [13] and Wilson who formalized the notions on tax competition developed by Oates [2]. Alternatively, the model is known as a ZMW model or a simpler version, according to Wilson [2], is known as ZM model [14]. Similar to Tiebout's model [15], the ZM model is built on those assumptions "(1) A large number of homogenous jurisdictions; (2) Perfectly competitive markets; (3) A Nash equilibrium in which each jurisdiction takes as fixed the after-tax return to capital and the tax rates set by other jurisdictions; (4) Fixed population and land in each jurisdiction; (5) Identical tastes and incomes for all residents of all jurisdictions; (6) A fixed national capital stock that is perfectly mobile across local jurisdictions; (7) A single good that is produced by capital and the fixed factor (labor/land) in each jurisdiction; (8) Government services that are "publicly provided private goods," benefit only residents, have no spillover effects to other jurisdictions, and can be modeled as purchases of the single private good;(9) Two local tax instruments—a "property tax" that applies to capital income and a head tax; (10) Local governments that act to maximize the welfare of their (identical) residents" ([1, 15] p. 654).

In the ZM model, interjurisdictional competition results in "race to the bottom," as all taxes on capital income are eliminated. Governments are only able to impose taxes on immobile factors of production only. The insight of this result serves as a model for a "small open economy" [16].

An important assumption of the basic tax competition model is that local public services are essentially another consumption good that enters individual utility functions. However, as Sinn correctly observes, one of the most important roles of government is to redistribute income which has nothing to do with consumption goods [17]. Income redistribution at least partially represents social protection against income uncertainty attributable to different macroeconomic shocks and, more broadly, differences in natural endowments and access to education. Private markets fail to insure against income uncertainty and other risks; therefore, public programs designed to smooth such shocks improve both equity and efficiency of resource allocation. Tax competition results in lower tax rates on mobile factors of production and thus limits the power of governments to engage in redistributive activities. It imposes important social costs. In case of perfect mobility of both capital and highly skilled labor, tax competition implies that only benefit taxes can be levied and the policy of income redistribution is given up. Though Sinn's observation relaxes one of the assumptions of the basic model, it fundamentally reinforces the central message of the basic model.

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

**3. Empirical evidence of tax competition**

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

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

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

Statutory, or nominal, tax rates are rates stated in a tax law (statute, code) expressed usually in percentage terms to be

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

have decreased substantially in the EU over the

International Aspects of Corporate Income Taxes and Associated Distortions

http://dx.doi.org/10.5772/intechopen.74213

27

**3.1. Trends in corporate income taxes**

CIT rates is undisputable. CIT statutory rates1

rate of −2% as shown in **Figure 2**.

applied to a tax base, for example, taxable income.

1

Taxation (2017).

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

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 basic tax competition model.

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 curbs the expansion of a Leviathan state.

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 the undue expansion of public budgets.
