WHY COMPETITION MAY SOMETIMES BE HARMFUL(Tax,Economy,Economics,GS Paper 3)

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Is more competition always better? Most conventional economists would say yes. And, in the marketplace, that nugget of economists’ wisdom usually holds true. Every student of first-year economics is taught that competition is good for consumers, as it leads to lower prices and more choice; monopolies, in contrast, raise prices and limit choice.


But it does not stand when it comes to competition among governments, although right-of-centre economists would say that more competition is better, be it in the economic or political marketplace.


Let’s consider the case of government taxation. To a dyed-in-the-wool libertarian, for whom taxation is, in principle, theft, any competition among jurisdictions which brings tax rates down is a welcome development. Thus, for instance, writing in Mint, columnist Prashanth Perumal arguedthat the proposed goods and services tax (GST) is a bad idea because it would inhibit healthy tax competition among states.


Libertarians favourably view competition over tax rates (for instance, to attract investments), irrespective of whether that competition is among subnational entities such as Indian states or among national entities, as it reins in the natural rapacity of the Leviathan-like state. The punishing reaction of foreign investors to the minimum alternate tax (MAT) that India had proposed is a great example of the power of the marketplace to discipline the taxes that governments levy in a world of mobile capital.


If indeed taxation amounts to nothing other than a payment for the provision of public goods and services, textbook economic theory likewise suggests that tax competition will be benign and the outcome healthy. There is a tradition in local public economics, going back to the seminal workby economist Charles Tiebout, which argues that competition among subnational jurisdictions within a federal state leads to the optimal balancing of public goods provision and tax rates across those jurisdictions. People (and their tax dollars) will “vote with their feet”, it is argued, so that high-tax, high-public goods states (say, California or New York in the US) will attract those who value public goods and are willing to pay for them, while low-tax, low-public goods states (say, Nevada or Texas) will attract those who prefer lower taxes and are willing to pay from their own pocket to make up for the absence of public goods (for example, gated communities and private security rather than more public policing).


However, the picture is more nuanced and complex if one accepts that governments have legitimate reasons to levy taxes other than merely to pay for public goods and services—such as to correct market failures and engage in socially worthwhile redistribution of income and wealth. In such a case, is it possible that governments might be forced to set tax rates too low—or perhaps even engage in ruinous and self-defeating tax competition—because they are competing for their share of a globally mobile pool of capital that does not care about the social goods that governments are pursuing?


This malign outcome is, indeed, possible. As political scientist Hans-Werner Sinn argues in a 1997 research paper, “If governments stepped in where markets failed, reintroducing markets through the backdoor of systems, competition will again result in market failure.” Sinn’s point is actually more general than taxation, and applies to what he dubs as “systems competition”—a broad-based competition among jurisdictions across a range of policy dimensions, both economic and non-economic.


The contest between the US and the Soviet Union during the Cold War was, in a sense, a form of systems competition, which had as much or more to do with a clash of fundamental values than it did with taxation and public goods, or even a choice of economic system.


But back to our more mundane running example of tax competition, on which there is by now a large and rich literature in economics, political science and public policy—nowhere more than in Europe, where the integration of economic activity within the European Union (EU) raised very early an alarm over the possibility of potentially ruinous tax competition among member states given that capital was freely mobile among them.


A comprehensive survey of arguments germane to the political debate in Europe may be found in this working paper prepared by the research group within the European Parliament. In a 1999 research paper co-authored by political scientist Philipp Genschel and me, we addressed this issue of capital tax competition among EU member states.


The chief finding of the analysis is that even in a contest between revenue-maximizing governments and in a world of perfect capital mobility, tax competition does not lead to a “race to the bottom” whereby tax rates are driven down to zero, but rather there is a “race towards the bottom”—that is, tax rates are lower in a world with tax competition than without, but not necessarily as low as feared by some of the most alarmist critics.


In other words, the “game” of tax competition—more precisely, the strategic interaction among governments, which leads to a situation in which each is doing the best it can, given what the others are doing—is self-limiting, and stops well above zero taxation, in any sensible configuration of model parameters.


The reasoning is simple. When a government raises the tax rate on mobile capital, there are two effects. Other things equal, a higher tax rate raises revenues, assuming that the tax base remains unchanged; but, if the tax rate is raised, and some capital flees the economy as a consequence, the tax base itself will drop, which will have the effect of reducing revenues. Clearly, the two effects pull in opposite directions. When the tax rate is low, its effect is larger than the tax base effect, so that revenues rise; whereas, when taxes are high, the opposite is true, and a higher tax rate will actually yield lower revenue. This implies that if one were to draw a graph of tax revenues against the tax rate, it would look like an inverted U, with the peak of the curve being the revenue-maximizing tax rate. The situation of strategic tax-setting by governments complicates the model but does not change this basic intuition.


But who benefits and who loses from tax competition?


As Genschel and I show, the government of an initially small economy is likely to gain, while the government of an initially large economy is likely to lose. A small economy sucks away enough of the mobile tax base from its competitors to make itself better off, at the expense of larger economies which, on the flip side, are losing a large chunk of their tax base. This theoretical result matches empirical evidence and common sense. In the European context, for instance, a small tax haven such as Luxembourg has clearly benefited from the possibility of playing a tax competition game with its EU neighbours, whereas Germany, with high taxes and high public spending, has clearly lost out.


But do the gains and losses of governments correspond to those of their respective citizens? That depends on the extent to which one agrees with the proposition that government policy in general, and taxation in particular, is levied by benign governments to correct market failures and engage in socially beneficial redistribution. To the extent that this proposition is valid, the interests of a government, and its citizens, should coincide.


The bottom line, though, is that while, in the economic marketplace, more competition is almost always better than less, the same does not necessarily apply to systems competition—tax competition included.


Members of the GST Council, take note!
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