TCS Daily

Backdoor Plan

By Daniel J. Mitchell - October 20, 2004 12:00 AM

Tax competition exists when people can reduce tax burdens by shifting capital and/or labor from high-tax jurisdictions to low-tax jurisdictions. This migration disciplines profligate governments, largely because politicians realize that they will have less money to redistribute if they scare away the geese that lay the golden eggs. Tax competition also rewards nations that lower tax rates and engage in pro-growth tax reform, thus creating a virtuous global contest for better tax policy. High-tax nations despise this liberalizing process, and they advocate tax harmonization so that taxpayers are subject to similar tax rates no matter where they work, save, shop, or invest. The geese are less likely to flee, after all, if all nesting sites are equally unattractive.

The good news is that tax competition has been winning, both substantively and politically. On the substance side, major reforms like the Reagan/Thatcher tax cuts, the Irish corporate tax rate reduction, and the Russian flat tax have compelled other nations to implement similar "supply-side" changes -- albeit often with great reluctance. On the political side, the tax harmonization schemes of the European Union and the Organization for Economic Cooperation and Development have been either defeated or stymied. Perhaps even more important, high-tax nations failed in their efforts to stick anti-tax competition provisions in the proposed EU Constitution.

But this silver cloud may have a dark lining. Having failed to impose tax harmonization through the front door, politicians from high-tax nations are trying to sneak in the back door. Specifically, they want low-tax nations to act as deputy tax collectors by collecting the private financial data of nonresident investors and then sharing that information with foreign tax authorities. The foreign tax authorities, not surprisingly, want this information so they can tax flight capital. Having failed in their efforts to explicitly harmonize tax rates, both the European Union and the Organization for Economic Cooperation and Development are now advocating this policy of "information exchange."

Opponents of tax competition deny that information exchange is a form of harmonization. They argue, for instance, that harmonization only exists when all nations have the same tax rates. This is a misleading assertion. Identical tax rates are a sufficient condition for harmonization, but not a necessary condition. Tax harmonization exists whenever individual taxpayers face the same tax rates regardless of where they work, shop, save, or invest. That happens if all nations rig tax rates at the same level, to be sure, but it also exists when taxpayers are unable to benefit from lower tax rates in other jurisdictions because their home government has the ability to track - and tax - flight capital.

In other words, there are two forms of tax harmonization, and they have similar economic consequences:

Explicit tax harmonization occurs when nations agree to set minimum tax rates or decide to tax at the same rate. The European Union, for instance, requires that member nations impose a value-added tax of at least 15 percent. The EU also has harmonized tax rates for fuel, alcohol, and tobacco, and there are ongoing efforts to harmonize personal income tax rates, corporate income tax rates, and the corporate tax base. Under this direct form of tax harmonization, taxpayers are unable to benefit from better tax policy in other nations, and governments are insulated from market discipline.

Implicit harmonization occurs when governments are able to tax the worldwide income of citizens, a policy that requires all nations to collect financial information on nonresident investors and to share that information with tax collectors from foreign governments. In this world of "information exchange" being advocated by the EU and OECD, taxpayers are unable to avoid the tax rates of their home nations. Under this indirect form of tax harmonization, taxpayers are unable to benefit from better tax policy in other nations, and governments are insulated from market discipline.

In either case, tax competition is emasculated, giving politicians much more leeway to maintain high tax rates. Harmonization policies also make it more feasible for governments to impose additional layers of tax on saving and investment. Yet these are the policies that are most likely to damage economic performance, which helps explain why several Nobel Prize-winning economists - including Milton Friedman, James Buchanan, and Gary Becker - have commented on the importance of tax competition. But Adam Smith probably was most eloquent on the issue. He wrote in The Wealth of Nations that:

An inquisition into every man's private circumstances, and an inquisition which, in order to accommodate the tax to them, watched over all the fluctuations of his fortunes, would be a source of such continual and endless vexation as no people could support.... The proprietor of stock is properly a citizen of the world, and is not necessarily attached to any particular country. He would be apt to abandon the country in which he was exposed to a vexatious inquisition, in order to be assessed to a burdensome tax, and would remove his stock to some other country where he could either carry on his business, or enjoy his fortune more at his ease. By removing his stock he would put an end to all the industry which it had maintained in the country which he left. Stock cultivates land; stock employs labour. A tax which tended to drive away stock from any particular country would so far tend to dry up every source of revenue both to the sovereign and to the society. Not only the profits of stock, but the rent of land and the wages of labour would necessarily be more or less diminished by its removal.

Unfortunately, Smith's prescient words are being ignored today -- at least in Paris and Brussels. Instead of fixing bad tax law so the golden geese do not flee, the OECD and EU assume that all geese are chattel and that it is the job of low-tax nations to help collect the golden eggs for high-tax governments.

Information exchange is just as misguided as the more direct forms of tax harmonization. Creating an OPEC for politicians would undermine economic reform and shield governments from much-needed competitive pressure.


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