2
Tax Competition under Budget Rigidities and Fairness Norms
1. Introduction
A striking feature of international tax competition is that independent jurisdictions
fully or partially share a mobile tax base. As a consequence, if one country re-
duces its tax rate strategically to attract mobile capital it provokes an immediate
inflow of capital, and this, in turn, creates a fiscal externality (i.e., a shrinking tax
base) in other countries (see Wildasin 1989). In the (Nash-)equilibrium, govern-
ments are left in a situation where tax rates (on capital and labor) are set at low
comparably levels. This result, dating back to the seminal contributions of Zod-
row and Mieszkowski (1986) and Wilson (1986), has become popular under the
‘race to the bottom’ hypothesis.
1
The race to the bottom hypothesis is matched by a surprisingly unequivocal em-
pirical evidence: While moderate versions of standard tax competition reasoning –
those predicting reductions of tax rates on mobile capital – have been mostly con-
firmed by the empirical research (see, e.g., Devereux et al., 2002a, 2002b; Slem-
rod, 2004), stronger versions – those predicting vanishing capital taxes, a shift of
tax burden from capital to labor and significant reductions in government spend-
ing – found little, if any, empirical support.
2
Indicative stylized facts may underline the discrepancy between theoretical pre-
dictions and the empirical evidence. First, though most OECD countries lowered
tax rates on mobile capital, cuts in total government spending were rare and rela-
tively modest. Some taxes have been increased even if the tax base became more
mobile (see Genschel, 2000; Basinger and Hallerberg, 2004). Second, while tax
competition has, to some extent, reduced the variance in the competing countries’
1
See Wilson 1999 and Wildasin and Wilson 2004 for comprehensive surveys on subsequent
research. Whether these low tax levels increase or decrease aggregate welfare depends on the
behavior of governments in the absence of tax competition. When governments in the close
economy case chose an optimal provision of public goods and do not transfer rents to politi-
cally important actors, tax competition inevitably reduces the aggregate welfare. If, however,
governments tend to overprovide public goods and transfer rents to special interest groups, tax
competition can be beneficial.
2
See Hallerberg and Basinger, 1998; Rodrik, 1998; Altshuler and Goodspeed 2002; Bretschger
and Hettich, 2002; Swank and Steinmo, 2002.
Convention