3
tax systems, convergence remains far from perfect even after controlling for coun-
try size (Plümper and Schulze, 1999). Thus, one may fairly conclude that taxes on
mobile capital continue to be the rule rather than the exception.
Theoretical research on tax competition has offered several explanations for the
apparent gap between theory and empirical evidence. For instance, Rodrik (1998),
among others, argues that economic integration is accompanied by additional ‘ex-
ternal risks’ (e.g., sectoral downturns or unexpected losses of income), which, in
turn, induce an increase in public spending.
3
Keen and Marchand (1997), in a dif-
ferent line of reasoning, have shown that countries do not compensate revenue
losses from capital taxation through a reduction of total public expenditure, but
through a shift from public goods (e.g., welfare transfers) to public inputs (e.g.,
infrastructure). Hallerberg and Basinger (2004) show that tax cuts are deeper in
countries where the number of veto-players is small. Finally, Baldwin and Krug-
man (2004), focusing on the geographical dimension of tax competition, have
demonstrated that economic integration does not necessarily induce a race to the
bottom in capital tax rates.
This paper provides an alternative answer by combining arguments on tax system
effects of capital mobility with standard political economic reasoning. Essentially,
we argue that tax rate setting is, in fact, restricted by international tax competition,
but is also affected by the objective to maintain a balanced budget (at least in the
long run) and to achieve societal fairness norms (i.e., tax equity). Our analysis
differs from the existing literature on tax competition with respect to the percep-
tion of governments’ political constraints. While most of the previous research
implicitly assumes that the imperatives of tax competition fully dominate political
decisions in the various national arenas, we argue that domestic constraints remain
effective even in the presence of complete capital mobility. No doubt, the aim of
attracting mobile capital influences public policies. But at the same time govern-
ments are concerned with the provision of public goods and the avoidance of ine-
qualities due to taxation. These domestic constraints prevent governments from
implementing policies, which reduce tax revenue and, simultaneously, preclude
3
This argument is often referred to as the ‘compensation hypothesis’. See also Hicks and Swank
(1992), Garrett (1995, 1998), Quinn (1997), Swank (1998), and Schulze and Ursprung (2002)
for an overview.
Convention