In a world where barriers to the international integration of capital markets are lower than in the past, capital can move where taxes are lowest. This has forced governments to compete for mobile resources by providing business-friendly conditions, such as low taxes on capital gains and corporate profits. But has it, in practice, eroded the taxation of capital, as some had predicted?

Today there can be little doubt that history has proven that prediction wrong. Yet you still get people, like John Vassallo (writing in both The Sunday Times of Malta and the Times of Malta), who inveigh against Malta for using what he calls a “dirty” corporate tax imputation system, equating it without the slightest shred of proof with widespread money-laundering. He even calls it “criminal”.

I am amazed that he does it against the backdrop of the massive tax overhaul in the US. This cuts the corporate income tax rate to 21 per cent from 35 per cent, creating a business income tax deduction for owners of ‘pass-through’ businesses, such as partnerships and sole proprietorships; allowing for immediate write-off by corporations of new equipment costs; and eliminating the corporate alternative minimum tax.

Under a new territorial system, the tax Bill exempts US corporations from taxes on most of their future foreign profits. How’s that for fair tax competition? Yet, according to Vassallo’s holier-than-though scenario, Malta should unilaterally give up its competitive advantage while the wealthiest country on earth pursues a ‘once-in-a-generation opportunity’ to help US businesses.

Comparative data on corporate and capital tax rates demonstrates that governments in all economies continue to tax mobile sources of capital; that effective capital tax rates have not changed much compared with the mid-1980s, when tax competition was triggered by the 1986 US Tax Act; and that tax systems are as varied as countries and political systems themselves, with no visible sign of converging.

The two charts show that corporation taxes as a percentage of GDP have not changed much in the EU, with the exception of Luxembourg, except for cyclical pre-recession and post-recession ef­fects. They confirm the higher percentages achieved by Malta, Cyprus and Luxembourg, but their combined tax share is a mere one per cent of the EU total. So, what on earth is Mr Vassallo arguing about?

Substantial declines in nominal capital tax rates among US states and European countries have been linked by many commentators to tax competition as an inevitable ‘race to the bottom’. An important paper by Robert S. Chirinko and Daniel J. Wilson of the Federal Bank of San Francisco (‘Tax Competition among US States: Racing to the Bottom or Riding on a Seesaw?’) analyses this contention.

This paper’s results suggest that the secular decline in capital tax rates reflects synchronous res­pon­ses among States to common shocks rather than competitive responses to foreign State tax poli­cy. Rather than ‘racing to the bottom’, the findings suggest that States are “riding on a seesaw”. The authors conclude that policies aim­ed at restricting tax competition to stem the tide of declining capital taxation are likely to be ineffective, but on the contrary may lead to an increase in the provision of local public goods.

Much as predicted by the economist Charles Tiebout, globalisation has empowered the multinationals to vote for market liberalising economic policies with their feet. In this world, if the government of an open economy were to increase tax rates above that of the international equilibrium, it would simply drive away investment and stimulate a capital flight.

Rising trade and investment flows, greater labour mobility, and rapid transfers of technology have meant that the majority of industrial nations have been forced to reduce commercial tax rates in recent years, and in doing so have pushed the average top corporate tax rate in the OECD down from the 55 per cent to 28 per cent range in 1982 to between 34 per cent and 12.5 per cent now.

The options governments face now are either to pursue pro-business deregulation and market liberalisation or to remain on the moral high ground – and fall behind in the investment race.

Some economists like Killian McCarthy, Frederik van Doorn and Brigitte Unger have argued (‘Globalisation, Tax Competition and the Harmonisation of Corporate Tax Rates in Europe: A Case of Killing the Patient to Cure the Disease?’) that tax competition has resulted in an unfair burdening of labour, because of its immobility relative to that of capital.

But the authors also contend that the European Commission’s tax harmonisation proposal is not a panacea. On the contrary, they believe it is not feasible, as it will result in negative externalities, since it will result only in a disadvantage to members of the EU relative to their neighbours.

They also illustrate other prominent reasons not to harmonise taxes, such as that it would exacerbate the economic core-and-periphery divisions already so prominent in the Union, and result in the over-provision of infrastructure.

The median voter in Malta quite rightly does not care a hoot about being fair on corporate taxes

As an alternative, the authors propose a shift in the tax base from mixed taxes (residence and withholding) to pure residential taxation, which would eliminate tax competition through investment decisions. But they then admit that the residence principle too is not a flawless solution. For example, investors may relocate to another residence country in order to realise the highest after-tax gain.

The fact is that tax competition affects countries differently and does not lead to a ‘race to the bottom’ since capital is not completely mobile either. The competitiveness of a particular country forces other countries to adjust their fiscal strategies. Cutting capital taxes, therefore, will not necessarily generate more capital inflows.

When a country reduces the effective capital tax rate, revenues from taxing the domestic capital stock decline (the tax rate effect).  At the same time, due to the lower capital tax rate, the country imports capital from nations with higher capital tax rates (or exports less capital to countries with low capital tax rates). The inflowing capital will be taxed at the reduced tax rate (the tax base effect).

In tax competition, small is beautiful. Because small nations can import more capital from larger countries than the latter can import from smaller ones, the tax base effect is more likely to dominate the tax rate effect. If a country is small enough, reven­ues from taxing capital can in­crease when the government significantly reduces the effective capital tax rate and thus induces sufficient capital inflow relative to the domestic capital stock.

Countries with a relatively large domestic capital stock, such as the United States, also attract capital inflows when they reduce the effective capital tax rates. How­ever, revenues generated from this additional capital are far less likely to compensate for the income losses caused by the reduction in capital tax rates. In fact, the tax Bill in the US is expected to add at least $1 trillion to the $20 trillion US national debt over 10 years.

Policy-makers in small countries have more leeway in setting out their economic agenda. Small countries can reduce capi­tal tax rates, hold effective labour taxation at the same level and reduce debt simultaneously, as Ireland has done. Malta and Luxembourg are a good example of countries that have pursued an alternative adjustment stra­tegy, whereby the government reduced effective labour taxation and held effective capital tax rates constant at low levels, while at the same time increasing social security transfers.

Finally, a paper by Philipp Genschel, Hanna Lierse, Henning Schmidtke, Laura Seelkopf, Stefan Traub, and Hongyan Yang (‘Tax Competition and Inequa­lity - The Political Foundations of Tax Competition’) shows that it is the left and right alike in small countries, and not just the ‘the richest one per cent’ that drive international tax competition. This naturally has important implications for any serious attempts to reign in international tax competition via international cooperation, be it within the EU or elsewhere.

As for workers rising up against their own “socialist” government, I think Mr Vassallo is totally out of touch and patronising, because the median voter in Malta quite rightly does not care a hoot about being fair on corporate taxes, but cares more about his own income gains and ability to improve his standard of living.

Corporation taxes as % of EU total