Cracking the Mainstream Notion of Fiscal Competition

by Maria Salfi (Intern at ECIPE)

There is a general widespread notion within the European Union that a lower corporate tax rate can harm society. In fact, the European Commission strongly advises the EU’s member states to raise the rate until a certain threshold – about 30% – and to harmonize the tax among countries. A lower corporate tax rate leads to a lower return in government revenues and therefore a lower public goods’ provision for society. Corporate tax rate can be used as a fiscal tool in order to attract capital and labor because firms have an incentive to relocate in a country where the tax rate is lower.

According to the figure below, the corporate tax rate differs across EU countries. Newly member states tend to have lower tax rate compared to countries such as France, Italy or Germany which are characterized by a rate of 30% or more. Being the EU’s average tax rate 21%, half of the member states are actually below or equal to the average (Estonia and the United Kingdom are two examples).

However there are some misleading ideas about the role of the corporate tax rate in society and about the popular “race to the bottom” argument. Although the economic literature widely investigates fiscal competition and its impact on society and it strongly affirms that firms relocate where tax is lower and that it can indeed lead to a lower supply of public goods, the economic models date back to the 80s such as Zodrow and Mieszkowski (1986) or late 90s such as Keen and Marchand (1997). Empirical literature is quite more recent nonetheless it reports controversial results.

Yet, the general public looks at only one side of the coin. First of all, firms are influenced by different factors when relocating to a country – and corporate tax rate is only one of them. According to Ernst and Young (2004), firms look at 18 main factors[1], where corporate tax rate occupies only the 11th place on the list. Second of all, following the argument that a low tax rate will attract multinationals, it leads to a larger tax base. Since a higher amount of firms relocate in one country, the tax base is enlarged and the government can re-balance the tax return although the tax rate is lower. Third, harmonization of the tax rate will not necessarily lead to welfare gain. Countries will find another tool to enhance fiscal competition. In fact, fiscal competition’s studies often forget that corporate tax is not the only tool that countries can use to attract capital and labor: public spending can be used in a similar way to achieve similar results. Government can indeed increase public spending in certain categories in order to attract firms. Generally speaking, a country investing in domestic infrastructure will not only benefit society and domestic industries per se but also foreign firms which will want to relocate to profit from the business environment, causing an agglomeration effect. Nonetheless governments should be careful when allocating public revenues since using public expenditure as a fiscal tool can provoke a shift in the supply of public goods. Infrastructure expenditures could be increased at the expenses of social spending.