Understanding the Potential Challenges of International Tax Harmonization and the Potential Benefits from Embracing Tax Competition

Introduction

Countries currently have the freedom to form their tax policy as they wish, without regard to how their tax policy decisions may affect the wellbeing of other countries.  It is clear, however, that one country’s tax policy can have spillover effects for other countries. If Country A raises taxes to increase revenue, it may see firms move to Country B where taxes are lower. The migration of capital and firms out of Country A would reduce its taxable base, which could entirely nullify Country A’s efforts to increase tax revenue. In this scenario, Country B’s low taxes limit Country A’s ability to raise revenue through raising its tax rate.

For Country A to increase its tax revenue, it would need Country B to raise their taxes to match Country A so that Country A does not suffer from capital outflow. Essentially, Countries A and B need to form a cartel to limit competition and increase tax revenue.

Advocates of international tax harmonization state explicitly that the goal of harmonization is to limit competition to increase tax revenue, as well as limit fraud and tax evasion.[1] [2] The call for coordinated collective action to limit competition in order to raise revenue is in essence, advocating for a multinational tax cartel. While economic cartels are not inherently bad, they come with their own host of costs and benefits. The literature on economic cartels informs the potential challenges for tax harmonization that I present below.

Efforts to implement international tax harmonization will run up against three categories of costs that will challenge the effectiveness of tax harmonization:

• Bargaining and Negotiation Costs
• Knowledge and Decision-Making Costs
• Monitoring and Enforcement Costs

Further, effective international tax harmonization would suppress international tax competition, which would:

• Reduce the efficiency of public goods provision
• Reduce the flexibility that democratic governments have to respond to their citizens
• Potential hinder modern economic growth

Potential Challenges of Tax Harmonization

1. Bargaining and Negotiation Costs: Creating a Sufficiently Comprehensive Tax Harmonization Coalition

A tax harmonization coalition (the set of countries that agreed to harmonize their tax rate with the other countries in the set) is only as effective as it is comprehensive. The goal of tax harmonization is to mute the effects of competition, and competition depends on the availability of substitutes. As long as firms have opportunities to move from high tax regions to viable low tax regions, pressure from tax competition will be active. It is important to note that having low taxes does not necessarily mean that that country is better for business than a high tax country. Some low tax countries maylack effective courts, protection of private property, and rule of law, or suffer from expected or ongoing violence. Turkmenistan, Kyrgyzstan, and Timor-Leste all have extremely low corporate tax rates (all less than or equal to 10%), but lack the institutions that are necessary to attract multinational corporations, and therefore could not effectively act as a holdout to a tax harmonization coalition.[3] Within the class of countries that are safe and attractive for multinational countries to conduct business, all countries must join the coalition to harmonize taxes and reduce competition. Partial harmonization is much less effective than full harmonization.[4]

A problem with needing full harmonization for the tax harmonization to be effective is that the coalition needs to be large to be effective. Countries who want to raise their taxes would have an incentive to join the coalition, but low tax countries like Ireland that are currently tax havens would lose their comparative advantage by joining the coalition. Current tax havens would be reluctant to join and could benefit from being holdouts to joining the coalition. Holdouts would need financial compensation to incentivize them to join. Abe and Okamura (1989) find that lump-sum transfers are the only way to institute tax harmonization in a way that improves the welfare of all the member countries.[5]

The need for holdouts to get compensation to join creates the additional problem of coordinating around deciding what amount each particular country should contribute to compensate holdouts for joining. Countries would also have an incentive to cheat on the tax harmonization arrangement (described below), which means they would have to work to negotiate over how to best form an agreement that managed the incentives to defect.[6]

2. Knowledge and Decision-Making Costs: Determining What the Coalition Tax Rate should be and When it should Change

Another disadvantage of needing full harmonization to make harmonization effective is that the size of the cartel would increase the cost of collective decision making.[7] Advocates of tax harmonization therefore face a harsh tradeoff. A small group of countries that engage in tax harmonization can easily decide on an optimal rate but are ineffective in raising the average global tax rate. As the coalition grows and perhaps has a greater impact on average global tax rates, the coalition itself suffers from increasing coordinating and decision-making costs.[8]

Hines Jr. (2023) offers a potential solution to the problem of coming to a decision on what tax rate to use as the standardized rate for a coalition of nations instituting tax harmonization.[9] He finds that the optimal tax rate for a system of tax harmonization has to be at least one standard deviation greater than the average tax rate of the countries that are members of the tax harmonization coalition. Whether or not one agrees with how he derives the conclusion that the optimal tax rate, he offers a potentially helpful and impartially derived focal point for a tax harmonization coalition to coalesce around.

The problem with Hines Jr.’s solution is that it is only effective at resolving the issue of deciding an initial rate for members to converge with. If the coalition was successful in including all the potential rivals in tax competition in the coalition, then the average tax rate of relevant rivals will be the rate set by the coalition and the standard deviation will be zero. Hines Jr.’s solution relies on knowledge that is created by tax competition, so creating a system of tax harmonization would destroy the knowledge necessary for adjusting the tax harmonization rate to match the optimal tax rate.[10]

3. Monitoring and Enforcement Costs: Making sure Members do not Defect and Punishing them when they do

Forming a tax harmonization coalition with all the countries that are relevant competitors and setting an agreed upon tax rate is not enough to establish a successful tax harmonization regime. Once the regime is established, the agreed upon rules must be monitored and enforced, which is no easy task. Once again, the tax harmonization coalition is essentially a cartel of countries, so every country has an incentive to defect from the agreed upon tax rate.[11] Given that all other countries are setting their tax rates above the competitive equilibrium rate, any country could attract investment and increase tax revenue by lowering their tax rate below the agreed upon rate.[12]

Defection would not need to be something as blatant as lowering the base rate of corporate taxation. Selective incentives, tax loopholes, and emergency tax breaks are all among the options that governments have to lower their effective corporate tax rates without doing so explicitly. As tax codes have become more complex, they have also become more difficult to standardize across counties. Uncertainty concerning whether other members of the coalition are defecting can incentivise coalition members to defect from the agreed upon rate.

Complex tax codes create ambiguity in compliance with tax harmonization policy, which creates the need for establishing some sort of impartial monitoring system to enforce the agreed upon tax rate. The complexity of modern tax codes will make it difficult for monitoring agents to identify when a country has violated the tax agreement, and the competing national loyalties of the monitoring agents could cloud or corrupt their judgement in assessing the compliance of the various member countries.

Beyond the problems with monitoring, once a country was found to have violated the tax agreement, the coalition would then have to decide how to enact reprisals on the non-compliant countries. The punishment would be costly to enact no matter what form of punishment the coalition decided upon, which would once again create an incentive for member countries to defect from the rulings of the harmonization coalition.

Benefits of Embracing Tax Competition

None of the costs outlined above rule out the possibility that establishing a tax harmonization coalition would be beneficial. They do, however, demonstrate that there are large costs associated with establishing and maintaining international tax harmonization that could easily negate the revenue advantages of a tax harmonization coalition.

Beside avoiding the costs outlined above associated with attempting to create and maintain a tax harmonization regime, there are several benefits to embracing tax competition over harmonization.

1. Tax Competition Incentivizes States to Provide Efficient Combinations of Taxation and Public Goods

Charles Tiebout sparked the study of tax competition between political jurisdictions. He used an evolutionary model to understand interjurisdictional competition, where political jurisdictions that provided inefficient combinations of taxation and public goods would cease to exist after all their citizens and firms migrated to political jurisdictions with more efficient combinations of public goods.[13] Tiebout recognized that political jurisdictions need firms and citizens in their borders to continue to exist, so they would compete over populations with other political jurisdictions by offering more efficient combinations of public goods and taxation, until all jurisdictions converged to some efficient combination of public goods and taxation that was attractive to some portion of the population.

Tiebout may paint the picture too rosily, however. Later scholarship has identified a set of conditions that must hold for interjurisdictional competition to actively put pressure on lawmakers: the first condition being that “lawmakers must have a vested interest in attracting or maintaining population” and the second being that “individuals must have the knowledge and means to actively move from less preferred to more preferred jurisdictions”.[14] These conditions demonstrate that rules and regulations regarding free mobility of labor, capital, and knowledge about other political jurisdictions are deeply connected to tax competition and interjurisdictional competition.

If the conditions for interjurisdictional competition hold, then governments will be pressured into providing efficient combinations of taxation and public goods. Restraining tax competition restrains a mechanism for government accountability.

2. Governments have the Flexibility to meet their Citizens’ Demands regarding Taxation

It seems sensible that full international tax harmonization would increase the tax revenues of the average member state. However, it is not obvious that increasing the fiscal capacity of national governments is worth the cost of hindering the democratic process in the member countries. To uphold their obligations to the harmonization coalition, member countries would have to take significant aspects of tax policy outside the scope of the national democratic process.[15]

The tax harmonization coalition could only survive over time if member countries could credibly commit to setting their tax rates at the rates determined by the coalition. The member countries would have to insulate their tax policies from the democratic process to achieve stability, otherwise a shift of attitudes in the voting population of any member country could undermine the efficacy of the harmonization coalition.

If the citizens of the counties that would need to join the tax harmonization coalition for the coalition to be effective could reasonably disagree on the optimal combination of taxation and public goods, then a tax harmonization coalition would suppress the population of a nation from getting what they could reasonably demand from their government. It is not self-evident that high taxes and high public good provision are the optimal role of government in society. While a tax harmonization coalition would help enable some governments to achieve the combination of public goods and taxation and public goods, they desire by helping their national government increase tax revenue, other countries would suffer from being forced into a regime where the government had higher taxes and more public goods than their citizens would prefer.

3. Tax Competition may be better for Long Run Economic Growth

An international coalition that established tax harmonization would almost certainly increase the average tax revenues of the member countries in the short run if it were costlessly created and governed. However, economic production, growth, and innovation thrive in low tax environments. A successful tax harmonization coalition might raise tax revenues in the short run but kill the geese that have laid the golden eggs of modern economic growth.[16] [17]

International tax competition, on the other hand, should tend to keep tax rates lower, which should in turn promote long run economic growth. Lower global tax rates can encourage foreign direct investment, and lower global rates do not necessarily mean lower revenue from corporate taxation. Over the past 50 years, average corporate tax rates in the OECD have fallen from 48% to 24%, while during the same period the average share of corporate tax revenue in government budgets has increased from 2.3% to 3.5%.[18]

If one holds the perspective that low taxation and strong interjurisdictional pressure to provide efficient combinations of taxation and public goods are critical for encouraging modern economic growth, then international tax competition should be seen as a critical bulwark protecting the great economic improvements of the last quarter millennium.

Conclusion

Although it is impossible to know with certainty the viability of a full international coalition for tax harmonization and the welfare effects it would have, it is clear, however, that there are a variety of costs that would complicate the establishment, governance, and enforcement of such a tax regime. These costs call into question the viability and efficacy of proposed systems of global tax harmonization and are all too often overlooked or downplayed by advocates for global tax harmonization.

Further, there is reason to believe that tax competition puts power in the hands of a country’s citizens to shape their government into the government they desire, and that it may very well be critical for maintaining modern economic growth. Given that modern economic growth and citizens’ voices in government are at stake, advocates of international tax harmonization should have to clear a high intellectual bar when they advocate for their position.

Notes

[1] OECD. “Cross-Border and International Tax,” n.d.

[2] Maucour, Cyril. “International Tax Harmonization – Altertax Avocats.” Altertax Avocats, June 24, 2024.

[3] Enache, Cristina. “Corporate Tax Rates around the World, 2024.” Tax Foundation, December 16, 2024.

[4] Hines, James. “Evaluating Tax Harmonization”. Cambridge, MA: National Bureau of Economic Research, November 2023. https://doi.org/10.3386/w31900.

[5] Abe, Kenzo, and Makoto Okamura. “THE WELFARE EFFECTS of INTERNATIONAL TAX HARMONIZATION.” The Economic Studies Quarterly 40, no. 3 (September 20, 1989): 203–11.

[6] Stigler, George J. 1964. “A Theory of Oligopoly.” Journal of Political Economy 72 (1): 44–61.

[7] Buchanan, James M, and Gordon Tullock. The Calculus of Consent : Logical Foundations of Constitutional Democracy. Indianapolis: Liberty Fund, 2018.

[8] Olson, Mancur. 1965. The Logic of Collective Action: Public Goods and the Theory of Groups. Cambridge, Massachusetts: Harvard University Press.

[9] Hines, James. “Evaluating Tax Harmonization”. Cambridge, MA: National Bureau of Economic Research, November 2023.

[10] Economic rivalry creates knowledge that can guide economic actors. Lavoie, Don, Peter J Boettke, and Virgil Henry Storr. Rivalry and Central Planning the Socialist Calculation Debate Reconsidered. Arlington, Virginia : Mercatus Center, George Mason University, 2015.

[11] Osborne, D. K. “Cartel Problems.” The American Economic Review 66, no. 5 (1976): 835–44.

[12] Holcomb, James H., and Paul S. Nelson. “Cartel Failure: A Mistake or Do They Do It to Each Other on Purpose?” The Journal of Socio-Economics 20, no. 3 (1 September 1991): 235–49.

[13] Tiebout, Charles M. “A Pure Theory of Local Expenditures.” Journal of Political Economy 64, no. 5 (1956): 416–24.

[14] Jayme S. Lemke, “Interjurisdictional Competition and the Married Women’s Property Acts,” Public Choice 166, no. 3-4 (March 2016): 291–313.

[15] Kopits, George. Tax harmonization in the European Community, (USA: International Monetary Fund, 1992) accessed Dec 17, 2024.

[16] Organization for Economic Co-operation and Development. Tax policy reform and economic growth. OECD Publishing, 2010.

[17] Arnold, Jens Matthias, Bert Brys, Christopher Heady, Åsa Johansson, Cyrille Schwellnus, and Laura Vartia. “Tax policy for economic recovery and growth.” The economic journal 121, no. 550 (2011): F59-F80.

[18] Michel, Adam. “Competing for Capital: Tax Competition and Globalization.” Cato.org, March 19, 2024.