Institute for Research in Economic and Fiscal issues

IREF Europe - Institute for Research in Economic and Fiscal issues

Fiscal competition
and economic freedom


Fiscal Competition for an Accountable Government

The Institute for Research in Economic and Fiscal Issues (IREF) and the Council on Public Policy jointly hold a symposium on "Fiscal Competition for an Accountable Government" in Berlin on November 9, 2007. Victoria Curzon-Price (University of Geneva), Charles B. Blankart (Humboldt University, Berlin), Michael Eilfort (Stiftung Marktwirtschaft, Berlin) and Lars Feld (University of Heidelberg) were invited to give sound theoretical insights and to present reliable empirical data on fiscal competition. Furthermore, these reputable experts in fiscal issues were concentrating on fiscal competition on a federal level. conference was opened by Ji?i Schwarz (University of Economics, Prague), who emphasized that the effects of fiscalcompetition are a hot topic in European Union. Pierre Garello (University of Aix-Marseille, IREF) afterwards introduced the Institute for Research in Economic and Fiscal Issues (IREF) to the auditorium. The establishment of IREF in 2002 was motivated, inter alia, by OECD’s labeling of fiscalcompetition per se as harmful. IREF’s mission consists particularly in promoting scholarly research on fiscal issues and taxation and to linking this academic work to public policy.

Victoria Curzon-Price started her presentation with an examination of the reasons why OECD initiated a debate on "harmful" tax competition. Global tax competition in the last decades obviously had the effect that tax rates went down globally. OECD feared that this competition for lower tax rates initiates a "race to the bottom" where the state, as we know it, could no longer exist. Tax competition was consequently declared as harmful and those "pesky little states" with existing low taxes should be prevented to again lower the rates to not harm the overarching state in high-tax countries. Global tax competition indeed has had effects. Between 1980 and 2003 the older developed countries have reduced marginal tax rates on personal incomes from about 70% to 44% in average. The transition countries have cut tax rates from nearly 100% to 23% on average. With the exception of only six countries every state in the world has cut tax rates for personal incomes. The same holds true for corporate tax rates. Some Baltic states now have zero percent corporate tax rates. Ireland has re-duced corporate tax rates from about 50% to 12.5%. Even taxes on labor—i.e. social insurance contributions—were going down, on average. The only area where the effect of global tax competition doesn’t exist to such an extent is that of VAT. However, there is no race to the bottom as OECD fears. Even if tax rates were cut in the period mentioned, tax revenues went up due to the Laffer Curve Effect, every-where. Most countries that have lowered tax rates also boosted public expenditure in percent of GDP. But there are also some countries such as Ireland or New Zealand that have reduced both tax rates and public spending. This group of countries enjoyed—on average—a rate of economic growth that was twice as high as the rate for those countries that haven’t reduced public expenditure in proportion of GDP. The rules of the game of tax competition are clearly laid out. Countries have to be attractive for the international capital, not only to attract foreign investors, but also to not expel businesses. This competition, however, is not harmful because there is a very good chance to increase the rate of economic growth by cutting tax rates. Op-posed to OECD’s warning of tax competition, there is no race to the bottom. The ma-croeconomic data that Victoria Curzon-Price presented clearly shows that cutting taxes leads to higher rates of economic growth, which produces growing public revenues.

Charles B. Blankart (Humboldt University, Berlin) examined the effects of fiscal au-tonomy of subnational entities, exemplified by the cases of two local communities in Germany and in Switzerland. The small Saxon municipality of Oderwitz in 1992 de-cided to build a new gym in public-private-partnership, i.e. leasing that building from the private investor with the option of buying it some decades later. The Saxon Court of Auditors later declared this contract as uneconomical and the municipality then sued the supervising authority for compensation. The federal court of justice finally decided that the district authority has to compensate due to its obligatory supervision over the subordinate municipalities. Local authorities in Germany therefore never can go bankrupt. Leukerbad in the Swiss canton Valais has become insolvent in 1998. Some creditors then sued Valais for assuming this municipality’s debts. The Swiss Federal Court, however, decided in favor of fiscal autonomy. Thus, a canton is not liable for its subordinate authorities’ debts. Following this decision the capital market in Switzerland has gone through reorganization. Rating agencies appeared that made it possible for creditors to differentiate between good and bad debtors.The framework of incentives exemplified in the case of Oberwitz leads to an exces-sive level of debt. But the results are very different if a public debtor—like Leuker-bad—is allowed to go bankrupt. The municipality now has the incentive to become a good debtor. Creditors on the other side only grant credits if there is a good chance for fulfilling these obligations. This different framework of incentives also increases ex-ante as well as ex-post efficiency. The former means creating procedures that allows the creditor to reliably estimate the financial standing of a potential debtor (e.g. transparency rules or proper financial conduct). The latter describes the establishment of procedures and rules (e.g. insolvency code) of coping with the case of bankruptcy, i.e. to cut the possible losses for both sides. The actual trend from loans to bonds in public finances also provides incentives for more transparency and the creating of procedures for the case of insolvency, even if bankruptcy of local or regional authorities is not possible. At present there is no political demand for creating an insolvency code for political subdivisions in Germany. Nevertheless, establishing e.g. collective action clauses in case of issuing a public-sector bond can be considered as some kind of an insolvency code restricted to that bond. As Charles B. Blankart pointed out, these procedures have an impact on interest rates and can lead to more favorably refinancing of political subdivisions.

Michael Eilfort (Stiftung Marktwirtschaft, Berlin) wanted to advocate the principal of fiscal competition. If tax rates or the tax structure in a country would be all-decisive for that nations wealth, he stated, there would have been no economic revival in Germany and all domestic businesses would have been emigrated. Therefore, the role of fiscal issues should not be over-stated. However, Stiftung Marktwirtschaft for a long time criticized the German system of taxation and has worked out suggestions for a sustained tax reform. Stiftung Marktwirtschaft’s main objective is the reform of tax structure in Germany, because aspects like trust, reliability, predictability of fiscal legislation, or transparen-cy are at least as important as low tax rates. Therefore Michael Eilfort welcomed the efforts of European Union to harmonize the systems of taxation to thin out the thicket of German taxation: No real Common Market in European Union without tax competition on equal terms. Actual fiscal policy in Germany however makes the German system of taxation even more obscure. Red tape, complexibility and intransparency have reached a record high now. Eilfort illustrated this with an Indian proverb that fits well to the Grand Coalition governing Germany at present: Whether elephants make love or fight, the grass suffers. Regarding the communal level Eilfort emphasized with respect to Charles Blankart’s lecture the role of Switzerland as a model for Germany. Speaking for Stiftung Marktwirtschaft he called for a municipal rate on the income tax—fixed by the muni-cipality—publicized to all taxpayers concerned. This would lead to more fiscal re-sponsibility and to lower municipal spending.

In the last lecture of this conference on fiscal competition Lars Feld (University of Heidelberg) examined if it is reasonable to concede fiscal autonomy to the German federal states. Before however answering this question in the affirmative he first contributed to the discussion followed Michael Eilfort’s rejection of fiscal competition in the field of tax structure. There are particularly two reasons in favor of harmonizing tax structure in Europe, e.g. the base for corporate taxes. First, nations with high corporate tax rates are suffering from the tax minimizing strategy of European businesses to move their earnings to low tax countries. Second, if there are no restrictions in designing the base for corporate tax hidden subsidies in the form of tax exemptions can easily created. However, harmonizing the tax structure leads also to leveling tax rates and provides incentives for businesses to unwanted adjustments to the respective definition of the taxable base. Thus, the disadvantages of harmonizing tax structure can be higher than those of the transfer of profits. Lars Feld highlighted the need for a rigorous reform of the constitutional rules go-verning public finances in Germany. The federal states in Germany are suffering a structural, financial crisis as a consequence of the absent states’ autonomy on the revenue side. Public debt is the most flexible instrument in the federal states’ public finance. Together with an all-flattening financial equalization scheme this leads to wasting public funds and to an excessive level of debt. The development of national debt in Switzerland shows a similar trend as in Germa-ny. But due to the existing fiscal competition regional and local authorities in Switzerland are not overindebted; the federal level is most responsible for the growing debt. In contrast to Germany where the revenues of the most important taxes are shared and the rates of nearly all taxes are harmonized, cantons have real autonomy on the revenue side. Instead of taking up new debts to refund public spending they adjust the level of taxation. Taxation between the cantons can differ enormously and the taxpayers’ mobility is an incentive to limit spending and to a more efficient provision of public goods. Fiscal competition is a crucial element to Swiss federalism. The introduction of fiscal autonomy in Germany is particularly objected by the argument that the federal states in eastern Germany wouldn’t be able to generate substantial revenues by autonom-ous taxation. This, however, is misleading because the GDP’s variability in Switzer-land is as high as in Germany. Relative deviations from national average in GDP per capita are about the same comparing the economically weakest cantons in Switzerland to eastern German states. Even taking the effects of fiscal mobility in account public revenue in East Germany wouldn’t collapse by introducing fiscal autonomy, Lars Feld concluded. In a nutshell, introducing fiscal competition in Germany is possible and would limit public spending in the federal states.

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