Article 09-Wilson

Forum on Mobility and Tax Analysis Theories of Tax Competition Abstract - A central message of the tax competition literature is that independent governments engage in wasteful competition for scarce capital through reductions in tax rates and public expenditure levels. This paper discusses many of the contributions to this literature, ranging from early demonstrations of wasteful tax competition to more recent contributions that identify efficiency- enhancing roles for competition among governments. Such roles involve considerations not present in earlier models, including im- perfectly-competitive market structures, government commitment problems, and political economy considerations. INTRODUCTION he modern literature on tax competition began with an Tattempt to understand the potential efficiency problems associated with competition for capital by local governments. Oates (1972, p. 143) describes this problem as follows: “The result of tax competition may well be a tendency toward less than efficient levels of output of local services. In an attempt to keep taxes low to attract business investment, local officials may hold spending below those levels for which marginal benefits equal marginal costs, particularly for those pro- grams that do not offer direct benefits to local business.” In other words, local officials will supplement the conventional measures of marginal costs with those costs arising from the negative impact of taxation on business investment. These additional costs might include lower wages and em- ployment levels, capital losses on homes or other assets, and reduced tax bases. Their presence will reduce public spending and taxes to levels where the marginal benefits equal the higher marginal costs. Oates’s conclusion that this behavior is inefficient rests on the idea that when all governments be- have this way, none gain a competitive advantage, and con- sequently communities are all worse off than they would have been if local officials had simply used the conventional measures of marginal costs in their decision rules. John Douglas Since the mid-1980s, there has been an outpouring of aca- Wilson demic research on tax competition, and this research contin- Department of ues unabated. Interest in this area has been stimulated by Economics, highly publicized instances where U.S. states and localities Michigan State do seem to have engaged in tax competition, including the University, East many cases where they have offered large subsidies to for- Lansing, MI 48824 eign and domestic automobile companies in an attempt to 269 NATIONAL TAX JOURNAL influence plant location decisions. In ad- to be unsuitable for private markets” (p. dition, researchers and policymakers have 248). Through a series of examples, Sinn found that Oates’s (1972) description of tax essentially argues that if private markets competition can be applied more broadly fail to efficiently provide particular goods to a host of important policy concerns, such and services, then introducing competi- as competition for investment through tion among governments that seek to pro- weaker environmental standards or reduc- vide them will generate similar problems. tions in welfare payments by states trying Given the central importance of tax com- to avoid attracting poor households. petition in these ongoing policy debates, More generally, the view that intergov- the time seems ripe to assess what we have ernmental competition is wasteful has learned from the large and growing theo- raised fundamental questions about the retical literature on this phenomenon. This appropriate roles of the central govern- is the objective of the present paper. ment and lower level governments. In The scope of my discussion is broader particular, this view runs counter to the than Oates’s (1972) original description of highly influential “Tiebout Hypothesis.” tax competition. Thus, I discuss models Tiebout (1956) argues that competition for in which the governments may be inter- mobile households is welfare enhancing, preted as local, state, or provincial gov- and subsequent work has applied similar ernments within a country, or as countries ideas to competition for mobile firms, in within the world economy. I often use the direct conflict with much of the tax com- term “region” to encompass these various petition literature. This conflict is reflected interpretations. A common feature of most in the ongoing “devolution debate” over of the models considered here is that the desirability of “devolving” federal re- each government independently (or sponsibilities to lower levels of govern- “noncooperatively”) chooses its tax or ment within the United States.1 subsidy policies to maximize the welfare Moreover, this conflict has surfaced in of residents within the region, and its debates concerning the appropriate de- choice affects the size of the tax bases gree of economic integration between available to other governments. These tax countries. In Europe, integration has bases often consist of mobile capital, but I proceeded to the point where barriers to consider alternatives, such as competition labor and capital mobility have been for cross-border shoppers. While the main officially dismantled (although cultural focus of my discussion is on the nonco- barriers remain). The Tiebout literature operative choice of taxes or subsidies, I supports policies that allow free factor also discuss cases in which governments mobility and enable national governments compete by using nontax instruments to function independently in most policy such as expenditure or regulatory policies. areas, and the Treaty on the European My survey shows that the initial formal Union reflects a presumption in favor of models of tax competition largely confirm this independence. In contrast, the tax Oates’s (1972) conjecture, since they stick competition literature draws attention to most closely to the situation he envi- the potentially adverse effects of this in- sioned. Subsequent extensions of these dependence. Similar concerns about inte- models produce a variety of inefficiencies gration surface in Sinn’s (1997) discussion that differ from the original conclusion of the “selection principle,” which identi- that taxes and expenditures are ineffi- fies a “fundamental selection bias towards ciently low. Toward the end of the paper, [government] activities that have proved I discuss recent work that identifies some 1 See Tannenwald (1998) for an overview of this debate. 270 Forum on Mobility and Tax Analysis beneficial effects of competition among models. As Huang (1992) argues, unem- governments that seem not to have been ployment may provide an additional in- previously recognized, in part because they centive for wasteful tax competition, since represent departures from both the stan- governments now benefit from the em- dard tax competition models and Tiebout ployment generated by additional capital.2 models. My concluding remarks call for My discussion of competition for capital more work on the potentially important is also restricted to “industrial capital,” trade-offs between the good and bad as- rather than “residential capital.” The lat- pects of intergovernmental competition. ter type of competition has been investi- This paper is organized as follows. I be- gated using what Mieszkowski and gin in the next section by discussing the Zodrow (1989) refer to as “metropolitan idealized Tiebout world and how tax com- models.” Such models contain residential petition models typically depart from it. housing and assume interjurisdictionally The third section then surveys a large num- mobile residents, making them less appli- ber of models in which governments use cable to tax competition between countries. tax policies to compete for mobile capital. Although I briefly discuss multinationals, Throughout this discussion, firms are as- interested readers should consult more sumed to be competitive, and only taxes on specialized surveys on this topic, such as mobile capital are considered. The fourth Gresik (1998) and Hines (1997, 1999). Fi- section discusses several attempts to ex- nally, my focus on theories of tax competi- pand the basic model to include multiple tion precludes a detailed examination of tax instruments, including models where the empirical work on its existence; see both capital and labor are mobile. In the Brueckner and Saavedra (1998) for some fifth section, I change the focus to “com- empirical evidence and related references. modity tax competition,” where regions compete for cross-border shoppers, a situ- THE TIEBOUT MODEL ation that is relevant not only for regions, states, or provinces within a single coun- Tiebout’s (1956) theory of local public try, but also for countries with few border good provision also provides a theory of controls, such as the European Union. The efficient tax competition. In modern for- sixth section briefly discusses competition mulations of the theory, it is often as- involving nontax instruments. In the sev- sumed that each region’s government is enth section, I turn to two areas of research controlled by its landowners, who seek to where the concern has been that taxes are maximize the after-tax value of the too high, not too low: competition between region’s land by attracting individuals to different levels of government (“vertical tax reside on this land. To do so, the govern- competition”) and the use of double taxa- ment offers public goods that are financed tion conventions. The eighth section then by local taxes.

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