What is Tax Competition?

Tax competition is the practice of lowering tax rates, and sometimes regulatory costs, below those of other jurisdictions. There are various reasons a jurisdiction may engage in tax competition, the most common being to attract businesses and people to the area, and to dissuade exports of goods and/or the out-migration of people. The alternative to tax competition is tax harmonization, which can be described as the movement of tax rates and regulatory costs to a single level, so that there is no tax advantage to moving from one jurisdiction to another.

Although the effect of tax competition is lower tax revenue, some jurisdictions target preferential policies. For instance, a government might offer a special tax break for a certain period of time to a relocating company if it promises to employ a minimum number of residents, or it may exempt an enterprise from having to pay certain fees. This targeted approach is useful in attracting new investment without eliminating existing revenues, but must be undertaken with great care so as to avoid alienating existing businesses and encouraging them to move elsewhere.

The importance of tax policy in influencing businesses and people to consider moving to another jurisdiction has grown together with people’s enhanced mobility. Policymakers in American states are constantly reviewing their own states’ tax policies as compared to others, both in the same region and nationwide. The handful of American states without a personal income tax stress that fact in their outreach to companies and families considering a move, while the high-tax states stress the wide range of services available that the low- or no-tax states might not be able to match.

Tax competition has always been a controversial issue in Europe, but has become more so since the formation of the European Union, the establishment of the Euro as the continent’s currency and the trend toward a single monetary policy. As the European Parliament establishes itself as the central policy-making body across the continent, tax policies are among the few areas where formerly sovereign states exercise real sovereign control. Some nations, most notably the Republic of Ireland, reduced tax rates dramatically, attracting foreign investment and growing their industrial sector significantly. The shortfall in tax revenues was partially made up with funds received from the EU, which prompted net contributor nations like Germany to complain that they were funding their own competition. The initial impact on Ireland’s economy was dramatic and positive, but Ireland’s economy couldn’t ride out the global recession that started in 2008, finally collapsing in 2010.

Proponents of tax harmonization point to situations like Ireland’s as evidence that tax policies should be uniform throughout a region. What Ireland did, they argue, was provide a tax haven for global enterprises that exploited the cheap business environment and moved their profits offshore, and then simply closed up shop when the bad times hit. Ireland was left with shuttered factories, high unemployment, and a battered treasury incapable of helping its people weather the storm.

Ireland’s woes haven’t reduced the fervor of the proponents of tax competition, though. Tax competition, they argue, provides the same benefits to the global economy that industrial competition provides — namely, innovation and invention. Just as competitive forces with the auto industry, for example, spur the drive for safer, more efficient, less costly automobiles, so the existence of tax competition drives governments to find ways to provide necessary services to their people more efficiently and cost-effectively. In addition, tax competition prevents traditionally high-tax nations from becoming complacent and hide-bound in their tax policies, because the people and the companies that employ them can simply “vote with their feet” and migrate to a nation whose tax policies are more beneficial.