Tax competition refers to the process of reducing the tax burden of a country in relation to foreign jurisdictions to attract foreign direct investment (FDI). Foreign direct investment in this case refers to a case where a company sets up, expands, or takes over another company in a foreign country. These investments lead into the ownership of physical assets of the new company. Investments from foreign countries create jobs, facilitate economic growth, and introduce new technologies. The concept of tax competition arises tax bases of a country are exceedingly mobile. At the global level, much focus is on corporate taxes. However, this can also apply to excise products including alcohol and tobacco. The increase in labor, flows of capital, products, and services across borders as a result of globalization has drawn significant attention of countries on the global implications of their respective systems of taxation. Consequently, this has resulted in reductions of both corporate and personal income tax rates, which partially represent tax competition. This tendency could, however, be due to various other causes rather than simply tax competition. It is essential to consider the fact that tax competition can also apply to provinces or states in a decentralized or federal system within a state. It essential to note that the statutory rates of corporate income tax for developing countries have fallen and the tax rate has also fallen leading to a decrease of the corporate tax revenue to the GDP ratio. On the other hand, in the developed nations, the decline in rates had been offset by a broadening of the base. This, therefore, implies that the ratio has increased.
Effect of Tax Competition on FDI
Tax competition drives down corporate income tax rates and; therefore, leads to a significant decline in these rates as a source of revenue for the government. Consequently, this limits the sum of public products that governments can supply. It compels governments to depend on other forms of taxes that distort or are in conflict with objectives of equity. Tax competition, therefore, differs from region to region and from country to country. Thus, the effect of tax competition on FDI varies from one country to another. Looking at the case of Caribbean Nassar (2008) notes that tax competition in the Caribbean has increased over the last two decades. Since the mid-1980s, statutory rates have decreased by an average of 30%. In this case, governments in the Caribbean have been trying to expand their economies from agriculture. In fact, they have directed focus on tourism by investing in infrastructure. They use tax incentives in their commercial sector to attract foreign direct investment. The results are large debts and fiscal deficits increased by tax incentives provision that have eliminated the tax base. In addition, they have narrowed the capability of governments to raise revenue.
Some studies provide evidence on the effectiveness of tax competition. For instance the OECD policy Brief (2008) state that while tax is known as being an essential factor in deciding on where to invest, it is not the key factor. Foreign direct investment is attracted to States that provide a variety of gains. These include access to profit opportunities and markets, macroeconomic stability, a regulatory and legal framework that is non-discriminatory and predictable, responsive and skilled labor markets, as well as, well developed infrastructure. All these determinants affect the long-term profitability of a project. It is estimated that FDI declines by 3.7% following an increase of 1% in FDI’s tax rate. However, there is a variety of approximates with a large number of studies revealing declines in the 0% to 5% range. This rate partially represents alterations in countries and industries believed studied or the time period involved. However, a recent evaluation supports the perception that FDI’s sensitivity to tax relies on the mobility if business activities that underlie the tax base and the host country.
Specifically, where companies benefit from gaining production in big markets in order to reduce trade costs such as the costs of transportation, a particular level of inactivity is anticipated in the choice of location of firms. The benefits of the host country and some degree of capital fixity imply that gains may be taxed up to some level without dampening investment. The perception is steady with the fact that some economies of OECD with strong FDI inflows and large domestic output have comparatively high rates of corporate tax rate. FDI is becoming more and more responsive to taxation, representing the rise in mobility of capital while non-tax obstacles are eradicated. It is not, however, unambiguous that a reduction in tax is needed in order to attract foreign direct investment. In cases where a higher burden of corporate tax is matched by appropriate public services, developed infrastructure, as well as, other attributes of a host nation that are attractive to business such as the size of the market, tax competition from low-tax countries that do not offer similar benefits may not affect the location choice seriously. In fact, some OECD countries that have high rates of effective tax are exceedingly successful in attracting foreign direct investment.
This implies that the size of the market and other attributes of a host country are essential in attracting foreign direct investment, as well as, the presence of gains, which governments are able to consider for taxation. It is, therefore, evident that a low burden of tax is not capable of compensating for unattractive or weak foreign domestic investment. Tax is an element that cannot compensate for limited or restricted market access, poor infrastructure, or even other unattractive or weak conditions of investment. In addition, while attention is concerned with corporate tax income, the significance of other forms of taxes should be acknowledged. For instance, payroll taxes, non-profit-related business taxes, and energy taxes have increasingly been on the limelight by policy makers and investors. How business friendly the administration of tax is perceived, is also a significant factor that needs to be taken into account.
On the other hand, average effective tax rates and statutory rates for developing countries have an effect on the location of capital. Furthermore, other factors matter for attracting foreign direct investment more than tax including labor costs, macroeconomic stability, the growth and size of the domestic market, employment protection, and the accessibility of governance and location issues.
There is a variety of consequences of tax competition. Apart from the fact that low regimes of tax attracts FDI and; therefore, good for growth, there exist negative impacts of tax competition. Incase tax competition leads to a descending tendency in the tax amount paid by individuals and corporations, and revenue on tax cannot be replaced easily with other revenue sources, the implication on the ability of governments to offer services and facilitate welfare could be a critical concern. The consequences of tax competition may be classified into some categories that are loss in revenue, equity, welfare effects, democracy, corruption and discretion, and national sovereignty in matters of taxation.
On revenue loss, tax competition eliminates the tax base particularly because a variety of investments would occur even without the tax incentive (Tanzi and Zee, 2001). When existing companies disguise themselves as new ones, it may lead to abuse of incentives. Additionally, the challenge with tax holidays and tax concessions is that it is hard to reverse these situations. Once a competitive regime attracts inward investors, they are in a powerful position to bargain for increase in taxes. They also threaten to move to another location, which becomes the essence of tax competition. Furthermore, domestic firms may lobby for concessions of a similar nature. Losing revenues for governments may compel them to depend on other taxes that are in conflict or distort the equity objectives. As governments have to look for revenues elsewhere, it means a movement towards taxes, which are easily collectable and that do not apply to large corporations including Value Added taxes or other forms of taxes such as payroll tax and sales tax. Also, taxes on land are corporate to similar forces as personal and corporate income taxes. If such a shift is done by governments, there is a general shift from progressive taxes to regressive taxes. Therefore, there are direct impacts on equity caused by tax competition.
OECD (2008) ‘Tax Effects on Foreign Direct Investment’, OECD Policy Brief, February, Paris: Organization for Economic Cooperation and Development.
Nassar Koffie (2008) ‘Corporate Income Tax Competition in the Caribbean’, IMF Working Paper, 08/77, Washington DC: International Monetary Fund.
Tanzi Vito and Zee Howell (2001) ‘Tax Policies for Developing Countries’, Washington DC: International Monetary Fund.
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