In the context of a stylised gaine theoretical framework of capital tax competition, we show that when repeated policy interactions are associated to a systematic punishment of the deviating policymaker, a coordinated outcome can be the solution to the non cooperative tax game. This resuit suggests that explicit forms of policy coordination, such as a centralised tax authority, could in fact be largely unnecessary.Policy coordination, international fiscal issues

Jean-Pierre VIDAL

Marco CATENARO

English

Research Papers in Economics

Implicit tax coordination under
repeated policy interactions
Marco Catenaro*
European Central Bank
Jean-Pierre Vidal*
European Central Bank
1 Introduction
It is often argued that, in an environment in which capital is able to move
freely, governments' ability to rely on capital taxation becornes increasingly
constrained. Fiscal authorities would then be made better off by more acti-
vely co-ordinating their tax policies or, alternatively, by relinquishing their
tax authority in favour of a supra-national authority. While the common
wisdom that capital mobility exerts a "race-to-the-bottom" on capital tax
rates is widely accepted in the theoretical literature on tax compétition, the
empirical literature so far has found little support for this outcome. ce
The theoretical literature on tax compétition1 is largely based on con-
ventional static frameworks, in which the tax game lasts only one period,
thereby disregarding the possibility of repeated interactions between policy-
makers. Concerning capital income taxation, in particular, it traditionally
relies on the assumption that capital owners are sensitive to net returns to
capital (i.e. to tax differentials) when making portfolio choices or investment
décisions. Settings of thèse tax compétition models are essentially twofold.
The authors are grateful to Bertrand Crettez, Luca Onorante, Pierre Pestieau, Ludger Schuknecht, Rolf
Strauch, Emmanuelle Taugourdeau, Juergen von Hagen, an anonymous référée of the ECB Working Paper
Séries and three anonymous référées of this review for comments and constructive criticism. An earlier
version of this paper was presented at the 5th Banca d'Italia Workshop on Public Finance (Perugia, 3-5
April 2003). Comments from Vieri Ceriani, David Heald, Michael Keen, Ranjana Madhusudhan and other
workshop participants are also gratetully acknowledged. The opinions expressed herein are those of the
authors and do not necessarily reflect those of the European Central Bank.
marco.catenaro@ecb.int jean-pierre.vidai ©ecb.int
See Wilson (1999) for a comprehensive survey.Recherches Économiques de Louvain - Louvain Economie Review 72(1), 2006
On the one hand, small open économies compete for a fixed amount of inter-
nationally mobile capital (e.g. Zodrow and Mieszkowski, 1986), but fail to
internalise the impact of their respective tax policies on the world after-tax
return to capital. On the other hand, governments are assumed to engage
in tax games à la Nash, in the context of which they are, however, aware
that their tax policy affects the after-tax return to capital (see for instance
Wildasin. 1988). Under both settings, capital mobility drives down capital
tax rates, albeit to a lower extent in the latter class of models. When tax
revenues finance public goods, this results in an under-provision of local
public goods that negatively affects the citizens' welfare. Nevertheless, tax
compétition is welcome if governments are revenue-maximisers and subor-
dinate their compétitive behaviour to, for example, the aim of increasing
their size. Clearly, a normative assessment of tax compétition ultimately
dépends on the views one has on the préférences of governments (Edwards
andKeen, 1996).
Even though the above static tax compétition models generally con-
clude that tax compétition leads to a "race-to-the-bottorn", empirical re-
search has so far found mixed évidence at best about a significant downward
effect of capital mobility on tax rates. In this regard, a récent review of em
pirical studies on the sensitivity of capital flows to tax rates by Krogstrup
(2003) has also concluded that capital tax compétition would appear to hâve
put a downward pressure on capital tax rates while shifting the burden from
capital to labour in EU member states during the 1980s and 1990s. This
pressure seems to hâve been counteracted by agglomération économies. Re-
garding the location choice of foreign direct investment, it is stressed that,
on the one hand, empirical évidence supports the view that the tax policy of
a country does not affect the choice of its résident investors between home
and foreign investment. On the other hand, a country's tax policy affects
the investment décisions of prospective foreign investors.
This paper attempts to reconcile theory and évidence by extending
the basic tax compétition model to account for repeated policy interactions
between governments. We argue that, when such interactions are associa-
ted to a systematic "punishrnent" of the deviating policymaker, the Nash
equilibrium outeome of static tax compétition models may not necessarily
coincide with the outeome of the tax game in a repeated interaction fra-
mework. On the contrary, goveinments may secure a co-operative outeome
by threatening to retaliate if one of them déviâtes from the co-ordinated
tax rates. In such a case, explicit policy co-ordination via a supra-national
tax authority would not be necessary. However, one could argue that some
explicit tax co-ordination might be désirable in order to avoid the pitfalls of
compétition from smaller économies, when there are incentives to free ride.
This policy asymmetry relates to the fact that large régions face a weaker
response of the capital stock to tax rates, which means that they are less
inclined to engage in tax compétition. By contrast, as compétition gene
rally benefits smaller économies, the latter are more likely to be the sourceMarco Catenaro, Jean-Pierre Vidal
of négative externalities to large countries in the absence of supra-national
régulation.
To our best knowledge, there are only few papers in the literature
addressing the topic of fiscal compétition in a repeated interaction frame-
work. In his model of property tax compétition, Coates (1993) assumes that
governments do not take into account the externalities associated to the use
of their domestic tax rate, showing that there may be incentives to sub-
sidise capital. Cardarelli, Taugourdeau and Vidal (2002) extend upon the
framework developed by Coates, setting up a repeated interactions model
of tax compétition and establishing the conditions under which tax policy
harmonisation can resuit from repeated interactions between the policyma-
kers. They show that tax harmonisation will not prevail in the case of strong
régional asymmetries2, in which case the establishment of a centralised fis
cal authority is suggested as a solution to the tax compétition problem. In
a related game theoretical approach inspired by Barro and Gordon (1983),
Fourçans and Warin (2002) also find that the lack of explicit tax harmonisa
tion may not lead to a "race-to-the-bottom" of tax rates, as a co-operative
outcome can resuit from repeated interactions between governments.
This paper aims to build upon the model by Cardarelli et al. by looking
at capital tax compétition in a repeated interaction fiamework characterised
by the absence of capital mobility sunk costs. While such costs were postu-
lated in their paper to avoid a zéro tax rate on capital under the assumption
of linear technologies, the underlying assumption in our paper is that pro
duction occurs according to Cobb-Douglas technologies. Furthermore, we
analyse the rôle of cross-country asymmetries on the outcome of the tax
compétition repeated game. We adopt the view that governments compete
for a fixed world supply of capital and abstract from welfare considérations,
assuming that governments only aim to maximise tax revenues. Moreover,
governments are either short-sighted, maximising only current revenue, or
far-sighted. seeking to maximise a discounted sum of current and future tax
revenues. Only under the second scénario is the co-ordinated tax outcome
ultimately sustainable, provided cross-country asymmetries remain limited
and governments are sufficiently patient.
The paper proceeds as follows. Section 2 develops a streamlined one-
shot model of tax compétition. Section 3 extends this model to account for
repeated interactions, while section 4 concludes.
2 The "one-shot" tax game
Let us consider a world economy consisting of two countries (indexed with
subscripts i and j), whose governments compete to tax the income of a fixed
Taugourdeau (2002) extends Ihe analysis of Cardarelli étal. (2002) by considering a bargaining equilibrium
between governments.8 Recherches Économiques de Louvain - Louvain Economie Review 72(1), 2006
and exogenously given world supply of capital. The allocation of capital
between country i and j satisfies :
2k = ki + kj (1)
where 2/c stands for the world total supply of capital. Labour is perfectly
immobile and in fixed supply, whereas capital is perfectly mobile. The pro
duction technologies are assumed to be of the Cobb-Douglas type. The gross
marginal return to capital invested in country i is given by :
n = aAik?-1 (2)
where Ai is a country-specific parameter. capturing cross-country différences
in their endowments of immobile factors such as, for example, labour, land,
or even différences in total factor productivity. For the sake of simplicity3, in
the remainder of this paper we shall refer to Ai as the size of country i. Per-
fect capital mobility implies that net marginal returns to capital are equal
in ail locations. The equilibrium capital allocation is therefore determined
by the arbitrage condition :
(1 - U) aAik?-1 = (1 - t^aAjk"-1 (3)
Governments levy taxes on capital according to the source principle
of taxation4. The capital tax revenue in country i is :
r, = UaAikf (4)
where U is country i's capital income tax rate.
Governments act strategically with a view to maximising capital in
come tax revenue. We assume that governments are intrinsically revenue-
maximisers, hence departing from the view of governments as benevolent
social planners. In this context, it should be noted that our model abstracts
not only from labour income taxation but also from spending, so that we
are focusing on a précise aspect of tax policy, namely the taxation of inter-
nationally mobile capital.
Governments choose their capital income tax rate under the constraint
that capital is perfectly mobile, taking other governments' tax policies as
3 Assuming that production in each country occurs according to a neoclassical technology using three inputs,
capital {k^, labour (^) and land (a^), output is given by : yi = B^fcf lfx\~a~x. When labeur and land
endowments are exogenous, we can write :?/j = Aikf, where AiB^ a;]~a~x reflects différences in
endowments of immobile factors, labour or land, or in productivity.
4 There are two polar principles of international taxation : the résidence (of the taxpayer) principle and the
source (of income) principle. Under the résidence principle, résidents are taxed on their whole income
regardless of its origin. Under the source principle, ail incomes originating in a country are taxed in this
country regardless of the country of résidence of the taxpayer. The source principle is usually assumed in
models of tax compétition; see Razin and Sadka (1994) for a survey on tax compétition.Marco Catenaro, Jean-Pierre Vidal
given. This is a Nash tax game. where government i maximises its capital
income tax revenue (4) from an internationally mobile tax base under the
arbitrage condition for capital (3), taking government j's capital tax rate
as given. Government i's reaction function is therefore the solution to the
following maximisation problem :
max tiaAi [ki (ti,tj))a (5)
where
is the equilibrium stock of capital as a function of tax rates resulting from
the arbitrage condition (4).
After some computations, the reaction function of government i, U =
Ri (tj), is defined by the following équation, which results from the fîrst-
order condition of problem (5) :
Note that although one does not obtain an anaJytical solution for
government i's reaction function iî^, the properties of the above expression,
which implicitly defines this function, can be easily analysed. Equation (7)
is of the form :
where x, y and F dénote 1 — U, 1 — tj and ^, respectively. The domain
of / is [0, q[ and its range [0, +oo[. One can easily check that / is strictly
increasing and convex on ]0, a] (implying strict concavity of government i's
reaction function) and that /(0) = 0, lim f(x) = +oo and /(0) = 0.
x—»a
The reaction function of government j is derived analogously :
This expression, which can be easily obtained from (7) by substituting
i with j, is of the form :
l-a

Implicit tax co-ordination under repeated policy interactions

http://sites.uclouvain.be/econ/DP/REL/2006011.pdf

Implicit tax co-ordination under repeated policy interactions

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics