Contrary to the belief of many, tax competition did not undermine the foundations of the
welfare state and did not even abolish the taxation of capital. Instead, tax competition caused
governments to shift the tax burden from capital to labor, thereby increasing income
inequality in liberal market economies that traditionally redistribute income by relatively high
effective capital taxes and relatively low effective labor taxes. In contrast, income inequality
did increase little or not at all in social welfare states that dominantly use social security
transfers to redistribute income. Governments in social welfare states found it easy to
maintain high social expenditures because they increasingly taxed labor, which is relatively
immobile, to finance social security transfers. We test the predictions of this theory using a
simultaneous equation approach that accounts for the endogeneity of tax policies, fiscal
policies, and deficits
