The intuition is simple and, at least at the level of popular debate and policy discussion, compelling: when corporations face few barriers to locating in the lowest tax jurisdiction, countries will be forced to compete for mobile capital with artificially low tax rates. In an era of “globalization” that is, international economic integration and an accompanying increase in capital mobility the implication is that governments may find themselves drawn into an internecine “race the bottom” in capital taxation, undermining the financing of the welfare state and the provision of public goods generally. Further, taxes must then come to fall unduly on immobile factors, specifically labor, exacerbating labor market rigidities and unemployment.
The popular appeal of this common sense fuels not only the fears of anti-capitalist activists and the hopes of some seeking lower taxes (e.g. Economist [1997], Lee and McKenzie [1989]), but also policy initiatives by governments struggling with persistent budget deficits. During the 1990s, both the OECD and EU took up the issue of “harmful tax competition,” concluding that international cooperation was needed to prevent the erosion of corporate tax revenues and the introduction of distortions to the international allocation of capital [OECD, 1998].
The view that, in an attempt to prevent mobile capital from fleeing, governments are led to adopt inefficiently low capital taxes and a suboptimal level of public goods provision, was first articulated in modern form by Oates [1972]. The idea was subsequently formalized in now-canonical models by Zodrow and Mieszkowski [1986] and Wilson [1986]. Propelled by widespread interest in this issue, a large theoretical literature surveyed by Wilson [1999] explores extensions to the Zodrow Mieszkowski-Wilson framework.
These models of tax competition among sub-national government authorities had an obvious application to the international context as barriers to international capital mobility eroded during the post-1945 period, a trend that accelerated in the 1980s. Building on the work of Diamond and Mirrlees [1971], tax economists like Gordon [1992] and Razin and Sadka [1991] argued that taxes on corporations were no longer a viable option for small open economies. Even if governments continued to levy corporate income taxes, the incidence would fall on labor in the form of lower wages. The claim that economic globalization undermined the taxing capacity of national governments became a staple of the critical scholarly literature on economic globalization in the 1990s [Teeple, 1995; Scholte, 1997; Strange, 1996].
Empirically there can be little doubt that corporate investment decisions are sensitive to tax policy. The substantial body of evidence supporting this not very surprising proposition has been surveyed by Hines [1999] and Devereux and Griffith [2002]. Recent contributions include Devereux and Griffith [1998], who study the determinants of investment location, and Devereux, Lockwood, and Redoano [2002], who estimate country reaction functions and find that countries compete over corporate tax rates.
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