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Tax Harmonization versus Tax Competition: A Review of the Literature

Tax Harmonization versus Tax Competition: A Review of the Literature


Tom Stults's Entry For The 2004 Moffatt Prize in Economics

As the European Union heads down path toward a more complete integration, several economic policy questions have arisen and now remain without a definitive response. Among these, perhaps none are as contentious as the future of taxation within the Union. But before even addressing the diverse arguments surrounding the topic, it is important to note just why the issue is so salient. First, following the introduction of EMU and the "Europeanization" of monetary policy, fiscal policy including taxation remains one of the few tools left at the disposal of national governments in their effort to influence their own economies. Furthermore, even fiscal policy has been constrained by the introduction of the Stability and Growth Pact, making taxation perhaps the final component with which individual countries can deal with asymmetric shocks. This being said, it is no surprise that the debate over taxation within the EU is a heated one. This being said, the literature on the subject is fueled by one central question: Is regulated tax harmonization or is market driven tax competition the best solution to the awkward state of asymmetric tax rates that currently exists in the EU? Not surprisingly, the existing viewpoints run the gamut from entirely pro-harmonization to pure pro-competition stances. As a whole however, the literature simply reveals the ambiguity of the issue, as reflected by its increasingly complex attempts to convey the reality of the European situation.

As we have already mentioned, the question of taxation within the EU (and EMU) has become a crucial one. Of course, the concern over the subject springs from a general acknowledgement that increased integration within the Union will pressure asymmetrical tax rates among member countries to converge to some point. The simple knee-jerk logic is this: As factor mobility increases within the EU, pressure will be placed on member states to lower their tax rates on mobile factors in order to attract business. This unchecked competition will lead to a 'race to the bottom' in which tax rates will dip so low as to threaten countries' abilities to supply public goods. In response, one might argue for the necessity of strict supranational rules that set a harmonized tax rate at a level that guarantees the adequate supply of these public goods. In fact, the EU requires "a value-added tax of at least 15 percent, and the Brussels-based bureaucracy is seeking to harmonize taxes on corporate income, tobacco, energy, and digital products," which clearly illustrates a rule-led effort toward harmonization. (Mitchell, 1) Yet, as was hinted in the introduction, this simple reasoning and the policies that have resulted from it are far-removed from the reality facing members of the EU (and are certainly not unanimously accepted by member countries). The broad array of suggestions presented by scholarly arguments lends credence to this fact. As we shall show, there exists substantial support for four main options: rule-led tax harmonization, the imposition of a minimum tax floor, or unregulated tax competition, either with or without informal coordination.

However, the earliest literature on the subject does, in general, reflect the simplistic logic laid out in the previous paragraph. As expected, scholars such as Oates predict an underprovision of public goods in an unregulated scenario: "The result of tax competition may well be a tendency toward less than the efficient levels of outputs of local public services. In an attempt to keep tax rates low to attract business investment, local officials may hold spending below those levels for which marginal benefits equal marginal costs." (Oates, 143) This general idea is also reflected by the work of Zodrow and Mieszkowski's 1986 essay, which cites a shortage of public goods as the result of mobile capital and tax competition. These scholars would clearly support some set of strict rules that harmonize taxes at a level high enough to ensure the continuity of public goods.

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