Tax Harmonization versus Tax Competition: A Review of the Literature

In their paper deceptively entitled "International Tax Competition and Gains from Tax Harmonization," Assaf Razin and Efraim Sadka lay a foundation in support of coordination between member countries. They first introduce a scenario that is "of particular relevance for Europe," in which member countries are recently faced with the prospect of tax competition. (Razin, 3) They argue that, "if the competing countries are sufficiently coordinated with the rest of the [region] so as to be able to effectively tax their residents on their income from capital in the rest of the [region], then tax competition leads each country to apply the residence principle of taxation and the equilibrium outcome is efficient." (Razin, 3) This simply implies that ad hoc discussions between EU members can establish a common tax policy that eliminates the need for strict harmonization in the face of tax competition. The dangers presented by non-coordination are made clear: "tax competition leads to no tax whatsoever on capital income… Naturally the outcome of tax competition in the case in which countries cannot tax their residents on capital income from the rest of the [region] is welfare-inferior to the case where they can. Thus, there are gains for the competing countries from tax coordination…" (Razin, 4) Similar to the rest of literature reviewed, Razin and Sadka clearly recognize the potential downward pressures of tax competition on mobile capital; they are nonetheless unique in promoting simple coordination within the EU as the most effective solution.

There are still other viewpoints that see continued interaction between member countries as an adequate guarantor of tax stability. Specifically, it can be argued that interactions within the EU framework (specifically with respect to the Stability and Growth Pact) protect against harmful tax competition, therefore rendering superfluous any additional tax harmonization rules. Thierry Warin and André Fourçans, who use a game theoretical approach to predict the outcome of the European tax situation, adopt this logic. As is true for almost all the literature reviewed, there exists the belief that some degree of tax competition does in fact exist, and demands a response. Yet the paper questions the EU's harmonization strategy, where taxes on savings will face "a minimum common rate of 15% until 2004, then 20% until the end of 2009…" (Fourçans, 3) The main reason is this: "as monetary policy is 'federalized', and as fiscal policy is constrained by the Stability and Growth Pact, taxation becomes the last macroeconomic instrument within governments' hands to deal with asymmetric shocks." (Fourçans, 4) With this in mind, tax harmonization appears overly restrictive. Yet the argument goes further by demonstrating that even a minimum tax floor may be unnecessary. Using game theory between member countries, it is argued that infinite interactions prevents a race to the bottom, and "underlines the role of tax competition to reach stability of the system." (Fourçans, 5) This stability is undeniably enhanced by each country's adherence to the Stability and Growth Pact: In the game theory model provided, "it is of a paramount importance for a country to be able to give a strong signal to the other country that a war of attrition is possible. For that, countries must have sound public finances." (Fourçans, 17) Clearly, the Stability and Growth Pact assures the existence of such sound public finances.

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