the international political economy of declining tax rates - National Tax ...

National Tax Journal, Vol. 42, no. 1, (March, 1989), pp. 79-83

THE INTERNATIONAL

POLITICAL ECONOMY TAX RATES

OF DECLINING

DWIGHT R. LEE* AND RICHARD B. McKENZIE** 1. Introduction HE marginal rates at which demoT cratic governments tax income have declined around the world at the same time the taxable income base has been broadened.' Such a widespread fiscal phenomenon calls out for an explanation. (This is especially true since the tax-reform movement has been accompanied by an almost equally widespread international movement to denationalize and deregulate industries and to privatize many government services. )2 What is it that has motivated so many governments to reduce their marginal tax rates on income at about the same time? Without question, an investigation of each country would reveal country-specific considerations behind lower tax rates. But this leaves unanswered the question of why these considerations became more or less relevant simultaneously in many different countries, beginning in the late 1970s. One possible explanation is that an ideological movement elevating economic efficiency over other social objectives has become a dominant factor in determining tax policy in democratic regimes. No doubt ideological considerations have played a' role in the global reduction in tax rates. Ronald Reagan in the United States and Margaret Thatcher in Great Britain share many political views. As important as ideology may be, however, ideology is typically resorted to as a residual explanation of political events and does little to advance our understanding. 3 It has also been suggested that when the United States began lowering its marginal tax rates in 1981, the boost to economic efficiency this gave the U.S. economy moti vated other economies to lower their marginal tax rates in order to remain competitive (Tanzi, 1987). Without deny*The University of Georgia, Athens, GA 30602. **University of Mississippi, University, MS 38677.

ing the importance of this explanation, one wonders why other countries waited on the United States before taking advantag.e of the obvious efficiencies of lower marginal tax rates, or why the United States waited so long to do so. In this paper we offer an explanation for the widespread reduction in marginal tax rates that is founded on the growing competitiveness of governments that can be attributed to the expanding mobility of world resources, most notably, capital (human and physical). In a few words, we argue that modern technological developments have increased the elasticity of demand for earning income within any given governmental jurisdiction, thereby increasing the potential for "capital flight" in response to changes in taxing and regulatory policies of individual countries.4 11. The Basic Model The taxing capability of any democratic government is necessarily Constrained by the existing rules of ordinary politics. Politicians need to get elected and reelected in order to do anything about taxes, and the competition among political parties and their candidates irnposes . an important first limitation on the fiscal authority of democratic governments. The extant procedural rules (limiting, for example, how legislation will be passed) and substantive rules (limiting what matters can be considered) affect fiscal outcomes, but such rules change very slowly. Given the rules and competitive pressures within existing political arenas, democratic governments are also constrained by market forces that are not unlike those faced by firms. One prominent constraining force on government is demand. Individual governments face a downward sloping demand for earned income, meaning the amount of income generated within a given governmental jurisdiction may be expected to be in79


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versely related to the "tax-price" (measured as a percentage of income) charged by the government. The elasticity of the earned-income demand depends upon the competitiveness of what might be termed the "govermental market." The competitiveness of the governmental market, in turn, depends upon a host of factors, not the least important of which are the size of the governmental jurisdiction and the mobility of resources across the jurisdictional lines. An increase in the size of a particular governmental jurisdiction can, ceteris paribus, increase the cost of moving out of a governmental jurisdiction and, hence, reduce the elasticity of demand for earned income. Assuming that revenue is a positive-valued argument in the government's objective function, the tax-price might reasonably be expected to rise with an expansion in the size of the governmental jurisdiction, assuming the other political and economic constraints are held constant. This theoretical line of argument has been employed to explain the relatively higher taxes imposed by the federal government over state and local governments and the increase in taxes associated with the consolidation of governments (McKenzie and Martin, 1975; Martin and Wagner, 1978). It was also the type of governmental theory that underpinned the Founders favorable view of the "compound republic," which they established through the U.S. Constitution (Ostrom, 1983). similarly, an increase in the mobility of resources -especially, but not exclusively, capital-can increase the elasticity of demand for earned income and, therefore, put downward pressures on the tax-prices governments can charge. This is likely to be the case because greater capital mobility implies a reduction in the cost and ease of resource movements across jurisdictional boundaries, which translates into a relatively greater capacity to move in response to tax and regulatory policy changes. The greater capital mobility also implies an increase in the competitiveness of governments because the expected gains from lowering tax-prices and the expected losses from raising (or

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even holding constant) tax-prices can be expected to mount with a relative greater volume of resource movement. Under the influence of growing competitiveness, governments are likely to be more concerned than otherwise with enhancing the efficiency of their economic system, which probably includes concern over reducing, where and to the extent possible, the distorting influence of the tax system. Concern over tax- iduced domestic distortions probably nieans that forced to compete with greater intensity, governments will seek to broaden their tax bases and lower marginal (and, possibly, average) tax rates-that is, reduce the progressivity of (or flatten) their effective tax schedules (from what they otherwise would have been).' 111. The Growing

Mobility

of Capital

The role that resource mobility plays in constraining government is not new. Madison reasoned in The Federal Papers (Hamilton, Jay, and Madison) that the free flow of resources within the United States would restrain the fiscal proclivities of the 6 various states. The constraining role of resource mobility on state fiscal capacities has also played a role in modern discussions of fiscal federalism since at least the 1950s (Buchanan, 1950; Tiebout, 1956; Breton, 1965; and Borcherding, 1977). More recently, the theoretical prospects of linkages between capital mobility and tax policy have been recognized in the context of a model founded on the constraining influence of a country's demand for earned income (Brennan and Buchanan, 1980). The Madisonian model of competitive governments should also be readily applicable to national governments, to the extent that resources are mobile across national boundaries. For several reasons, we submit that the mobility of capital across national boundaries has been growing.' First, transportation costs are being lowered because of technological developments and the deregulation of major transportation modes (Cooper, 1986). The costs of actually transporting a given volume of plant and equipment, and finished products, across


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national boundaries are no longer as ex (and tax), since it can now be reduced to pensive as they once were. The lower computer tapes and chips and sent across transportation costs are showing up in national borders, again, via satellites. dramatically escalating movements of Reductions in the cost of movement of goods and people across national and re- goods, capital and capital goods, enhances gional boundaries. Producers in any gov- the capacity of human and physical capernmental jurisdiction can, therefore, with ital (as well as other resources)." With the greater ease and at lower expense, move cost reductions, production will likely be and take their capital with them. They also spread more thinly throughout the world, need not be as concerned with where goods away from the market centers for the fiare produced, since transportation costs nal goods and services. At the same time, have become a smaller fraction of the to- the full impact of an increase in the ca tal costs of goods and services.8 pacity of capital to move may not be re Second, the size of capital required to vealed in actual capital movements. This produce any given volume of goods has is because the perception of increased been lowered. Greater and greater com- capital mobility may cause governments puting power has been reduced to smaller to adjust their tax policies toward capital, and smaller computer chips. The computand/or the income that can be earned from ing power of personal and mini computers capital. 12 The capacity of capital to move, has increased at the same time that their whether it actually moves or not, is at the "footprint" has decreased (Blumenthal, heart of the growing policy debate over 1987; 532-535), and there is every reason the ability and willingness of world govto expect a continuation of past trends ernments to coordinate their policies, es(which makes current investment at a pecially fiscal and monetary policies (Fie distance all the more attractive).9 A tex- leke, 1988; Cooper, 1986; and Frankel, tile production rate that until recently re 1986). quired an entire floor of machinery can Granted, entrepreneurs who move their now be produced with one modest-size capital to another country can still face machine, i.e., an air-jet loom. Most job domestic taxation of their foreign-earned growth now occurs in "small" firms (Birch, income, once the income is repatriated. The 1987). Production processes that once re- entrepreneurs may have to renounce their quired long assembly lines in buildings citizenship and even move abroad to fully that covered tens of acres can now be escape higher domestic taxation of their packed in plants with a fraction of the floor resources or to benefit from lower taxaspace. Firms are "down-sizing," a process tion abroad. Also, countries have strinthat is likely to continue (Crandall, gent immigration and emigration restric1988).lo tions that reduce the mobility of people Third, communications have has been and their capital and that impair the imdrastically improved and made less ex- pact of technological forces on the elaspensive. Firms can, with greater ease and ticity of demand for earned income. Howat lower cost, spread production among ever, such domestic tax and migration several plants scattered throughout the rules do not necessarily negate the imworld and still maintain contact through pact of changing technology and its influsatellites (and computers with modems, ence on the international mobility of refax machines, and telephones). Techno- sources. logical developments in communication Furthermore, the growing internapermit the decentralization of capital and tional mobility of capital does increase the the shifts in the use of capital through ability of entrepreneurs to shelter their "out sourcing," often at close to the speed income for a time in foreign countries and and cost of light (Cooper, 1986; Blumento manipulate their investments on a thal, 1987). world-wide scale in order to evade and Fourth, information has become a pro- avoid taxes (for example, through the gressively more important form of capi- maintenance of secret bank accounts and, tal, and information is difficult to contain probably more importantly, through as-


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signment and reassignment of production costs across national boundaries to minimlze tax payments). Capital mobilityespecially its financial dimensions-can increase the difficulty countries face in tracking and validating their residents' incomes and deductions. Simply stated, greater mobility of capital and other resources simply increases the opportunity set for earning an income through producing and taking advantage of taxavoiding opportunities, especially those offered in the world's tax havens. Finally, greater international mob or the potential for "capital flight," in real terms means migration of a country's savings. With the savings can go the country's ability to grow in terms of its jobs and income base-from which the government draws far more of its revenues than it might receive from contin ued higher taxes on repatriated foreignsource income. A particular government may be able to recover a portion or all of the lost taxes from the income on capital, per Se, by continuing to tax all repatriated (or even earned) foreign profit income. However, because of capital flight, it must suffer a loss of the growth in tax revenuegenerated by non-capital foreign resources.

IV. Concluding Comments Considered in the Most favorable light, we would not argue that we have presented a complete explanation for the globaldecline in marginal tax rates. Ideological considerations are not totally absent in the workings of the world economy, though they play no role in our discussion.Also, as recognized by others, through competition among governments, tax reform can beget tax reform, a consideration that is clearly consistent with, andindeedreinforces,our explanation. We have identified an exogenous change in economic

circumstances

-resource

bility-that exerts a simultaneous

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influence on tax Policy on countries around the globe. Growing evidence on tax policy around the world offers tentative albeit U_ incomplete, support for these concl sions.'3 Nonetheless, we recognize that

explaining the worldwide trend toward lower income tax-rate structures warrants more study. Hopefully, our discussion will motivate, and serve as a useful guide to, such study. ENDNOTES 'See Tanzi (1987) and Reynolds (1988) Indeed the has been growing less progressive since the 1970s. See Pechman (1985). 2 See Organization for Economic CooperaLion and Development (1986), Fixler and Poole (1988), Poole (1988), and Hanke (1987) 3 Representative of a growing literature on the importance (or unimportance) of ideology in determin ing political events are Kalt and Zupan (1984), Kau and Rubin (1979), Nelson and Silberberg (1987), and Peltzman (1985). 'Our analytical discussion can, at times, be viewed as drawing on and extending the work of Brennan and Buchanan (1980; mainly Chapter 3) in which the auth rs argue that governments are necessarily con straioned by the elasticity of demand for earning in come within any given governmental jurisdiction. We acknowledge the criticisms leveled against the "Lev iathan" model (Oates, 1985) However our concluions are not dependent upon such an extreme model sofgovernment behavior. Our conclusions also emerge from other less extreme models of government behavior, so long as goverrunent does have some objective function that is maximized within given political and economic constraints. 'These results hold for Leviathan governments that seek to charge the monopoly tax-price, but they also hold for the government that seeks to minimize the inefficiency from raising a fixed amount of revenue. In essence, the greater capital mobility causes the income demand curve to pivot on the initial tax-price (whether the imtial tax-piice is the monopoly tax pnee, the revenue-maximizing tax-price, or some lower taxprice chosen because of political or efficiency con traints). These points are developed in Lee and r'MeKenzie (1989). 6This organizational structure of government en visioned by the founders is developed at length in Ostrom (1983). 7 These reasons are developed with additional de tails in McKenzie (1988). 8rhe exact dimensions of the growing international openness and interdependency of national economies are surveyed in Cooper (1986). See also Fieleke (1988). 90n both of these points see Keatley (1985). locurrent surveys also indicate that a sizable per centage of companies are reducing the sizes of their plants and that the "down-sizing" process will likely continue (as reported in Wattenberg, 1988) "The actual movements of capital have, apparently been relatively small in relationship to domes tic pr'oduction and saving rates. Available analyses of data on the extent to which international capital movements have been able to narrow the real interest rate differential are not, at this writing, in full greement. See Fieleke (1988) and Frankel (1986). a 'Clearly, an increase in capital mobility will affect

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policies other than tax policies, for example, the extent and cost of business regulation. However, that is a topic beyond the scope of this article. "Our arguments are also consistent with global trends among world governments to deregulate and privatize government services (Fixler, 1988; Hanke, 1987). We recognize that base broadening has often offset the effects of marginal rate reductions. In addition, corporate tax rates were effectively raised in the United States under the guise of tax reform in 1986. At the same time, to the extent that the marginal tax rate schedule is flattened incentives can be improved and economic efficiency can be enhanced, especially if the growth in government expenditures is curbed at more or less the same time, which has been the trend across many countries (McKenzie, 1988). Finally, with the confluent of a multitude of domestic and international forces interacting within various domestic political arenas, not all of which are tied directly to economic considerations, no one should expect all fiscal changes in every country to be in one direction at every point in time.

REFERENCES Birch, David L., 1987. Job Ceatio-. in America (New York; Free Press). Blumenthal, Michael W., 1987/1988 "The World Economy and Technological Change," Foreign Af fairs (Winter): 529 550 Borcherding, Thomas E., 1977. Budgets and Bureau crats: The Sources of Government Growth (Durham, N.C.: Duke University Press), essays 3, 4, 7, and 8. Brennan, Geoffrey and James M. Buchanan, 1980. The Power to Tax (Cambridge: Cambridge University Press). Breton, Albert, 1965. "A Theory of Government Grants," Canadian Journal of Economics and Political Science (May): 175 187 Buchanan, James M 1950. "Federalism and Fiscal Equity," Anwrtcaii Ecotioinic Review (Fall): 583 599. Cooper, Richard N , 1986 "The United States in an Open Economy," Hoiv Open Is the U.S. Economy? R. W. Hafer, ed. (Lexington, Mass.: Lexington Books, Inc ): 3 24. Crandall, Robert W., 1988. "The Regional Shift of U.S. Economic Activity and Its Implications for Economic Welfare" (Washington: Brookings Institu tion, draft, June 22). Fieleke, Norman S., 1988. "Economic Interdependence between Nations: Reasons for Policy Coor dination," New England Economic Review (Federal Reserve Bank of Boston, May/June): 21 38. Fixler, Philip E. and Robert W. Poole, Jr, 1988. Pri valuation 1987- Second Annual Report on Privati zatwn (Santa Monica Reason Foundation, Inc.). Frankel, Jeffrey A, 1986 "International Capital Mo bility and Crowding-Out in the U.S. Economy: Imperfect Integration of Financial Markets or of Goods Markets?" How Open Is the U.S. Economy? R. W. Hafer, ed. (Lexington, Mass.; Lexington Books, Inc.)33 67. Hamilton, Alexander, John Jay; and James Madison, n.d. The Federalist, No 51 (New York: Modern Li brary Edition).

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Hanke, Steve H., ed., 1987. Privatuation and Devel opment (San Francisco: International Center for Economic Growth). Kalt, Joseph P., and Mark A. Zupan, 1984. "Capture and Ideology in the Economic Theory of Politics," American Economic Review (June): 279 300 Kau, James B. and Paul Rubin, 1979. "Self Interest, Ideology, and Logrolling in Congressional Voting," Journal of Law and Economics (October): 365 84. Keatley, Anne G., ed., 1985. Technological Frontiers and Foreign Relations (WashingtonNational Academy of Science). Lee, Dwight R. and Richard B. McKenzie, 1989. "Cap ital Mobility and Tax Reform under Leviathan," working paper (St. Louis: Center for the Study of American Business, Washington University). McKenzie, Richard B., 1988. "The Twilight of Gov erinnent Growth in t Competitive World Economy, Policy Analysis (Washington Cato Institute, July). McKenzie, Richard B. and Dolores T. Martin, 1975. "Migration Costs, Bureaucratic Profits, and the Consolidation of Local Governments," Public Choice (Fall). 95 100. Martin, Dolores, T. and Richard Wagner, 1978. "Institutional Framework for Municipal Incorporation- An Economic Analysis of Local Agency For mation Commission in California," Journal of Law and Economics (October). Nelson, Douglas and Eugene Silberberg, 1987. "Ide ology and Legislator Shirking," Economic Inquiry January): 15 25. Oates, Wallace E., 1985. "Searching for Leviathan: An Empirical Study," American Economic Review (September)- 748-57 Organisation for Economic Cooperation and Development, May 1986 "Deregulation and Privatiza tion," OECD Observer, no. 140, pp. 14 17. Ostrom, Vincent, 1983. The Political Theory of a Compound Republic: A Reconstruction of American Democracy as Presented in The Federalist, rev. ed. (Blacksburg, Va.: Center for the Study of Public Choice, Virginia Polytechnic Institute and State University). Pechman, Joseph A, 1985 Who Pays the Taxes? (Washington DC: Brookings Institution). Peltzman, Sam, 1985. "An Economic Interpretation of the History of Congressional Voting in the Twentieth Century," American Economic Review (September): 656-75. Reynolds, Alan, 1988. "International Tax Competition," a paper prepared for presentation at a con ference on Taxes and Growth, sponsored by the Manhattan Institute for Public Policy Research (Frankfurt, Germany; May 30). Poole, Robert W., Jr., Fall 1988. "Stocks Populi: Privatization Can Win Bipartisan Support," Policy Re view, pp. 24 29. Tanzi, Vito, 1987. "The Response of Other Industrial Countries to the U.S. Tax Reform Act," National Tax Journal (September): 339 355. Tiebout, Charles M., 1956. "A Pure Theory of Local Government Expenditures," Journal of Political Economy (October): pp 415-424 Wattenberg, Ben, 1988. "CEO'@ Optimistic about Fu ture of Business," Greenville S C.) News (March 5): 4A.