The current age of globalization can be distinguished from the previous one (1870-1914) by the much higher mobility of capital than labor. In the previous age, before immigration restrictions, labor was at least as mobile as capital. Today's increased capital mobility reflects both technological changes (the ability to move funds electronically) and policy changes (the relaxation of exchange controls and liberalization of trade rules).
The mobility of capital in turn has led to tax competition, especially for foreign investment. Sovereign countries lower tax rates on income earned by foreigners within their borders in order to attract both portfolio and direct investment. Tax competition, in turn, threatens to undermine the individual and corporate income taxes that traditionally have been the main source of revenue for modern welfare states.
The developed countries responded, first by shifting the tax burden from (mobile) capital to (less mobile) labor, and second, when further increased taxation of labor became politically and economically difficult, by cutting the social safety net. So globalization and tax competition have led to a fiscal crisis for countries that wish to continue providing social insurance to their citizens, at the same time that demographic factors and the increased income inequality, job insecurity, and income volatility resulting from globalization have rendered such social insurance more necessary.
If social insurance programs are to be maintained in the face of globalization, one imperative is to limit tax competition. Democratic nations should remain free to define the desirable size and mission of their governments.
Competing to Cut Taxes
The income tax is more progressive than other forms of taxation such as consumption or payroll taxes, partly because it has graduated rates that rise with income and partly because it includes income from capital as well as labor. However, the ability to tax saved income from capital (income not vulnerable to consumption taxes) is impaired if the capital can be shifted to overseas tax havens. Two recent developments have made it easier for both individuals and corporations to earn tax-free income overseas: the effective end of withholding taxation by developed countries and the rise of tax havens in developing countries. Since the United States abolished its withholding tax on interest paid to foreigners in 1984, no major capital-importing country has been able to impose such a tax for fear of driving mobile capital elsewhere or increasing the cost of capital for domestic borrowers, including the government itself. The result is that individuals can generally earn investment income free of host-country taxation in any of the world's major economies.
Moreover, in the absence of withholding taxes imposed by host countries, even developed countries find it exceedingly difficult to effectively collect the tax on the foreign income of their residents because the investments can be made through tax havens with strong bank secrecy laws. Developing countries, with much weaker tax administrations, find this task almost impossible. Thus, cross-border investment income can largely be earned free of either host- or home-country taxation.
For example, consider a wealthy Mexican who wishes to earn tax-free interest income by investing in the bonds of an American corporation. For a nominal fee, he sets up a Cayman Islands corporation to hold the bonds. The interest payments are then made to that corporation without any U.S. tax withheld under the so-called "portfolio interest exemption." The individual does not report the income to the Mexican tax authorities, and they have no way of knowing that the Cayman Islands corporation is effectively an "incorporated pocketbook" of the Mexican resident. Notwithstanding the U.S.-Mexico tax treaty, the IRS has no way of knowing that the recipient of the interest payments is a Mexican resident and therefore cannot report this to the Mexican authorities. As a result, the income is earned completely free of tax (the Caymans, of course, impose no income taxes of their own). Nor is such tax evasion limited to residents of developing countries. When the IRS recently managed to persuade one tax haven banker to talk, it discovered that most of the accounts were owned by Americans who wished to hide their income from the IRS.
So foreign portfolio investment income largely escapes tax. Likewise, direct investment. In the past decade, competition for inbound investment has led an increasing number of countries (103, as of 1998) to offer tax holidays specifically geared to foreign corporate investors. Given how easily an integrated multinational can shift production facilities in response to tax rates, such "production tax havens" enable multinationals to escape taxes on foreign income. Moreover, most developed countries (including the United States) are reluctant to tax the foreign-source business income of their resident multinationals, for fear of undermining their competitiveness against foreign multinationals or driving them offshore. So business income, like personal investment income, can also be earned abroad largely free of either host- or home-country taxation.
For example: Intel Corporation, a top-10 multinational, has operations in more than 30 countries. The company states that "[a]n Intel chip developed at a design center in Oregon, might be manufactured at a wafer fabrication facility in Ireland, packaged and tested in Malaysia, and then sold to a customer in Australia. Another chip might be designed in Japan, fabricated in Israel, packaged and tested in Arizona, and sold in China." Specifically, Intel has major manufacturing facilities outside the U.S. mainland in Puerto Rico, China, Malaysia, the Philippines, Ireland, and Israel, all of which grant tax holidays. And Intel does not pay current U.S. tax on its income from those foreign operations because, under U.S. law, active income earned by foreign subsidiaries of U.S. multinationals is not taxed until it is repatriated in the form of dividends, which Intel can delay for many years. So the effective tax rate on Intel's foreign-source income is far below the nominal U.S. corporate rate of 35 percent.
If income from capital can escape the income tax net, the tax becomes increasingly a tax on labor. Several empirical studies have in fact suggested that in some developed jurisdictions the effective tax rate on income from capital has dropped sharply since the 1980s and in some cases approaches zero. The two fastest-growing taxes in Organisation for Economic Co-operation and Development (OECD) member countries in recent years have been consumption taxes (from 12 percent of total revenues in 1965 to 18 percent in 1995) and payroll taxes (from 19 percent to 27 percent), both of which are more regressive than the income tax. Over the same period, the personal and corporate income taxes have been flat as a percentage of total revenues (the personal income tax accounted for 26 percent of total revenues in 1965 and 27 percent in 1995, while the figures for the corporate income tax are 9 percent and 8 percent, respectively). In the United States, corporate income tax revenues have dropped significantly from over 25 percent of total tax revenue in the 1960s to less than 9 percent now, and the percentage of tax paid by American corporations out of their book profits has declined from over 30 percent after the 1986 tax act to just over 20 percent now. The total tax revenue as a percentage of GDP in developed countries went up sharply during the same period (from an average of 28 percent in 1965 to almost 40 percent in 1994), and this increase is largely accounted for by the rise of consumption and payroll taxes.
The Social Insurance Crisis
The social safety net is in crisis for two reasons. The first is an increasing life-span and a decreasing number of births in most OECD member countries. The percentage of the population over 60 in the OECD is projected to rise from 18.2 percent in 1990 to 31.2 percent in 2050. Elderly people of course require higher outlays on pension and health programs. Second, globalization itself is linked to increased income insecurity and income volatility, resulting in heightened need for labormarket cushions such as unemployment insurance and retraining subsidies.
As a result of these factors, expenditures on social insurance programs (including pensions, health, and unemployment insurance) in OECD countries are projected to rise from 18.3 percent of GDP in 1990 to 25.5 percent of GDP in 2050, with significantly higher percentages in Japan (27 percent) and Western Europe (33.4 percent). So developed countries must either raise additional tax revenues or cut the social safety net. But, as noted, advanced countries face a diminishing capacity to tax capital and find themselves politically unable to raise income taxes on labor, consumption taxes, or payroll taxes any further. It's not clear this would be good policy in any case. High rates of income tax on labor discourage work, high payroll taxes discourage job creation and contribute to unemployment, and high general consumption taxes punish the working poor, while taxes on luxury goods drive consumption overseas. (The United States has more scope to raise taxes, since its overall level of taxation is significantly below the OECD average and it is the only OECD member without a consumption tax at the federal level.)
By default, the only recourse under current tax structures is to cut the social safety net. However, cutting that net threatens to erode the social consensus that underlies modern industrialized societies--and to create a backlash against globalization, despite its overall benefits. The previous age of globalization collapsed in the face of such a backlash in the 1920s and 1930s. The alternative is to restore the capacity to tax, in part by limiting burgeoning tax-cut competition.
Preventing a Race to the Bottom
The tax competition problem is partly one of coordination and trust. Each jurisdiction would prefer to tax investors from abroad to gain the revenue, but is afraid to drive investors to tax havens. If there were a way to coordinate actions among nations, they all could gain added revenues without running the risk of losing the investment.
A good illustration of how this dynamic works is the recent history of German taxation of interest income. In 1988 Germany introduced a 10 percent withholding tax on interest paid to bank depositors, but had to abolish it within a few months because of the magnitude of capital flight to Luxembourg. In 1991 the German Federal Constitutional Court held that withholding taxes on wages but not on interest violated the constitutional right to equality. The government then reintroduced the withholding tax on interest, but made it inapplicable to nonresidents. Nonresidents may, however, be Germans investing through Luxembourg bank accounts. To cope with this problem, the Germans have led an EU effort to introduce a 20 percent withholding tax on all interest payments to EU residents. However, both Luxembourg and the United Kingdom have so far blocked the adoption of this plan, arguing that it will lead to a flight of investors to Switzerland or the United States.
So the tax competition problem requires a broad multilateral remedy, through an organization such as the OECD. If all OECD members enforced taxation of portfolio investment, it could be subject to tax without requiring cooperation from developing-nation tax havens, which are considered too risky for portfolio investment without the tacit collusion of OECD countries. About 85 percent of the world's multinationals are headquartered in OECD member countries. This is likely to continue a while because OECD members offer stable corporate and securities law protection to investors that is often lacking in other countries. If all OECD members agreed on a coordinated basis to tax their multinationals currently on their income from abroad, most of the problem of tax competition from both direct and portfolio investment could be solved.
The OECD has the required expertise (its model tax treaty is the global standard) and has already started on the path of limiting tax competition. In 1998 it adopted a report entitled "Harmful Tax Competition: An Emerging Global Issue." This report is somewhat limited because it only addresses tax competition for financial activities and services (as opposed to, say, Intel's manufacturing plants). And the model treaty does not address the taxation of investment income. But it represents an extremely useful first step and proof that a consensus can be reached on the tax competition issue. Switzerland and Luxembourg abstained but did not dare veto the adoption of the report by the other 27 members of the OECD.
The OECD makes a useful distinction between tax competition in the form of generally applicable lower tax rates and tax regimes designed to attract foreign investors. Restricting tax competition should not and cannot mean that voters in democratic countries lose their right to determine the size of the public sector through general tax increases or reductions. But it does mean that countries should not provide windfalls for foreign investors at the expense of the ability of other countries to provide those public services their residents desire. Such limitations are particularly appropriate because those foreign investors themselves often reside in countries providing a high level of public services and yet refuse to pay the tax price that providing such services entails.
Depending on the OECD for solving the tax competition problem suffers from one major drawback: Developing countries are left out and may perceive the OECD as a cartel of rich countries operating at their expense. But it is unlikely that general tax competition benefits developing countries, who need the tax revenues they give up to attract foreign investors. If all developing countries could be prevented from competing in this fashion, they all could gain. In the longer run, the need for global standards and the fight against harmful tax competition could become part of the World Trade Organization's agenda, or even require a new "world tax organization," in which developing countries are adequately represented. This would also solve the problem of what to do about the 15 percent of multinationals who are not headquartered in OECD member countries, a percentage that can be expected to grow if the OECD indeed moves to restrict tax competition for its multinationals.
Governing Global Commerce
As a result of globalization and tax competition, tax rules can no longer be set by countries acting unilaterally or even by bilateral tax treaties. In a world where capital can move freely across national borders and multinationals are free to choose among many investment locations, the ability of any one country (or any two countries in cooperation) to tax or otherwise regulate such capital is severely limited. Any such unilateral attempt will be undercut by other countries and will probably not even be attempted in the name of preserving national competitiveness. Thus, a multilateral solution is essential if the fundamental goals of taxation or other regulation are to be preserved. Private market activities that span the globe can only be regulated or taxed by organizations with a similar global reach.
Achieving this goal will not be easy, given the likely resistance of both private investors and corporations eager to preserve their freedom from taxation and of governments concerned about preserving their sovereign ability to set their own tax rules. But it is not impossible. Although champions of pure globalization tend to understate such problems, the corrosive effect of global commerce on government's ability to underwrite public welfare is another issue that must be addressed by concerted supranational action if it is to be addressed at all. The alternative is the slow collapse of the mixed economy on which a balanced market society rests. ¤
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