20/02/25
Is Corporate Tax Competition Harmful Or Efficient?
To address whether international corporate tax competition is harmful or beneficial, we must first examine the purpose and rationale behind corporate income taxes. The history of the US corporate income tax offers important context. When the tax was introduced in 1909, the rate of one per cent impacted only businesses earning over $5000. It then gradually increased over the years, peaking at 52.8 per cent in 1968, accounting for 23 per cent of federal revenues. However, by the 1970s, these high tax rates were seen as a barrier to economic growth. This shift in thinking led to the belief that reducing corporate tax rates would foster investment and spur economic growth, ultimately increasing revenues and benefitting the middle class through higher wages and incomes. In response, the corporate tax rate was reduced to 35 per cent in 1993 and then to 21 per cent in 2017 under the Tax Cuts and Jobs Act. Over time, the corporate income tax's share of federal revenues has steadily declined, currently accounting for about seven per cent. Perhaps more importantly, these changes in US tax policy have occurred alongside global efforts to reduce corporate tax rates, resulting in global corporate tax competition. This article explores what research tells us about the effects of this tax competition on the economy and recent efforts to move towards tax harmonisation.
Trends In Corporate Taxation
Over the past 42 years, corporate tax rates have steadily declined on a global scale. As per the Tax Foundation, in 1980, the average worldwide statutory corporate tax rate was 40.11 per cent.[1] By 2022, this rate had decreased to 23.37 per cent, marking a 42 per cent reduction. The weighted average statutory tax rate, which accounts for countries’ economic contributions, has consistently been higher than the simple average during this period. Before the US tax reform in 2017, the United States imposed relatively high corporate tax rate of 35 per cent. The reform significantly reduced the US corporate tax rate to 21 per cent, which contributed to a decline in the worldwide weighted average rate from 46.52 per cent in 1980 to 25.43 per cent in 2022. Globally, more countries have adopted corporate tax rates of 30 per cent or lower. The most substantial shift occurred between 1990 and 2000, with the percentage of countries taxing below 30 per cent rising from 27 per cent in 1990 to 48 per cent in 2000. This trend accelerated in the following decade, with 78 per cent of countries imposing statutory rates below 30 per cent by 2010.
Empirical research suggests that foreign direct investment responds to corporate tax rate differences which spurred further tax competition. Studies consistently report a positive correlation between levels of foreign direct investment (FDI) and after-tax rates of return at both industry and country levels. Economists Harry Grubert and John Mutti (2000) find that average effective tax rates play an important role in driving cross-country investments.[2] A one per cent increase in the after-tax return to capital is associated with a three per cent increase in real capital investment if the country has an open trade regime. Economists James Hines and Eric Rice (1994) show that US companies showed high levels of after-tax profits in tax havens with low corporate tax rates, and that these rates created incentives to shift profits out of high tax jurisdictions.[3] These and similar findings collectively imply that FDI volume, along with accompanying economic activity and corporate tax bases, is highly responsive to local tax policies.[4] Consequently, countries that lower corporate income tax rates can anticipate increased foreign investment. This incentive has intensified since the 1980s, as global FDI levels have risen sharply.[5]
How Did The TCJA Impact The US?
The recent change in tax law in the US exemplifies this ongoing impact of tax competition. Prior to TCJA, the US had one of the highest corporate tax rates among developed countries. Post-TCJA, the reduction to 21 per cent brought the US corporate tax rate closer to the OECD average, making the US a more attractive destination for investment. Other changes also incentivised higher investments. It allowed businesses to deduct the full cost of short-lived capital investments (like machinery and equipment) immediately, rather than depreciating them over time. This provision was temporary, with phasing out starting in 2023. The US shifted to a more territorial system by reducing taxes on repatriated foreign earnings, aimed at reducing incentives for profit shifting and encouraging US-based investment. A couple of recent studies find significant impacts of the TCJA on investment and wages. A National Bureau of Economic Research (NBER) study found that the TCJA increased corporate investment by 20 per cent in the years following its implementation, and estimates a likely long run impact on wages of 0.9 per cent.[6] Lower corporate tax rates and full expensing significantly reduced the cost of capital, incentivising businesses to increase spending on equipment, machinery, and other productive assets. A second study finds that the lower corporate taxes resulted in gains to workers, although 80 per cent of the gains went to workers in the top 10 per cent of the income distribution.[7]
Tax Harmonisation: A Shift Away From Tax Competition?
More recently there have been efforts at tax harmonisation—the idea that every country should adopt a common minimum tax rate that prevents competition from driving rates below a certain level. Economists Michael Keen and Kai A. Konrad's paper, The Theory of International Tax Competition and Coordination[8] argues that in a world with many countries competing for investment, each nation has an incentive to lower its tax rates to attract foreign capital. This ‘race to the bottom’ can result in tax rates that are too low to fund essential public services or maintain adequate infrastructure, potentially eroding the tax base of all countries involved. Instead, if countries could coordinate their tax policies, they could avoid this race to the bottom, ensuring that tax rates are set at a level that sustains public goods without unnecessarily undermining each other’s tax revenues. Coordination can also prevent tax havens from attracting too much capital at the expense of higher-tax jurisdictions. The authors reference various models to show how tax coordination might work. The Zodrow-Mieszkowski model describes a situation in which tax competition leads to lower taxes in all countries, reducing welfare. The model suggests that countries could benefit from harmonising tax policies to a higher standard, which would increase overall welfare by removing inefficient tax competition. The Kanbur-Keen model incorporates the strategic behaviour of countries in a dynamic framework, showing that countries may, under certain conditions, prefer to coordinate tax policies to avoid a harmful race to the bottom.
The OECD’s Global Minimum Tax is a move in this direction.[9] It sets a minimum 15 per cent rate for large multinationals irrespective of which jurisdiction they operate in. This framework is an attempt to curb the race to the bottom. However, there are challenges to coordination as evidenced by the current lack of a global agreement on the OECD global tax deal.[10] Different countries have different economic structures, levels of development, and priorities. This makes it difficult to agree on a one-size-fits-all tax policy. Smaller or developing countries might argue that lower tax rates are necessary to attract investment and foster economic growth, while wealthier nations might have more leeway to raise taxes. Second, national governments have domestic political pressures that may conflict with international cooperation. For example, countries with large multinational corporations may be reluctant to agree to higher taxes if it affects the global competitiveness of their firms. Finally, countries may be unwilling to give up sovereignty to set their own tax rates. The enforcement of international tax coordination agreements would also be complex, as it would require mechanisms for monitoring compliance and resolving disputes.
Is The Global Minimum Tax Changing Incentives?
The World Bank and the OECD have recently published papers analysing how the global minimum tax might change the design of countries’ tax incentives. Their recommendations are also in line with benefitting real investment and workers’ wages. The World Bank's report, The Global Minimum Tax: From Agreement to Implementation, explores the implementation of a global minimum tax (GMT) and its potential effects on investment and wages.[11] By ensuring that MNEs face a minimum tax rate globally, the GMT aims to level the playing field, potentially leading to increased investment in jurisdictions with higher tax rates. However, the report notes that the actual impact on investment will depend on how countries adjust their tax policies in response to the GMT. Further, the GMT could influence wage levels indirectly. By reducing tax avoidance, governments may experience an increase in tax revenues, which could be allocated to public services and infrastructure, potentially enhancing productivity and economic growth. This, in turn, could create a more favourable environment for wage growth. However, the report also cautions that the GMT's impact on wages will vary depending on how governments utilise the additional tax revenues and the broader economic context.
The OECD report, Tax Incentives and the Global Minimum Corporate Tax, suggests that tax incentives, such as tax holidays or preferential rates, may become less effective in attracting investment if they result in an effective tax rate below the GMT threshold. MNEs would be subject to top-up taxes to meet the 15 per cent minimum, diminishing the benefits of such incentives. Countries may need to reassess and redesign their tax incentive structures to align with the GMT, ensuring that incentives do not inadvertently lead to tax rates below the minimum threshold. Instead of traditional tax incentives, countries might consider non-tax incentives, such as infrastructure development or workforce training programs, to attract investment without conflicting with the GMT.
In summary, as with any policy, the reality on the ground is that both tax competition and tax coordination, have their pros and cons. Tax competition may be beneficial if it encourages investment and subsequent wage increases, but in the long run has no detrimental impacts on a country’s fiscal situation. If it does indeed result in a harmful race to the bottom that starts to strain country budgets, this could inadvertently hurt workers in the long run. But tax harmonisation, while aimed at reducing tax avoidance, could be increasingly hard to enforce across countries dealing with different economic systems and political pressures. Impacts from these are uncertain and may lead to other types of unintended consequences. Therefore, careful consideration should be involved in pursuing either tax competition or tax harmonisation in order to balance efficiency, equity and economic growth.
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[1] https://taxfoundation.org/data/all/global/corporate-tax-rates-by-country-2023/#:~:text=The%20weighted%20average%20statutory%20corporate,over%20the%2043%20years%20surveyed.&text=All%20regions%20saw%20a%20net,rates%20between%201980%20and%202023.
[2] https://econpapers.repec.org/article/ntjjournl/v_3a53_3ay_3a2000_3ai_3a4_3ap_3a825-40.htm
[3] https://academic.oup.com/qje/article-abstract/109/1/149/1850027
[4] https://www.imf.org/external/pubs/ft/fandd/2001/06/gropp.htm
[5] https://unctad.org/data-visualization/global-foreign-direct-investment-flows-over-last-30-years
[6] https://conference.nber.org/conf_papers/f191672.pdf
[7] https://patrick-kennedy.github.io/files/TCJA_KDLM_2024.pdf
[8] https://gabriel-zucman.eu/files/teaching/KeenKonrad13.pdf
[9] https://www.oecd.org/en/topics/sub-issues/global-minimum-tax.html
[10] https://news.law.fordham.edu/jcfl/2024/10/08/taxing-the-digital-giants-what-the-oecd-global-tax-deal-means-for-the-u-s/#:~:text=Pillar%20Two%20establishes%20a%20global,system%20fairer%20and%20more%20transparent.
[11]https://documents1.worldbank.org/curated/en/099500009232217975/pdf/P169976034c92506a0a1190bc5e3a05e3ed.pdf
Aparna Mathur
Aparna Mathur is a former Senior Fellow at Harvard Kennedy School’s Mossavar-Rahmani Center for Business and Government where she is researching the US social safety net. She is a Visiting Fellow at FREOPP and a Senior Research Manager in Economics at Amazon. Aparna spent a year as a Senior Economist at the Council of Economic Advisers during the pandemic. She joined the Council as part of the COVID-19 response task force at the peak of the crisis in April 2020 and worked with epidemiologists on the health aspects of the crisis, while also tracking the economic downturn that came with the lockdowns. Prior to joining CEA, she was a resident scholar in economic policy studies at the American Enterprise Institute. At AEI, she directed the AEI-Brookings Project on Paid Family and Medical Leave, building bipartisan momentum on paid leave, for which she was recognized in the Politico 50 list for 2017. Her academic research has focused on income inequality and mobility, tax policy, labor markets and small businesses. She has published in several top scholarly journals including the Journal of Public Economics, the National Tax Journal and the Journal of Health Economics, testified several times before Congress and published numerous articles in the popular press on issues of policy relevance. Her work has been cited in leading news magazines such as the Economist, the New York Times, the Wall Street Journal and the Washington Post. She has regularly provided commentary on prominent radio and television shows such as NPR’s Marketplace and the Diane Rehm Show, as well as CNBC and C-SPAN. She has been an adjunct professor at Georgetown University’s McCourt School of Public Policy. She received her Ph.D. in economics from the University of Maryland, College Park in 2005, and is currently serving on the University of Maryland Economics Leadership Council. She is also on the Board of the National Academy of Social Insurance, Simply Green and the National Economists Club.
