The Political Foundations of Tax Competition

According to the conventional wisdom in international political economy, tax competition increases domestic income inequality by decreasing the tax burden on capital and by increasing the (relative or absolute) burden on labour. According to the conventional wisdom in comparative political economy, labour income is generally the major source of income of the median voter. If both wisdoms hold, tax competition should be a short-lived affair because median voters would pressurize governments to stop it. Yet, this doesn’t happen. Instead, governments in Ireland and elsewhere insist on keeping their capital taxes low (with the full support of the Irish labour party by the way!) and block attempts at European tax harmonization. Why?

To answer this question, we build a theoretical model of asymmetric tax competition. The model includes two countries (one large and one small). In each country, the median voter is a poor wage earner: labour sets the capital tax rate. Nevertheless, tax competition persists in equilibrium because labour in the small country benefits in net-income terms (through net capital inflows and hence, higher wages and employment). This explains why tax competition is politically robust even if rich capital owners have no control over the tax rate. We test the empirical implications of our model against a sample of European countries and discuss theoretical and normative implications.