Tax competition: An era of mixed messages

By Michael Alberga, partner, Myers & Alberga

The ‘harmful tax competition’ campaign of the Organisation for Economic Cooperation and Development (OECD) is stalled. Many low-tax jurisdictions did send so-called commitment letters to the Paris-based bureaucracy earlier this decade after being threatened with financial protectionism, but almost all the persecuted financial centres insisted that the letters would be binding only if the ‘onshore’ nations also agreed to abide by the same misguided rules – the ‘level playing field’ requirement. And since OECD member nations such as Luxembourg, Switzerland and the US have no intention of emasculating their free-market policies, this stalemates the OECD.

This is very good news for the world economy. Globalisation has generated huge benefits due to an expansion in trade and because governments now face pressure to adopt more market-friendly policies. This process of ‘tax competition’ began about 25 years ago when Margaret Thatcher and Ronald Reagan dramatically slashed personal income tax rates. These policies helped rejuvenate the UK and US economies, but other nations also felt compelled to lower their tax rates in an effort to maintain competitiveness. Today, top income tax rates in industrialised nations are about 23 percentage points lower than they were in 1980.

Tax competition has also helped lower corporate tax rates. Ireland’s decision to slash the corporate rate from 50 per cent to 12.5 per cent was a great boon for the Irish economy, but the impact on other nations – especially in Europe – was equally remarkable. The average corporate tax rate has dropped from nearly 50 per cent to less than 30 per cent. Similarly, the flat-tax revolution in Eastern Europe is another indication that tax competition encourages politicians to improve tax policy even if they are normally disposed to raise tax rates and play the politics of class warfare. At least nine nations now have very successful flat-tax systems, largely because of a desire to attract jobs and investment in a competitive global economy.

Not surprisingly, some high-tax governments resent tax competition. Politicians from these nations believe they have some sort of perpetual right to tax the labour and capital that exists inside their borders at any point in time. They complain that it is ‘unfair’ or ‘harmful’ when economic activity migrates to lower-tax jurisdictions. Unfortunately, they have actioned their complaints by enlisting various international bureaucracies, such as the OECD, in a campaign to persecute low-tax jurisdictions.

The OECD is infamous for its blacklisting of free-market capitalistic economies which they have labelled low tax or no-tax centres, but this is just the tip of the iceberg. The European Commission pushed a ‘code of conduct’ designed to hinder tax competition for business activity and a savings tax directive to harmonise the taxation of personal savings. The United Nations has concocted various schemes involving global taxes, and endorsed several proposals to undermine tax competition. The Financial Action Task Force, the Financial Stability Forum and the International Monetary Fund have also pursued projects that – at the very least – harass capital-generating economies. That’s the bad news.

The good news is that tax competition has survived. Much of the credit belongs to the US-based Center for Freedom and Prosperity (www.freedomandprosperity.org), a non-profit organisation formed in 2000 to influence the US government’s approach. This proved to be a pivotal event. Thanks to the Center’s tireless efforts, more than 150 members of congress denounced the OECD’s anti-tax competition campaign. Combined with an aggressive campaign to educate White House officials, the Center was able to reverse the US position. Since creating an international tax cartel without US support would be like trying to create OPEC without Saudi Arabia, this effectively weakened the OECD’s power and gave low-tax jurisdictions the necessary leeway to defend their national interests.

The OECD has not abandoned its efforts. In all likelihood, the bureaucrats in Paris are biding their time, hoping that a more statist administration will take office after the next US presidential election.

In some sense, the tax competition battle is like a race. Politicians from uncompetitive nations like France and Germany are very anxious to thwart the global shift to lower tax rates and less oppressive tax systems – particularly since every time a country decides to lower tax rates or adopt a flat tax, the potential coalition of nations against tax competition becomes smaller.

This already has happened inside the European Union (EU). The Brussels-based bureaucracy has traditionally been an unrelenting advocate of tax harmonisation. Even today, the European Commission has a proposal to harmonise the way corporate income is defined. But this is a timid agenda compared to past proposals, and one of the reasons for this retrenchment is that nations such as Ireland, Slovakia and Estonia now realise that it is not in their interest to support such explicit tax-harmonisation policies. Prior to the dramatic tax cuts, Ireland probably would have been on the wrong side. And if Slovakia and Estonia had been EU members prior to adopting flat taxes, they would likely have sided with France and Germany.

Hopefully, the same forces will begin to weaken the OECD’s advocacy of bad tax policy.

This is why advocates of economic liberalisation should band together to protect tax competition. If enough nations respond to competitive pressure and improve their tax regimes, the OECD will, almost surely, be unable to generate momentum for a new assault on low-tax jurisdictions.

Before the Center for Freedom and Prosperity was created, it appeared that low tax and direct tax countries were going to be isolated and forced to change their market-oriented policies. Today, it is much more likely that France and Germany will be isolated and forced to change their statist policies. Not a bad ending for a story that had such a scary beginning.

Recently in the decision of Cuno v Daimler Chrysler, the US Supreme Court decided to support competitive behavior of States and voted in favour of tax competition.

Unfortunately, overbearing regulation is hampering capital generation and competitive markets. Excessive regulation costs about 8 per cent of GDP in the US. This is about US$3,500 for every man, woman and child. In some European nations it is believed that the cost is even greater as a percentage of GDP. Recently, the US Chamber of Commerce issued a warning that excessive regulation was beginning to affect the attractiveness of the US as a leading capital markets jurisdiction and that the country’s ability to maintain that role was threatened.

Law enforcement on a worldwide basis are engaged in a battle against identity theft, which has been partially caused by overburdening regulations. The imposition of obligations on financial service providers to collect extensive personal data on legitimate business persons, including their passports, driver’s licenses, electricity bills, national identity numbers and references has created more criminals instead of identifying existing ones. The cost of this regulatory burden is in the billions of dollars on a worldwide basis, excluding the cost to law enforcement of trying to stem the tide of this illegal activity.

It appears that many of the buds that have emanated from Brussels need to be more carefully pruned before they blossom into capital devouring and obsessive regulatory monsters. Europe, as it moves towards a more free market and competitive environment, lacks the intellectual debate which has developed in the US through various think tanks. Unfortunately, the remnants of the left-wing socialism era, which appears to have gathered in Brussels, has paid little regard to the historical fact that high taxed and over-regulated economies have been unable to generate the standard of living for the majority of its people, which has become more evident in low taxed and sensibly regulated economies. Hopefully the tide will change in the very near future.