Does Trade Liberalisation Trigger Tax Competition? Theory and Evidence from OECD Countries

• Published date: 01 January 2017
• DOI: http://doi.org/10.1111/twec.12405
• Author: Nelly Exbrayat
• Date: 01 January 2017

Does Trade Liberalisation Trigger Tax

Competition? Theory and Evidence from

OECD Countries

Nelly Exbrayat

University of Lyon, UJM-Saint-Etienne, CNRS, GATE L-SE UMR 5824, F-42023, Saint-Etienne, France

1. INTRODUCTION

ACCORDING to the seminal models of tax competition (Zodrow and Mieszkowski, 1986;

Bucovetsky, 1991; Wilson, 1991), capital mobility leads governments to strategically

decrease their capital tax in order to prevent their country from suffering large capita l out-

flows. Empirical research has generally been supportive of this proposition, both when analys-

ing the sensitivity of firms’ location choices to fiscal policy, as well as fiscal interactions

between governments. For example, comparing the results of 25 empirical studies on the

sensitivity of foreign direct investment to corporate taxation, De Mooij and Ederveen (2003)

estimate the median value of the tax base elasticity to be 3.3. Moreover, tax rates across

countries exhibit significant positive spatial dependence, suggesting the presence of strategic

interactions among governments (e.g. Cassette and Paty, 2008; Devereux et al., 2008; Over-

esch and Rincke, 2011; Redoano, 2014).

More recently, models using a new economic geography (NEG) framework show that the

intensity of tax competition depends in fine on the level of trade integration, through its

impact on the sensitivity of capital flows to fiscal policies. More precisely, the relationship

between corporate taxation and trade integration is non-monotonous (Ludema and Wooton,

2000; Andersson and Forslid, 2003; Baldwin and Krugman, 2004; Ottaviano and Van Yper-

sele, 2005). Unfortunately, almost all empirical studies on international tax competition

implicitly refer to the standard tax competition literature, according to which firms are per-

fectly competitive and there are no frictions to trade (Cassette and Paty, 2008; Devereux

et al., 2008). An exception is the empirical study by Davies and Voget (2011) on corporate

tax interactions in the European Union. Building on a stylised model of tax competition

between three countries, they show that firm location strategy is driven by the relative level

of after-tax market potential. Therefore, assuming that governments seek to maximise corpo-

rate tax revenues, the tax level in one country is more sensitive to that of countries where

firms enjoy a higher market potential. Davies and Voget (2011) provide empirical evidence

for this finding and show that governments respond more to taxes set in EU countries as com-

pared to non-EU countries, suggesting that European enlargement might exacerbate tax

This paper is a shortened version of a chapter from my dissertation. I am grateful to my supervisor,

St

ephane Riou, for his help and advice. For valuable comments and discussion, I am also grateful to

Aur

elie Cassette, Pierre-Philippe Combes, Ron Davies, Benny Geys and Sonia Paty, as well as partici-

pants at the VIIIth RIEF Doctoral Meetings in Barcelona, the 1st workshop ‘Economie et Espace’ in

Lille, the WZB seminar in Berlin, the workshop ‘Frontiers in Public Finance’ in Munich, the French

conference of spatial econometrics in Besancßon and the world conference of spatial econometrics in

Barcelona. This work was supported by the German Science Foundation (DFG) and the French Research

Agency (ANR) through the grant ‘Competition among Nation States’ [KO 1437/9-1].

©2016 John Wiley & Sons Ltd

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The World Economy (2017)

doi: 10.1111/twec.12405

The World Economy

competition. However, none of these studies investigate the specific –and ambiguous –

impact of trade integration on taxes. A first contribution this paper makes to the literature is

to translate the NEG framework into an empirical model that allows us to determine how

trade integration affects tax competition. This is important as it provides the tools to evaluate,

for example, whether further trade integration among OECD countries would exacerbate or

dampen tax competition.

Our second contribution likewise follows from the use of NEG models of tax competition.

Unlike most previous empirical papers –which define links between countries in an ad hoc

manner (for an exception, see Davies and Voget, 2011) –we set up a model of tax competi-

tion characterised by imperfect trade integration, increasing returns to scale and asymmetric

market sizes, from which we explicitly derive the tax reaction function. In such a framework,

the existence of agglomeration economies carries two implications regarding the slope and the

constant of the tax reaction function: tax interactions are stronger for the less populated coun-

try, and the constant of the reaction function is increasing with the number of firms that a

country would attract in a world without public policies. Indeed, the tax base elasticity is

lower in the bigger country that benefits from a higher market potential, so that the govern-

ment can tax agglomeration economies. Our empirical approach then consists of estimating

this tax reaction function with a panel covering (up to) 26 OECD countries over the period

1982 to 2006. Specifically, we test (i) whether tax interdependencies are linked to the relative

size of countries and the level of trade integration (using a theoretically grounded index of

bilateral trade integration), and (ii) whether market potential positively affects corporate tax

rates. Note that the latter tests whether further trade liberalisation, by improving the market

potential of countries, allows governments to raise taxes (through the constant of the reaction

function), whereas the former tests whether it contributes to the decline of corporate taxes by

fostering tax interactions (through the slope of the reaction function).

The paper proceeds as follows. We start in Section 2 with a brief description of the model

and present the tax reaction function that will be tested. The empirical specification is

described in Section 3. Our results and robustness checks are described in Section 4. The

results broadly support the theoretical prediction regarding the constant of the tax reaction

function. The real market potential exerts a positive and very significant impact on effective

average tax rate or statutory tax rates. The empirical evidence regarding the slope of the

reaction function depends on the weighting schemes. We provide clear evidence that national

governments significantly react to a cut in corporate taxation in the most populated countries

of the sample. The empirical evidence regarding the influence of trade integration on tax

interactions is less clear-cut. Our findings reveal that bilateral trade integration gives rise to

significant interactions with respect to effective average tax rates when we consider a subsam-

ple of European countries. Therefore, in the case of European countries, we provide empirical

evidence for the ambiguous impact of trade integration on corporate taxes in European coun-

tries. On the one hand, the decline in trade costs strengthens tax interactions and contributes

to a race-to-the-bottom in corporate taxes. On the other hand, trade integration improves the

real market potential of countries and thus allows government to set a higher corporate tax

irrespective of the tax policy in the other countries. Importantly, we further investigate the

mechanism driving tax interactions by allowing the coefficient on tax interactions to vary

depending on the degree of capital mobility in countries. Our findings reveal that when using

relative population weights, a country adjusts its tax rate to the average level in the other

countries only if those countries are characterised by an equal or higher degree of capital

mobility. In the case of trade integration weights, the evidence shows that strategic

©2016 John Wiley & Sons Ltd

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